Keeping an eye on things
As part of my work with the Leasehold Knowledge Partnership I am looking at how the deferment rate used in leasehold tribunal decisions can be estimated using market data.
It already seems, see my previous post on this, that the rental-implied deferment rate changes through time, to my initial surprise. But it is equally surprising that there are considerable regional variations.
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.
Yesterday the Institute announced that the project to research equity release mortgages will be delivered by the University of Kent, led by Professor Radu Tunaru (Senior Researcher).
Many readers, not all, will be familiar with the Herengracht chart shown above. As Wikipedia explains, the index – of house prices along the Herengracht canal in Amsterdam – was created by real estate finance professor Piet Eichholz of Maastricht University. Eichholz was frustrated by the tendency of papers to take a ‘long run’ view of house prices that only went back 20 years or so. He suspected there was a myth which says that real-estate values go up significantly over time, and that this is especially true for central city locations, so he began studying transaction records for the Herengracht area going back to the mid 16th century. More than 300 years of data should be sufficiently ‘long run’, right? His data ended up challenging that myth. Note that the chart here is adjusted for the Dutch retail price index.
According to the Equity-release-graph, the product continues to grow apace. £1bn lent in the third quarter of 2018. But if the trend continues, it will lead to the first of the two problems I highlighted in this previous post. Lending will follow house price growth, house price growth will fuel the capitalisation model used by ERM firms, which will capitalise future predicted growth. This will then result in the second problem, namely that if the growth is not realised, it will go horribly wrong. Note ‘not realised’. It will go horribly wrong even if the growth is flat, and because of the large amounts lent, it will be horribly wrong in a horrible way.
You have to ask what the BoE, the guardian of financial stability, was thinking of when it approved these models in 2016. Actually I know what it was thinking of, but cannot say.
The chart above shows the growth of the equity release market since 2000, based on figures published by the Equity Release Council on their website. Blue line shows the number of new customers (including returning customers) each year. The red line shows new lending for the same year.
Ian Mulheirn writes
The price of a property is overwhelmingly determined by the value of the land it sits on, which makes it inherently positional, and not something you can cut to zero. For example, you can’t reduce the value of the land in the City to zero (or even make a material dent in it) by liberalising planning in Surrey. The reason is that the value of the land is determined by the discounted stream of rent you can get from it. This is unrelated to the cost of building. If you build somewhere where nobody wants to live, the discounted stream of rent, and hence the property value, will be zero.
My emphasis. Any offers on that house?
The chart shows the Japan housing index 1975-2018 Q1. There is a fascinating history behind this but I won’t go into that now. The point is about the risk of something similar happening here. Banking and insurance capital models work on the principle of Value at Risk, i.e. the amount required to sustain a loss over a specific time horizon, to a specified probability. For example, the advanced Basel IRB model has a time horizon of 1 year, with a probability of 1 in 1,000. The Solvency II model has the same time horizon, but a probability of 1 in 200. So the first would last us from the succession of Cnut the Great in Denmark in 1018 until now, the second from the birth of Karl Marx in 1818 until now.
But I wonder. Could the probability of a Japanese-style collapse here in the UK (or anywhere else in the West) be only 1 in 200? Ask most professionals in the business of capital management and they will say so. The fact that it happened in Japan doesn’t mean it could possibly happen here. Japan is such a terribly different, utterly different place from Britain, that no connection can be drawn between the two scenarios.
But I still wonder. There is a good FT article (31 August 2018) by Gillian Tett about a Japanese central banker warning that a financial crisis was about to explode. Déjà vu, he was saying, presumably not in Japanese, referring to the banking crisis sparked off by the collapse of the baburu keiki, or bubble of the 1980s, leaving about $1tn of bad loans.
If it happened there, could it happen here?
Here’s an intriguing chart I found in the archives. This is the nominal mortgage cost of the average UK house from 1980 to the end of 2017. Don’t take it too seriously. The crude methodology is as follows. Take the average UK house price from the Nationwide index, andihe short term interest rate for the relevant quarter, adding on 50bp for the likely spread charged by the lender. It turns out the nominal (not the real) cost of the interest charged has not changed significantly since 1980.
I have to pinch myself every time I look at this. Impossible! Think how much earnings have gone up since the days of pinstripe suits and hairstyles that were a fire hazard.
But it’s true, because we forget how high interest rates used to be. In March 1980 the average house would cost you about £23,000. But the interest would have been about 15%, so the interest cost would have been about £3,500 a year. Fast forward to the end of 2017, when the average house now costs over a quarter of a million. But the interest rate has fallen to below 2%, resulting in an interest cost of about £4,500. Result: no housing crisis, housing is very cheap! Indeed a member of my immediate family was offered a deal of 1.8%, immediately halving the cost of rent.
As Ian Mulheirn suggests, see e.g. my post here, is it the fall in global interest rates that has driven the phenomenal increase in housing prices across the world?
Of course it’s not nearly as simple as that, but enough for now.
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.