David Miles, Professor of Financial Economics at Imperial College Business School, examines rising house prices relative to average household incomes, and highlights why home ownership may eventually become unsustainable for many.
Substantial fluctuations in the value of houses have major economic consequences. For existing home owners, fluctuations can result in huge gains or losses. For people hoping to buy for the first time, price rises far in excess of income growth can mean postponing home ownership for years; even decades. Financial regulators and central banks now have a range of policy tools (including limits on loan to value ratios on mortgages, capital weights on mortgage debt, and limits on the value of home loans relative to household incomes) that they are increasingly willing to use to try to head off the sort of fluctuations in house values that have been associated with financial instability.
But to assess whether movements in housing prices are making them over-valued or under-valued requires us to have some idea of the evolution of prices that are consistent with a sustainable path. My recent research with Professor James Sefton explores what such paths might look like, and how they are particularly sensitive to shifts in technology, land availability and household preferences.
Over the past seventy years or so, house prices around the world have risen substantially faster than the price of other consumer goods. National, real house prices (that is, relative to consumer goods) averaged across all developed countries have risen by an average of over 300% since 1945. In some countries, national house prices have, on average and measured over many decades, risen faster than incomes. By 2015, UK house prices relative to average household incomes were around double the level from the late 1970’s. In London, the rise has been greater still.
This raises a series of significant questions. Can we expect house prices to continue rising relative to the price of other goods? What accounts for the tendency of prices in some countries to rise in real terms – but at a slower rate than that of incomes – while in others, the house price to income ratio has been on an upwards trend for decades? Is there a natural limit to how expensive houses become in terms of consumer goods or incomes? As average incomes and populations change (and typically grow), can we expect the regional patterns of housing prices and developments to vary systematically? Why did worldwide house prices seem to rise very little before 1945, but then treble in the next 75 years? And can we expect technological progress to help stop land and house prices rising faster than other goods?
Our research explored these questions, focusing on the evolution of property values relative to incomes and other goods, and how differences across regions vary as populations and average incomes change. We paid great attention to how the technology for producing houses impacts long run outcomes. Of particular importance is the substitutability between land and buildings in creating housing – that is the extent to which one can create housing of a given quality by reducing the amount of land used but compensating for this by using more resources on the structure built upon it.
We found that the pattern of development, the types of houses built and the values of structures are all highly sensitive to even small changes with regards to two key factors: the degree of substitutability of land and structure in creating housing, and the degree to which households substitute between housing and non-housing goods as prices change. It is easy to find sets of parameters for these degrees of substitutability that are plausible, and which imply that house prices can rise faster than incomes for periods spanning generations. But it doesn’t take much of a change in these degrees of substitutability for house prices to follow radically different trajectories.
We reached some stark conclusions.
- If the demand for housing continues to be insensitive to price, then with population and average incomes rising, housing could become increasingly expensive.
- With many people only able to borrow a fraction of the value of a house, the owner–occupation rate could fall steadily and the rental sector could steadily grow.
- If population and incomes continue to rise at the rates typical over the past few decades, houses could become like jets – too expensive for most people to own, so almost exclusively rented – with people indirectly owning claims on houses (jets) via holding shares in property companies (airlines).
However, rising house prices are not inevitable. If technology means that the land use for constructing homes can shrink (e.g., by building higher but at no greater cost) then even if available land does not rise, house prices might fall relative to incomes. Even small variation in a handful of factors can generate paths for house and land values that are dramatically different.