Topping Out: Why London’s prime property boom is over

Owning a house on Pepys Road, the fictional London street in John Lanchester’s novel Capital, “was like being in a casino in which you were guaranteed to be a...

Owning a house on Pepys Road, the fictional London street in John Lanchester’s novel Capital, “was like being in a casino in which you were guaranteed to be a winner”, writes Deutsche Bank’s Sahil Mahtani. Property prices in the city’s well-heeled districts today suggest the great lotto of London property has continued unfettered, to the point that even such fictional accounts seem understated. Prime London real estate has been going up for so long that new peaks are no longer news. In fact, any decline is a buying opportunity – or so everyone has come to believe.

The dinner-party perception that prices for prime London property1 have always gone up is potentially a reason to worry. That everyone strongly believes they will continue to go up further is a cause for anxiety. Still, timing any turn is hard and it has long been a losing battle to call an end to the froth in this market. But perhaps we are close to the turning point.

With the average asking price of a London residential unit now at £620,000 ($1m) the returns from property ownership over the past quarter of a century have undoubtedly been stellar. Every one pound invested in London bricks and mortar in 1990 has grown five-fold by now, double the performance of the FTSE 100. Lever up these returns using mortgage debt, add in a few tax sweeteners for buy-to-let investors and the true returns are tastier still. The rise was as relentless as it was spectacular. In the last 60 years, the Volcker recession of the early-1980s, the sterling crisis of 1992 and the 2009 financial crash, are the only three instances of nominal price declines for London housing.

Every one pound invested in London bricks and mortar in 1990 has grown five-fold by now, double the performance of the FTSE 100

There are many arguments for the rise and rise in prices. Most, however, are plain wrong. The economist Kristian Niemietz demolished the commonest explanations in a 2012 paper. Rising population densities in an overcrowded southeast? (The region is not particularly dense relative to continental Europe.) Housing benefit spending? (A symptom not a cause.) Thatcher’s decimation of social housing stock? (A fifth of total dwelling stock is still social housing, among the highest in rich countries, much of it in London.) Too-low property taxes? (As a percentage of total tax revenues it is the highest among rich countries – think stamp duty.) Smaller households? (No different elsewhere.) Under-occupation? (again, a symptom).

Having cast aside these arguments, Mr Niemietz cites just one factor as credible: poor planning that has led to an inelastic supply of homes amid fast-growing demand. Hence to solve what we have come to know as “the housing crisis”, London must build, build, build. This supply-side view has become the standard diagnosis among regular commentators on property prices, such as the Economist, Financial Times, Institute of Economic Affairs and the Royal Institute of Chartered Surveyors.

However, the impact of this supply-demand mismatch is perhaps exaggerated. For one thing, rents and house prices, theoretically subject to similar physical supply-demand dynamics, have diverged over the last decade with prices having risen by 35% more. In any case, physical supply and demand mismatches are often a poor indicator for future house price moves. This follows from the fact that housing is not only a durable consumption good but also a financial asset, and is therefore influenced by future price expectations and nancing, as much as by physical supply.

Physical supply and demand mismatches are often a poor indicator for future house price moves

These can change rapidly. Hong Kong property prices in 1997 dropped 40% over just 12 months. Like London, it was also densely populated with inadequate land and housing supply. Moreover, the approaching handover to China was spurring a return of optimistic and moneyed émigré residents, with mainlanders also eager to buy Hong Kong assets.

Despite this the property market endured a six-year downturn. Why? A Hong Kong Monetary Authority economic survey in May 1998 wrote: “coupled with the announcement of the government’s policy in October 1997 to increase the supply of housing units, the interest rate hike resulting from Asian financial turmoil sent property prices down by 20-30% in the last few months.” A stark reminder of the role financing and expectations play in the property market.

