There was a fascinating discussion between Ian Mulheirn and Robin Harding in the letters section of the FT a while ago (August 29 2018). Mulheirn, replying to an article by Harding (‘Planning rules are driving the global housing crisis’, FT August 15 2018), argued that:
The theory and the data clearly indicate that a shortage of homes has not contributed to the 150 per cent rise in UK real prices over the past two decades. Those who reject that conclusion should explain whether it’s the economic theory that’s wrong or the rent data.
The letter is behind a paywall in the comments section, but the substance is broadly as follows.
Mulheirn has been arguing for some time that it is the fall in global interest rates that has driven the phenomenal increase in housing prices across the world. His argument is based on three premisses.
First, that additions to the housing stock over the last 25 years have exceeded the growth of households.
Back in 1991 there were just over 3.0% more houses than there were households in the UK according to government data. Today, using the ONS’s latest household estimates, there appear to be 5.2% more places to live than there are households that want to live in them. 1
Hence the much vaunted shortage of homes is a myth.
Second, official figures like the ONS’s Index of Private Housing Rental Prices shows that the cost of renting actually fell in real terms from January 2005, to the end of 2014.
Third, the increase in house prices have been the result of interest changes, rather than ‘shortage’. Mulheirn’s argument is based on a simple dividend discount model used in the valuation of stock prices. If you think of net rental income as a kind of dividend, you can model the value of the house as the sum of rental cashflows in perpetuity discounted by a suitable funding rate, e.g. the risk free rate. As Mulheirn says here, the costs of owning a given house will tend to equal the cost of renting it in perpetuity, and that where these are out of line with one another, house prices will tend to adjust to bring them back into line. Thus:
If real global interest rates fall, as has been seen over the past 20 years, the effect is to lower the user cost of capital—both directly as mortgage rates fall, and indirectly as the opportunity cost of housing equity falls—and therefore boost prices for any given level of rent. Standard asset pricing theory would suggest that at constant rent, if the user cost of capital were to halve this would double house prices’. 2
In his comment on the FT letter, Harding takes him to task, arguing that such an adjustment is only ‘short term’, before we take supply into account. But if housing supply is fully elastic, ultimately house prices should fall back to the cost of building them. Since we do not see any sign of this, Harding says, it must be because of artificial restrictions on planning.
But Mulheirn rightly objects that ‘if rents are stable and prices rise because interest rates fall, that’s telling us that there is no shortage of housing services, of places to live’.
When you [Harding] say the ‘cost of a place to live’ that can only mean one of two things. To an economist it means the user cost or rent. But this is precisely the thing that has not risen relative to incomes in recent decades. Only the price of assets has (not a ‘cost’) – due to the falling cost of capital.
Thus the argument that ‘prices have risen because of a lack of supply’ isn’t true for the UK on the available data.
This has considerable implications for the valuation of the no negative guarantee embedded in equity release mortgages, as I shall demonstrate in a later post.
- ‘Is there really a housing shortage?’, medium.com, January 2016
- citing R. Hubbard and C. Mayer, “The Mortgage Market Meltdown and House Prices”, The B.E. Journal of Economic Analysis & Policy, 9: ISS. 3 (Symposium), Article 8. (2009)