Wednesday 5 July 2017 11:31 am

High London house prices are not a bubble waiting to burst

John Hawksworth is Chief Economist at PwC

History is replete with examples of financial bubbles, from Dutch ‘Tulipmania’ in the 1630s and the South Sea bubble of 1720, through to the Wall Street Crash of 1929 and the dot com boom and bust at the turn of the twentieth century.

Could London house prices be the next big bubble to burst?

To answer this we first need to define what we mean by a bubble. Generally this involves prices of some asset being pushed up to levels far in excess of any rational assessment of intrinsic value, leading to a subsequent crash as reality reasserts itself.

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How to spot a bubble

But, in practice, while it is easy to spot bubbles in retrospect, it can be far harder to do so at the time.

One reason for this is that there is normally some kernel of truth at the heart of a bubble.

Tulips were a relatively new and highly valued flower in Holland in the early seventeenth century. Strong post-war US growth driven by electrification and the expansion of the motor industry did offer some justification for rising US share prices in the 1920s. The web was a revolutionary new technology that offered many potential new business opportunities in the late 1990s.

Smart investors who spot these trends early can make exceptional returns. The problem arises when speculation and hype push prices far beyond what this kernel of truth justifies. But even here it can be rational to keep on investing so long as prices rise, relying on your ability to sell out before the crash comes. Fund managers who sit on the sidelines can lose their jobs.

Eventually though, the smart money does sell out and those who bought late in the cycle often face ruinous losses as everyone heads for the exits at the same time.

Double double London trouble

Do London house prices fit this profile? The top end of the prime central London market, in which prices have fallen back in some areas, does have some of these characteristics.

In this market, many rich overseas buyers were seeing London property as a purely financial investment to be held for capital gain, rather than as a place to live or even to rent out.

Such pure financial investments tend to be more prone to speculative bubbles, though house prices will generally be less volatile than share prices given the higher transaction costs involved in buying and selling properties.

In the case of prime central London property, sharp increases in stamp duty and the post-Brexit fall in the pound may have made these investments look much less attractive, so raising the possibility of a significant price correction.

For London property more generally, however, the case is much less clear. It is certainly true that traditional metrics like the ratio of house prices to incomes have reached record highs in recent years in London, which could raise concerns that a bubble was emerging.

Why are London prices so high?

But against this, there are several fundamental factors that support this high price to income ratio.

First, real mortgage rates remain very low by historical standards – indeed these may actually be negative for many borrowers given the recent rise in UK inflation to close to three per cent.

Second, land with permission to build remains in chronically low supply within London and the green belt acts as a corset preventing high levels of new housebuilding in the immediate area around the city.

The government is trying to make the planning process run quicker, and to release public land where possible, but it will be a slow process to make up for a housebuilding backlog in London that has been accumulating for decades.

Third, despite some recent decline in immigration following the Brexit vote, the population of London continues to rise faster than any other part of the UK according to the latest ONS estimates. So the underlying drivers of housing demand remain strong.

This is not to say that London house prices will keep on rising at anything like the very rapid rates seen between 2009 and 2015. The central London price boom is certainly over for now and price rises have also moderated in outer boroughs. Indeed, since early 2016, the fastest house price rises have been seen in commuter towns outside the M25 rather than in the capital itself.

But I think it would be premature to talk about a London house price bubble that is about to burst given the fundamental supply and demand factors underpinning the market. I would therefore expect average London house price rises to be sluggish for the next two or three years, but not for prices to crash.