Housing – house prices and home ownership – (technical stuff)

In this blog we examine some aspects of housing. All the material was produced by Oxford Economics.

The housing market is at the top of the political agenda. Growing concern has tracked two recent trends: rapidly rising house prices since the late 1990s, and home ownership rates that have dramatically declined since the start of the century. Over the ten years from the end of 1996 to the eve of the financial crisis, house prices rose by 151 percent after adjusting for general inflation, a pace of growth that has recently resumed. Meanwhile, the UK home ownership rate peaked at 69.3 percent in 2002 but has since fallen rapidly to stand at 63.1 percent by early 2014.
In this context, the Redfern Review into the decline of home ownership commissioned this study in order to:
 establish the drivers of these two important trends;
 understand the outlook for home ownership and house prices; and
 shed light on the levers available to policymakers to change the outlook for both house prices and home ownership rates.

In this report we set out a new approach to modelling the macroeconomic drivers of house prices and home ownership based on data from 1992 to 2014. This approach enables us to explore the drivers, outlook and policy options for the housing market in a more comprehensive way than most past studies, which tend to focus only on one aspect, such as house prices.

The modelling results illustrate how sensitive house prices and home ownership rates are to a range of different macroeconomic drivers, including the supply of housing, the cost of capital and people’s incomes. The model also allows us to diagnose the underlying causes of recent trends—why have prices risen and why has the home ownership rate dropped? The answers are somewhat surprising in the context of the current public debate around housing, and have important implications for the appropriate policy response.
The housing market is commonly thought of as a market for a single thing—houses—when in fact there are two distinct markets in operation. First, by living in a house one consumes housing ‘services’—having a place to live. Second, by owning a house one is seeking housing as an investment. The primary financial benefit of housing as an investment for an owner occupier lies in preventing him or her from having to pay rent.
Two sets of prices govern these markets. Rental prices balance the supply and demand for housing services, while house prices balance the supply and demand for housing as an investment. These markets are separate from one another. It is entirely possible to be in the market for one and not the other. Renting makes it possible to have a place to live without owning a house, or, conversely, to invest in housing but not live in it.
Although they are separate, these markets are closely related to one another. It is the intersection of the two which determines both house prices and home ownership rates. In terms of house prices, rent is of central importance because it affects how appealing owning is compared to renting. House prices, however, do not have an impact on rent. This relationship is analogous to the one between the price of the widgets sold by a company and the company’s share price: the ability to charge higher prices to customers will tend to boost the company’s share price, but fluctuations in the share price have no direct impact on the price of the widgets produced.

While rent influences house prices, it is not their only driver. A wide range of factors translate the house price into an annual cost facing owners. The so-called ‘user cost of capital’ is determined most obviously by the mortgage interest rate—if this rises so does the cost of owning a property at any given price level. It is also influenced by the forgone income that could have been earned on equity that is instead tied up in housing had it been invested in some other asset. In addition to these, property taxes, the costs associated with maintaining a property, and expectations of inflation and capital gains, all affect how costly it is to own a house of any given price.

The balance between the cost of renting and the annual effective cost of owning a property is the central determinant of the home ownership rate. If the annual costs associated with ownership begin to exceed rent, more people will choose to rent and vice versa. In normal times, theory suggests that the costs of renting and owning should be equal.

Again, a set of other factors also influences the balance of home ownership. These include the incomes of would-be first-time buyers and the costs of mortgage credit they face relative to those for existing owners who tend to have more equity and can therefore secure lower mortgage rates. The absolute level of house prices also has an impact of the affordability of buying a property: a rise in house prices implies a bigger cash deposit to access better mortgage rates.

Overall the interaction of these forces gives rise to the housing market system depicted in Fig. 1. This informs the basic structure of the three-part model for the housing market that we have developed for this study. It illustrates, how income, for example, affects house prices directly, but also indirectly through their influence on rent, which also has its own impact on house prices. In turn, income affects home ownership through several channels, since the home ownership rate is determined by a combination of house prices and rental prices (as well as other factors where income plays no role).



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