Why are houses so expensive? The answer has less to do with simple supply and demand considerations than you might think. A lot of the reason for stratospheric house price increases over the last 20 years is simply that these days, houses are financial assets.
For a buy-to-let investor, or someone owning a flat as part of their pension plan, the 'interest rate' they receive is the annual rent, divided by the value of the house. You'd expect that this 'rental yield' would need to be in the same ballpark as the yield on government bonds or savings accounts, and it usually is – rental yields over time have shown a fairly stable relationship with gilt yields.
So what happens when quantitative easing drives gilt yields down? Rental yields have to follow them. But rents don't often get cut; they tend to rise in line with average incomes. So the only way for the yield to fall is for the denominator of the fraction – the house price – to increase. In fact, people like Andrew Lilico argue that there is no housing shortage in the UK: rents have risen slower than the consumer price index over the last 10 years, and all the movement in house prices has been driven by interest rates, rather than supply and demand.
A lot of the reason for stratospheric house price increases over the last twenty years is simply that these days, houses are financial assets
So, is rampant house price inflation a necessary consequence of monetary policy? Well, let's look at that first assumption: 'Houses are financial assets'. Was this always the case? How could it change?
In fact, you can reasonably say that British housing became a financial asset on 28 February 1997. This was when the new version of the Assured Shorthold Tenancy (AST) was brought in, effectively reducing the notice period for British tenants to two months. The first quarter of 1997 also, and not coincidentally, saw the 'buy to let' mortgage market take off as a major category in the lending statistics.
The AST and the buy-to-let market were symbiotic developments; they were invented in order to support each other. Such short rental agreements are not necessarily a benefit to either tenants – who have no security of tenure – or to landlords – who get a procession of short lets to people with no incentive to maintain the property. However, it is a vital issue for mortgage lenders.
Houses with sitting tenants are difficult to sell, and banks and building societies are not set up to act as landlords. Because of this, they have always been very reluctant to make a loan if they are at risk of ending up having to repossess a house with a tenant in it. For this reason, before 1997 it was very difficult to get a mortgage to finance rented housing.
This was inconvenient from the point of view of public policy of the day. After years of Right To Buy and the consequent erosion of the council housing stock, Britain was facing a genuine shortage of rental properties. It was felt that something needed to be done to bring private sector capital into the rental market. The changes to the AST were the solution offered.
As a solution it worked, possibly too well. Lenders became not only willing, but eager to lend to buy-to-let investors, who became the marginal investors in housing. Because mortgage loans required little regulatory capital for banks to make, and could be easily financed in the securitisation market, supply was effectively unlimited. As the British middle class steady lost confidence in other asset classes after a series of scandals and crashes, the demand for houses as savings vehicles was also, for practical purposes, nearly unlimited. And then interest rates began to fall…
Rather than making houses cheaper to buy, why not make it less unpleasant to rent?
And here we are now. It is unlikely that any realistic housebuilding program will have much effect on rents. And it seems unsatisfactory to say that one day interest rates will rise and house prices will have to fall or stagnate. The AST is the source of the problem, so it needs to be the starting point for a solution.
Rather than making houses cheaper to buy, why not make it less unpleasant to rent? In Germany, for example, people seem very happy with a homeownership rate much lower than ours. They typically occupy property on leases of five years or more, giving stability and allowing them to maintain and improve their living space. German residential landlords are typically not leveraged, as a result, and Germany has not seen anything like the house price inflation observed in markets where housing is part of the financial sector.
Moving the UK to this model could not be done overnight but it would not be impossible, and as well as helping tenants, it would gradually bring about the end of the buy-to-let bubble. The experiment with moving the pension savings of the British middle class into property has had a fair chance, and it has not delivered the goods.