Geeks only. The chart above shows (blue line) UK house price index from 1969 to date, January 1969 = 100, (red line) UK nominal rentals also indexed from 1969, and (green line) the deferment rate implied by these numbers, with base case an assumed net rental yield of 2.6% in 2018, using data sourced from Zoopla, assumptions about management and maintenance costs etc., and a formula derived from Gordon’s dividend discount model.
This shows that the deferment rate – the rate that drives both the cost of leasehold enfranchisement and the cost of the No Negative Equity Guarantee embedded in Equity Release Mortgages, changes through time, rather than staying roughly constant.
This has significant policy implications.
When I worked at the PRA on the paper that became CP 13/18, I had assumed that the deferment rate stays roughly constant. The rationale is that if rentals are expected to increase, this would increase the market value of properties, all other things being equal. But all other things aren’t equal: there is strong evidence that nominal rentals track price inflation, and also strong evidence that interest rates anticipate inflation. So an increase in expected nominal rentals should correlate strongly with an increase in the interest rate used to discount the same rentals, and the rental yield, hence the deferment rate, should remain roughly constant.1 I assumed this, and I imagine the PRA assumed this too.
The graph above suggests this does not happen. The deferment rate falls to around 3% at the end of the 1980s, coinciding with the Thatcher boom in property prices. It rises throughout the subsequent 1990s collapse in house prices, then falls again with the apparently relentless post 90s rise in property values.
This variability does not imply any fault in the model. The constancy hypothesis depends on two assumptions, namely (1) ex post correlation of change in nominal rentals with change in the overall price index, which includes more than just rent, and (2) correlation of ex ante interest rates with ex post change in the overall price index. Neither of these is guaranteed to turn out in practice.
But the variability does have an important policy implication. Suppose house prices go up. This will tend to decrease the loan-to-value of an existing equity release mortgage, which will decrease the cost of the NNEG. At the same time, the graph above suggests the deferment rate will also fall, which will make the NNEG even cheaper, given that the deferment rate is the main driver of NNEG cost. Conversely, a fall in house prices will make the NNEG more expensive because of the fall itself, while making it even more expensive because of the implied rise in the rate. The cost of the embedded guarantee is doubly geared to the state of the housing market.
Will the PRA incorporate this effect into its capital requirement regime for equity release? As I say to anyone who will listen, the recent spate of regulatory papers has been about capital available. I shall discuss this later.