There’s more to house prices than interest rates

Lisa Panigrahi and Danny Walker

The average house in the UK is worth ten times what it was in 1980. Consumer prices are only three times higher. So house prices have more than trebled in real terms in just over a generation. In the 100 years leading up to 1980 they only doubled. Recent commentary on this blog and elsewhere argues that this unprecedented rise in house prices can be explained by one factor: lower interest rates. But this simple explanation might be too simple. In this blog post – which analyses the data available before Covid-19 hit the UK – we show that the interest rates story doesn’t seem to fit all of the facts. Other factors such as credit conditions or supply constraints could be important too.

Chart 1: Real house prices in the UK

Interest rates have fallen substantially in the UK over the past few decades. The rate on 10 year government bonds – the ‘risk free’ benchmark – is under 1% today, compared to 5% in 2000 and 12% in 1980. In real terms, the 10 year rate is around 7 percentage points lower than it was in 1980. Rates have fallen in many advanced countries, not just the UK. In fact, as Chart 2 shows, the fall in UK rates since 1980 is slightly less than the average across a sample of advanced economies.

Chart 2: Nominal long-term rates in advanced economies

In a standard asset pricing framework, a fall in risk free rates mechanically translates into a rise in asset prices. Discount rates are made up of a risk free rate plus a risk premium. This framework would predict large rises in the prices of many assets in response to the fall in risk free rates in recent decades. Given the fall in UK risk free rates from 1980 to today, a fictional asset that pays out a constant 9% of its price in cash every year and with a constant risk premium of 4%, would have quadrupled in price all else equal.

An influential academic paper from the 1980s showed that housing can be modelled like any other asset. The ‘user cost’ of owning a house should be equal to the rent. If prices were too high, there would be an incentive to rent, which would lead to a fall in prices. A recent post on this blog based on a paper by Miles and Monro (2020) found that the fall in rates over the past four decades, combined with the increase in incomes, might explain all of the rise in UK house prices since then.

But there are a number of facts that this framework doesn’t seem to explain.

The timing of the fall in rates and the rise in house prices doesn’t line up. Chart 3 plots the path of both variables for the UK. There are two periods that stand out. In the decade from 1990 to 2000, UK house prices rose by just 30% while rates more than halved, falling from 11% to 5%. Then from 2000 to the start of the financial crisis in 2008, house prices doubled while rates barely budged. Since the crisis rates have fallen to just above zero and house prices have risen by a further 20%. They have remained flat in real terms on average.

Chart 3: Nominal UK average house prices and nominal long-term rates

UK house prices have risen by more than in almost any comparable country. As Chart 4 makes clear, only three advanced economies – Australia, Norway and Spain – have seen a bigger rise in prices than the UK since 1980. At the other end of the spectrum, house prices in Japan are barely above their 1980 level. All of these economies have seen a similar fall in interest rates to the UK. If UK house prices had grown at the same rate as in the average advanced economy, they would be at half the level they are at now.

Chart 4: Nominal average house prices in advanced economies

The framework doesn’t account for house price growth in other countries. We have calculated what a user cost model would predict for house price growth in the UK and other countries since 1980. The model we use is the same as the one used this previous post and explained in some detail in this working paper, with a different data source. We input actual data on average rents and interest rates for each economy and hold all other factors constant over time. As Chart 5 shows, this model works relatively well for the UK, predicting only slightly higher price growth than we observe in the data. However, for countries like Germany, Italy and the US, the model predicts house prices of more than double the actual level in the latest data.

Chart 5: Predicted house prices in advanced economies vs actual prices

Other UK asset prices have risen by the same amount as in other countries. Given the growth in UK house prices, you might expect other UK asset prices to have risen a lot too. The most accessible risky asset class for households, apart from housing, is equities. Chart 6 compares UK equity prices to other advanced economies. Since 1980 equity prices have risen by almost exactly the same amount in the UK as in the average advanced economy.

Chart 6: Nominal equity prices in advanced economies

There has been large variation in house price growth across regions of the UK. Chart 7 shows how house prices have evolved at the local authority level in the UK over the period for which the statistical authorities produce data. London has seen the highest growth in house prices of any region. The City of London, Newham and Waltham Forest have all seen prices quintuple since 2000. In Blackpool, Burnley and the Isles of Scilly prices have risen by less than half as much over the same period. On a regional basis, house prices in the North East have grown the slowest. A previous post noted that rates alone would not explain this regional variation.

Chart 7: Nominal house prices in UK local authorities

The framework doesn’t account for differences in house price growth across UK regions. We again use a user cost model to predict regional house price growth, taking into account how rents have varied across regions and over time. We look at price growth since 2005, which is the period for which the statistical authorities produce data. And we hold all other factors constant, apart from the fall in rates, which applies to all regions. Chart 8 shows that though this model performs fairly well for the West Midlands and the North West, it under-predicts house price growth in London, the East and South East, and over-predicts it for the other regions. This may be because for regions like London, expectations of rental growth have risen over this period, or because houses in these regions are increasingly seen as safer assets than those in other regions.

Chart 8: Predicted house price growth in UK regions vs actual growth

So what might the framework be missing?

All economic models involve abstractions and simplifications – if they didn’t they would be useless. But given the importance of housing to economic growth and people’s wellbeing, and that changes in house prices could impact financial stability, we need a model that captures the key drivers.

There could be a role for changes in credit conditions. The framework assumes that people are not credit constrained, meaning they can exploit arbitrage opportunities by buying up rental properties. If there are frictions in practice, this could mean that credit conditions matter for house prices. Mortgage debt expanded rapidly as house prices rose in the UK before the crisis, so this could be an important channel for the UK.