Of course, blaming interest rates looks obvious. Financing became more expensive as capital outflows raised the interbank borrowing rate, which compelled banks to increase the best lending rate, on which mortgages were based, by 150 basis points in the space of four months. Nevertheless, delinquencies were low by international standards. Despite property accounting for half of total banking system assets, the main problems for Hong Kong banks were trade finance and corporate loans. Most homeowners made their payments and had plenty of equity because loan-to-value ratios were usually capped at 70%. While homeowners coped with higher rates, house prices still plummeted.

A shift in expectations about future supply was much more instrumental in bringing about the downturn. The post-handover government had made it known that it would welcome a decline in property prices and would increase supply by 85,000 units a year. In retrospect, at no point during the next five years did housing completions reach 35,000 annually. Yet because the decision had credibility, it changed expectations and the 85,000 figure is still cited today as a reason for the market decline. The government announcement precipitated a change in psychology that diminished the speculative increment in the market.

Hong Kong is not the sole example either. Japan famously endured a monster asset price bubble in the 1980s, with the vast portion of new debt and capitalisation secured by ever rising land values. There is the apocryphal story about the Imperial Palace and California but few also remember that the cash value of Chiyoda-ku, that same ward in downtown Tokyo, could by 1988 purchase all of Canada. The bubble ended two years later as the Bank of Japan raised rates by 350 basis points and the ministry of finance introduced the soryo-kisei restrictions on real-estate lending, which caused an immediate and dramatic drop in the availability of credit. As financing conditions and future price expectations changed, Tokyo residential land prices fell two-thirds from their peak in 1990.

Investors pushed average prices of condominiums in the nine square kilometres around central Tokyo to 16 times average gross incomes. Compare this to the 13 times using conservative estimates for London today and Tokyo-on-Thames seems a plausible scenario

Much like London today, the physical supply shortage argument was also advanced to justify Japan’s boom. Japan’s industrious and high-saving population was shoehorned into narrow coastal plains – only 14% of the country was flat and suitable for building. Investors duly pushed average prices of condominiums in the nine square kilometres around central Tokyo to 16 times average gross incomes. Compare this to the 13 times using conservative estimates for London today and Tokyo-on-Thames seems a plausible scenario.

So, if expectations are too buoyant, what will cause them to normalise? Even though price rises in prime London property have moderated this year, there are multiple catalysts to suggest that 2015 is the turning point. The most significant are: impending higher interest rates, tighter macroprudential policies and a deepening politicisation of the housing issue. Again, all that needs to happen is for investors to think price outcomes are asymmetric, with low upside and large downside.

Take interest rates first. Just under half of the UK’s £1.3tn mortgage debt is on variable rates and most of the remaining is effectively variable anyway given the fixed rate period typically lasts only two years. London residential mortgage debt amounts to a quarter of the country’s total. Given British households’ penchant for making huge interest rate bets, borrowers have enjoyed the post-2008 falling interest rate environment but things could get ugly when rates rise. Moreover, over a third of those with mortgages have interest-only loans, with the first sizeable wave of principal repayments due in 2017-2018. With affordability already stretched, a few rate rises can easily reshape consumption decisions for housing and the broader economy.

Surely if raising interest rates threatens to be cataclysmic, the Bank of England will simply not do so. Yet borrowers in large open economies are not insulated from global events raising the cost of credit

But surely if raising interest rates threatens to be so cataclysmic, the Bank of England will simply not do so. Yet borrowers in large open economies are not insulated from global events raising the cost of credit. Bank of England economists have pointed out that UK swap rates, a key input into commercial banks’ own cost of borrowing, are highly correlated with those in the US. On average, quoted UK mortgage rates increase by around 50 basis points in response to a 100 basis point increase in US swaps.

Counterintuitively, the US tightening cycle will hurt British households more than their American counterparts that rely on long-term fixed rate mortgages.

Macroprudential policies have also gained currency under current Bank of England Governor Mark Carney who views them as a way to tame house prices without hurting the overall economy. Under previous governor Mervyn King, the central bank avoided them for fear of political blowback but Mr Carney has called housing the “biggest risk to financial stability” in Britain.

