This time last year, prospects for the mortgage market didn’t look too positive. Demand in the first half of 2005 had been poor, though it had picked up a little by the third quarter. In September gross advances passed the £25bn mark for the first time in 15 months, but still there were few commentators who were prepared to argue that mortgage lending in 2006 would exceed £300bn by a significant margin.
So we’ve all been pleasantly surprised by the healthy growth in the mortgage market this year. The Council of Mortgage Lenders (CML) statistics show that gross advances should reach over £335bn this year, which is an increase of more than 15% over 2005. And the rise in demand for mortgage products has been remarkably steady, taking account of the usual seasonal fluctuations, which has made it easier for lenders and intermediaries to respond to the higher level of demand and meet the needs of their customers. From only £72bn in Q3 05, gross mortgage advances rose to £82bn in Q4, and have subsequently risen by £1bn a quarter to total £85bn in Q3 06. And advances in October, at £29bn, continue this strong trend.
This strengthening in demand has also been reflected in house prices. In Q3 05, the annual rate of increase in house prices, measured as the average of the indices published by Halifax and Nationwide, was running at only 2.8% - its lowest rate for nearly ten years. Since then, the rate of house price inflation has risen steadily, standing at 7.5% in Q3 06 and certain to rise to 9% in the final quarter of this year.
It’s worth considering why demand this year has proved to be so much stronger than expected as this should shed some light on the all important question of how the market will fare in the coming year.
The simple answer is just that most commentators were overly pessimistic. And it seems to me that they were unduly cautious on two counts.
First, they argued that improved retention activity by lenders would result in lower levels of remortgaging and, as a consequence, a reduction in gross mortgage demand. On this basis, they believed that net mortgage advances might match the levels of 2005, but gross mortgage demand would fall. As we know, this has not happened. Measured as a percentage of balances outstanding at the start of the year, 2006 has seen an increase in remortgage activity from 22.5% to 24.0%. As a result, the value of remortgage lending (measured as the difference between gross and net advances) increased by £33bn.
Secondly, and perhaps the more important error in terms of reading the market, was their belief that net advances would not increase. They believed this to be the case partly because of perceived weakness in consumer confidence. Although the base rate had been reduced back to 4.50% in August 2005, the beneficial impact of this was expected to be more than offset by adverse trends in energy prices, council taxes and in unemployment. But the major reason for the commentators’ pessimism was their belief that house prices were overvalued.
Now we have all grown accustomed to the idea that the ratio of house prices to earnings has moved to a new level of equilibrium. Whereas in the period 1970-1999, this ratio fluctuated (markedly) around an average rate of four times earnings, it now appears to be maintaining a rate of over six. And, as long as interest rates remain at 4.00%-5.50% and do not rise back to the levels of the mid -1990s of 5.50%-7.50% (or worse), this higher ratio is sustainable.
However, at the beginning of this year there were confident assertions that, even when the change in interest rates was taken into account, the rise in house prices was beginning to outstrip buyers’ ability to pay. As a result, the sceptics believed net mortgage advances would at best only maintain 2005’s level of £91bn.
So, what has driven this year’s growth in net advances which, with October’s buoyant £9.8bn, now looks likely to reach over £107bn? Partly it is down to the fact that anticipated increases in household bills such as gas and electricity have not (yet) been as large as expected, and the feared rise in council taxes barely registered at all. Real incomes have therefore been stronger than predicted and this has boosted consumer confidence.
It would also appear though that house buyers are not prepared to listen to pundits who tell them that they’re paying too much for their houses. Rather, they want to make up their own minds as to whether the price being asked for the property they are thinking of buying is reasonable or not. Certainly, it would seem that the rate of increase in house prices is currently being driven by fundamental supply and demand factors rather than by temporary speculation. There is little evidence that buyers are driving prices higher because they want to make money on their properties. Estate agents report that enquiries from potential new buyers remain steady rather than reflecting an inflation bubble. The increase in demand is in line with the growth in real incomes.
What appears to have driven house prices higher this year is a shortage of supply. This reflects the overall shortage of homes at a national level as the number of new properties built continues to be restricted by planning issues. However, it also reflects a sharp fall in the number of new instructions to sell property from existing owner-occupiers. Consequently, at local level, prices are being bid up as buyers chase a limited supply of available properties.
Can this continue? The mood within the mortgage industry suggests it can. The rise in base rate in August does not appear to have had much impact on demand and there are commentators who believe that the November increase will also make little impression. However, I am not quite so confident.
The reason for my less optimistic view revolves around affordability. This is not because of concerns about overvaluation in the level of house prices, but because of the higher cost of servicing debt following the increase in base rate to 5.00%. I do not believe that the housing market can shrug off increases in interest rates indefinitely. Yes, the increased use of fixed rate loans will undoubtedly have reduced the impact of the base rate rise across the market as a whole. It will have an impact, however: there will be buyers who previously would have extended their commitments in order to move who will now decide to postpone moving until the economic environment appears more certain.
And the stronger the housing market remains, the more the MPC is likely to be concerned that monetary policy still remains too accommodative. Not only have house prices risen, but equity prices have risen too. The growth in lending, particularly in the mortgage market, is seen by the hawks on the MPC as being too strong and posing a risk of further asset price appreciation. These factors all point to an increase in inflationary pressures and this would be a justification for restraining demand with another rate rise.
Ultimately this argument may become self-fulfilling. If the housing and mortgage markets do slow down in response to the rise in base rate to 5.00%, there is a reasonable chance that the MPC will hold off raising interest rates again. If demand in these two markets remains strong, the MPC will feel that it has to raise rates again.
So, looking ahead, I cannot see that prospective buyers will have quite the same confidence in the market that they have displayed this year. The mortgage market in 2007 is unlikely to be as strong as this year.
However, that does not mean that the market is poised for a downturn or that house prices are likely to collapse. I still believe that demand for mortgages will grow next year, albeit bolstered by continuing high levels of remortgaging. I would suggest that gross advances next year should approach £360bn. This would be consistent with the rate of house price inflation slowing from its current 9%-10% to be around 4%-5% at the end of next year.
Peter Charles, Chief Economist at Mortgage Express