The framework does not include an explicit role for supply elasticity. In practice, evidence suggests that housing supply responds very differently to prices in different countries and regions. The Barker review of UK housing supply pointed to low elasticity of supply in the UK. Where supply elasticity is low, as is the case in the UK, the same change in rates will have a larger impact on prices and rents. More work is likely required to document UK supply elasticities in detail and to explore what different elasticities have meant for growth in prices and rents over time and across places.

It’s hard to measure how expectations and risk premia vary over time and place but this could be important. Within the framework, an increase in rental growth expectations or a fall in risk premium would imply an increase in price. There is some evidence to suggest that returns on housing have been similar to other risky assets and relatively constant over the long term.

Other relevant factors might include maintenance costs and taxes. Maintenance costs have risen in line with inflation in the UK. UK property taxes are small and have been relatively flat – but there is evidence that higher taxes would likely reduce house prices. All of these are subject to considerable uncertainty.

Regardless of the consequences of Covid-19 on house prices, the long-term drivers discussed here will remain crucial parts of policy questions in coming years. Future research might be needed to better quantify some of these factors and to build them into a richer modelling framework that considers interactions between interest rates, credit conditions, rents and house prices.

Lisa Panigrahi and Danny Walker work in the Bank’s Macro-Financial Risks Division.

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13 thoughts on “There’s more to house prices than interest rates

  1. It is good to see the post acknowledge the important role of supply in explaining house prices. As the authors are no doubt aware, there is extensive spatial economics research on that point, and a consensus in that field that extremely low supply elasticity is a primary cause of high house prices in London and the South East (compared to the counterfactual of high supply elasticity).

    I hope that future posts will explore more of the existing spatial economics research; some of the previous posts by other authors do not seem to have fully taken account of it. (There are helpful summaries in, for example, the Handbook of Regional and Urban Economics, edited by Duranton et al.)

  2. In my home city during the decade up to 2008 house prices trebled.
    The population over that period barely changed – increased only on the previous long-term trajectory for northern UK cities.
    Change in demand from an increased population did NOT drive the rise in prices here.

    Rapidly lowering interest rates and increased supply of credit to borrowers (higher multiples of earnings secured on the rising asset values) created the mortgage feeding frenzy that drove the increase in prices. That was supplemented with the drive of many owners to invest in buy-to-let as well as their own homes supported by availability of easy credit on the same basis, and the artificial confidence that increases in the values of their own properties spawned.

    If interest rates had fallen more slowly, the effect might have been different, and other factors might have played a larger part. But the rapid resetting of base prices for housing was entirely down to the lowering of rates at an unhealthy speed.

  3. I do think there’s definitely an increase in urbanisation, with people moving to the larger cities, which would account for a fair chunk in the differences between regions.

    Be good to see if this can be included in a model.

  4. I am always surprised that economists despite the example of the GFC seem so reluctant to accept or even investigate the notion that bank generated credit might have anything to do with the rise in house prices.The huge increase in private sector credit dates from the nineteen eighties private Banks in the UK were allowed to enter the mortgage market allegedly to create competition with building societies. It is a total money spinner for the Banks. As one of the chief economists of a private bank said to the recent Australian Commission on Banking house prices are driven by “the demand for and supply of credit not the demand for and supply of houses”

  5. Responding to Ecgbert King, I think some of the discussion may be at cross purposes. Without the decrease in interest rates or increased credit, I agree that of course there would have been a much smaller increase in price. Equally, with plentiful supply of homes as happens in many different housing markets, there would have been little or no house price increase, whatever the decrease in interest rates or increase in credit. All of those changes were causes. The difference is that we can improve housing supply much more easily than we can increase, for example, real interest rates, and that a shortage of housing leads to enormous deadweight losses in welfare.

  6. To me this study completely ignores two important factors:

    1. The baleful influence of pension scheme scams and the raids carried out on pensions by various governments.

    2. Population increase and subsequent increase in demand for housing

    Everyone needs a roof over their head, and everyone needs somewhere to stash their savings. Given the choice between renting and pensions/ISAs/stocks & shares, or buying/mortgage/property price rises, the choice becomes obvious. Your owned home is one of the few assets that is almost impossible for the government to raid whilst simultaneously providing a vital service to you 24/7/365.

    Combine that with the collapse of pension schemes, laughable annuities, and an unedifying procession of City spivvery, it is hardly surprising that a large sector of the population regards retail finance with great suspicion and piles into housing instead.

    Add to the house price feedback loop this creates the increased demand for property by an expanding (largely urban) population, the UK’s house price inflation is mostly explained. For these reasons, despite fluctuations of a few percent, I think a house price crash is vanishingly unlikely, certainly in the South-East. The only event that could cause this would be overall, profound, permanent economic collapse. I doubt even Covid can do this.

  7. Chart 8: Predicted house price growth in UK regions vs actual growth , it can be easy be explained by GDP per capita, on the right richer counties on the left poorer.

  8. Far too many people have bought investment properties creating a false sense of lack of supply in the first time buyer housing stock

  9. In my view a key determinant of house price growth is the underwriting standards applied by lenders. Pre GFC here basically was no regulation on how to underwrite a loan from an affordability point of view, but underwriting was mainly asset based. And with the banks being able to increase the money supply, the upwards spiral started. Different underwriting standards between different countries is likely to explain part if not all the difference in asset growth. Luckily the regulators have realised the need to focus on affordability, and forced strict rules on the lenders. There have been some side effects, but that is better than the alternative, which would have brought down the system. Leverage needs to be strictly controlled, and affordability focus does that.

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