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Bond managers often thrive on a steady diet of bad news. Recessions are the trigger for lower yields, steeper curves, volatility and more attractive corporate yields. Fortunately for some but unfortunately for U.K. bond managers, the U.K. economy has recently offered little to feed our natural appetite for bad news. Wages are stable, employment is growing (despite higher unemployment), profits are strong and business and consumer sentiment are holding up in spite of higher interest rates. All in all the economic landscape seems to conjure no interesting ‘speed bumps’ or negative surprises. Economists have almost given up trying to identify triggers that could upset this ideal state of affairs.

In search of solace from all this positive news, I spent a recent weekend re-reading the book by Fred Harrison, Boom Bust: House Prices, Banking and the Depression of 2010. As the title implies, this is hardly a cheerful book. Harrison’s analysis, though, is worth a closer look even if you aren’t a bond manager searching for solace from all the good news. The essence of the book is to review why there has been such a regular boom-bust cycle in the U.K. economy over the past 400 years. Harrison makes the case for the existence of an 18-year business cycle, which is intrinsically linked to speculation in the property market and, in particular, land prices. As Table 1 highlights, there seems to be long-dated evidence that the 18-year cycle is more than just the creation of a fertile imagination.

In Harrison’s view, the boom part of the cycle lasts 14 years on average and is followed by a bust period that lasts four years. The genesis of the relationship between money and land prices is the fact that Treasury laws set the maximum rate of interest at 5% in 1714.

The interest rate of 5% meant that participants in building societies took 14 years to raise enough cash for every member to secure a house. In principle, this by itself should not have caused a boom-bust cycle, but the reality was otherwise. The rise of building societies created the equivalent of financial booms in the housing market that were followed by a bust once the excessive supply, or the inability of the builders to rent or sell, led them to bankruptcy. The last phase of the boom is the most interesting one. Harrison appropriately calls it the ‘Winner’s Curse’. During the Winner’s Curse phase, trading in real estate and land becomes frenetic and the dominant psychology is that properties must be purchased at all cost. The activity in the real estate market during this stage is almost exclusively driven by speculation. Fred Harrison describes it as follows:

In the market for houses in Britain, the Winner’s Curse is signalled by the advent of ‘gazumping’. Vendors double-cross people to whom they have already agreed to sell, in favour of a latecomer who trumps the price that the previous bidder last thought of. This is the process of random errors in action on the doorstep. The winner’s success is a curse to him and everyone else: the price is unbelievably high.

Eventually this frenzy gives way to a levelling off as doubts start to creep in. At some point, ‘the horror dawns’ as investors realise that the yield on the properties bears no relationship to the price paid for them. The bust phase follows.

Back to the Future

Looking at 2007 and beyond, there is no question that parts of the U.K. property market bear the hallmarks of the Winner’s Curse phase. Three aspects in particular seem to stand out as symptoms of the curse. Firstly, affordability is declining fast, particularly for first time buyers. Secondly, buy-to-let schemes, which have been increasing in importance, are now facing negative cash flows. Finally, the valuations in areas of London are truly out of sync with economic reality.

Affordability has been declining for a while, but the trends of the last three months have exacerbated the problem. At an overall level, the house price to earnings ratio is running just under six times, compared to a ratio of three times in 1993 when the rally started. The fact that this level of valuations has not been seen for a very long time does not seem to worry the pundits because they argue that interest rates on a nominal and real basis have returned to very low levels. This is indeed true, and without any doubt, declining real yields have been a key factor behind this extraordinary rally. The day in May 1997 when Chancellor Gordon Brown made the MPC independent was indeed a great day for homeowners in the U.K., but you cannot live off that forever. Following the recent hikes in the base rate, a new borrower will on average spend 45% of take-home pay putting a roof over his head.¹ Simulations done by Capital Economics, a consultancy group headed by Roger Bootle, suggest that a move by the MPC to 5.5% combined with an appreciation by just 8% year-over-year would push this figure to well above 50%. The 30-year average is around 37%. The real problem of affordability appears clearer, though, when you look at first time buyers. Initial mortgage payments for a first time buyer amount on average to a whopping 120% of take home pay.¹ This level has not been seen since the last ‘curse phase’ in 1991 and indicates that you now need 60% of both salaries for a newly wed couple to afford a dwelling. Not surprisingly, first time buyers as a proportion of new home sales represent just over 10% of overall turnover compared to a peak of 30% in 1993 when the rally started. I might be somewhat simplistic in my views, but it is difficult to see how a real estate rally can be sustained if first time buyers cannot afford to buy a house at the peak of the economic cycle.

The buying so far in this cycle has been led by the ‘buy-to-let’ brigade. The data speak louder than words. Mortgage approvals accounted for by the Bank of England have increased from a low in early 2005 of just under 80,000 per month to a current level of 130,000 per month. This figure includes buy-to-let schemes. If, however, you take out the buy-to-let transactions, as per the data published by the Council of Mortgage Lenders, the rise in approvals as seen in the chart below looks a lot less impressive at around 80,000 per month.

At the moment, the buy-to-let market is nicely supported by the wave of new immigrants, which has beefed up the numbers looking for rentals. At the margin, however, the business underpinnings of this activity are starting to look more fragile. Capital Economics suggests that landlords can expect gross yields of 3.9% in 2006-2007, but can expect running losses in 2008. At a gross yield of 3.9% anybody with a mortgage greater than about 70% would in fact already be losing money. A study conducted by Keefe, Bruyette, Woods Ltd. suggests that the marginal investor who is exposed to just one property and has borrowed 85% of the property value would already have a negative cash flow of around £1,000 per annum. While most reports are pretty bullish about the outlook for the buy-to-let activity, the data would suggest pretty clearly that the logic of getting into this activity is entirely related to the expected appreciation. This would be pretty symptomatic of the Winner’s Curse rather than of a healthy real estate market about to make multi-year price increases.

The final aspect of the U.K. real estate market that seems to bear the hallmarks of the Winner’s Curse is London property prices. Estate agents qualify recent activity as a ‘frenzy’ and the current level of prices appears to justify their characterisation. The table below, sourced from global property specialist Knight Frank, gives some indication of the relative insanity of London prices relative to the rest of the world:

The figures come with huge disclaimers and refer to small samples of top-end properties that might create an upward bias in the average number. The point still holds, however, that London is rapidly getting to levels where the best comparison seems to be Tokyo in the heydays of the late 1980s. At that point, the Japanese model looked rock solid and nobody questioned the logic of real estate prices because that was the place where the business was happening. The transient nature of liquidity flows did not seem to have any impact on the valuations of housing at that point, and it does not seem to be much of a factor when looking at Kensington or Chelsea prices today. This is a paradise for the ‘gazumpers’ referred to by Harrison.

Once the frenzy is over, however, we could see the winners face the same curse that Harrison refers to in looking at 400 years of U.K. real estate cycles. What then? With household debt at all time highs, real disposable income hardly growing, sterling close to the $2 level and the government out of firing power on the spending side, the only option is likely to be a reversal of monetary policy. Watch out - the next 18 months could be a roller coaster ride! And bond managers’ appetite for bad news might be satisfied after all.

Emanuele Ravano
Managing Director

¹ The data is based on four assumptions: one, the borrower is on average earnings; two, the purchaser buys a house at the average price; three, the effective rate is the actual rate paid by new borrowers, i.e., the average rate of all variable rate mortgages taken out in that quarter; and four, the loan to value ratio is assumed at a constant 80%.