What does the real price of houses tell us about the property market?
You may think that house prices have risen slowly but surely since the end of the credit crunch-induced crash, but house prices are still at 2003 levels – which is also where they were two years ago.
In the 18 months up to early 2009, house prices fell around 25% to just under £150,000, according to quarterly data from mortgage lender Nationwide. The last time house prices were so low was back in the first half of 2004, so we lost five years' worth of house price increases.
Since then, up to the final quarter of 2010, prices appear to have risen by 9%. And so they have. If you buy an average UK home now at an average price it'll cost you between £160,000 and £170,000. This appears to bring prices back to early 2006 levels. Again, that was five years ago.
Yet, in real terms, prices have barely moved at all over the past two years. In fact, in real terms, prices fell during the crash not just to 2004 levels, but down to 2003 levels. Indeed, real prices are still today at autumn 2003 levels.
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What do I mean by 'real prices' and 'in real terms'?
When you see the word 'real' in financial jargon, it doesn't mean 'non-imaginary' or 'not fake'. It means that it takes into account inflation – the rising prices of all the goods and services we buy, or to put it another way the rising cost of living.
If the government freezes spending at £700bn at a time when prices are rising, it means the budget has been cut in real terms, because the same amount of taxpayer money can't buy as much as it used to.
Similarly, if house prices rise 1% and so does average inflation, in real terms house prices haven't changed. House prices generally go up as the cost of living goes up, plus a bit more. Any increase over and above the cost of living is a 'real' increase. Anything less is a 'real' decrease.
No real increase for eight years
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Now you understand the difference between real house prices and 'unreal' – actually called 'nominal' – house prices, I can explain to you that the 9% increase in house prices over the past two years has been almost completely wiped out by general inflation. Hence, the real house-price increase, according to Nationwide data, has been just 1% over the past two years. So basically, in real terms, we've had no change to house prices since the end of the crash.
What's more, when adjusting for inflation in this way, house prices today are at the same level as in the second half of 2003. You can see why, when you read Inflation rockets to 4%.
What does all this mean?
In terms of the future of the property market, no real change in prices since 2003 means the chances of another crash becomes less likely. That is not at all to say that it is unlikely, however. Even in 2003, some commentators were warning that a bubble had occurred, and I see there are plenty of reasons why prices might fall again.
One of those is our earnings. Our earnings have not been increasing in line with inflation recently and it's very possible that 2011 will be the same. This will put downward pressure on house prices. Then we have rising interest rates, a potential double dip, tighter lending, unemployment, and unmanageable debt levels being just a few more possible causes of another fall.
A soft landing
Despite those warnings, the high inflation we're experiencing makes a soft landing possible. A soft landing is a correction to house prices through cost-of-living inflation rather than falling house prices.
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You see, there are two ways mis-pricing can correct. House prices might not fall to what many think is the 'right' level, but instead the right level will rise swiftly due to high general inflation and the big pay increases that eventually result from inflation.
Homebuyers should prefer house prices to correct by a straightforward crash, so that the deposit they need doesn't stretch further away from them. Homeowners looking to upsize should also prefer a crash, as it's more likely that they'll save more pounds on buying the bigger property than they'll lose when selling their smaller one.
Conversely, homeowners looking to downsize should prefer a correction through inflation for the opposite reasons: they will probably see the house they're selling go up more in pound terms than the one they're buying. Also, any homeowner worried about negative equity – when the price of the property falls below the outstanding mortgage – will prefer that high inflation supports or pulls up the fair price of their property.
The main point I'd like you to take from this is that inflation is yet another factor that makes forecasting property-price changes over the short term nigh on impossible – without a large dose of good luck, anyway. Take a look at The economy in 2011: what the forecasters say for an idea of the difficulties that you face when trying to read the future.
Interesting as this may be, when it comes to property decisions, forecasting is one of the last things you should worry about. Read why in Now is the time to buy property.
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