In February 2015, the central bank was granted direct powers to control loan-to-value and debt-to-income ratios where previously, they could only recommend changes. Lending requirements for owner-occupier mortgages were already raised in 2014, with no more than 15% of banks’ new mortgages to exceed a loan-to-income ratio of 4.5 times. Tighter controls on fast-growing buy-to-let lending appear likely to follow given this sector is disproportionately leveraged and two-thirds of all such mortgages are interest-only.

There is plenty of scope to do more on this front. The most advanced practitioners of macroprudential policy are Hong Kong and Singapore where loan-to-values for buy-to-let properties are capped at 50%, foreign purchases of property are hit with 15% stamp duty and second and third home buyers face differentiated, punitive treatment. In this approach, housing becomes more like a utility and less like a financial asset. The Bank of England appears to be moving in this direction.

The final catalyst that could well push prime property prices over the edge this year is politics

The final catalyst that could well push prime property prices over the edge this year is politics. The prevailing political attitude to housing, in particular buy-to-let, seems to be changing fast. The UK chancellor said in his summer budget: “we will create a more level playing-field between those buying a home to let and those who are buying a home to live in.” His budget proposals included a phased reduction in the tax relief on mortgage interest payments for buy-to-let landlords from the 40% to 20% tax rate over the next six years. Moreover, landlords also lose the right to automatically claim 10% of the rent against wear-and-tear costs. These are serious blows to levered buy-to-let portfolios.

To see why, imagine a buy-to-let at worth £500,000 earning a 4% rental yield and nanced with a 75% loan-to-value mortgage on a 4% interest rate. Under the current rules, the net cash income of £5,000 (£20,000 rent less £15,000 mortgage interest) incurs a tax liability of £1,200 for a landlord paying the 40% rate of income tax. However, following the full implementation of all the budget changes by 2021, the entire £5,000 income will go towards taxes. Sure, London’s housing demand also includes relatively non-return-sensitive buyers such as owner-occupiers and foreign safe-haven seekers. But these changes threaten to dent the demand from the highly return sensitive buy-to-let landlords.

Other recent tax changes also signal the UK government’s willingness to extract more revenue from the booming real estate sector. A major overhaul of stamp duty last year increased the cost of buying homes worth more than a £1m, putting disproportionate pressure on the prime end of the London market. Moreover, permanent non-domicile status, which benefits some 100,000 people, will be abolished, while foreign owners of property who were previously exempt from capital gains tax will have to pay it.

These tax changes are occurring as public discussion about foreign buyers of high-end London property has turned toxic. For instance, after a television documentary exposé on money-laundering at real estate agencies, Prime Minister David Cameron was compelled to speak on the issue, stating “London is not a place to stash your dodgy cash.”2 This rhetoric itself is new and unusual, even if serious action is still awaited.

Changes are afoot on the spending side of scale policy as well. In an effort to slash the £25bn annual housing benefit bill, the government plans to lower the ceiling on the total benefits any household can receive by £3,000 to £23,000 for London. Since payments such as child benefits and tax credits are fixed sums, housing benefit will likely bear the brunt, putting substantial downward pressure on rents from social housing tenants to private landlords.

The home ownership rate in Britain peaked at 70% in 2002 and has since dropped well below two-thirds

Meanwhile, the housing issue continues to move up the political agenda. The home ownership rate in Britain peaked at 70% in 2002 and has since dropped well below two-thirds. Conservative party policymakers are aware that this precipitous fall needs to be stemmed, if not reversed, to secure the next generation of Conservative voters, given the propensity of homeowners to vote for the party in the past. Unsurprisingly, the centrepiece of David Cameron’s speech at this year’s Conservative party conference involved policies aimed at “turning generation rent into generation buy”.

Housing is fast becoming the rallying point for the younger generation. Only 40% of today’s 25-34 year olds own homes compared with two-thirds of those in 1991. A 35-year old born in 1981 carries twice as much debt as those born in 1951 at the same point in their lives, even though their weekly income is the same in real terms. That suggests Burke’s notion of a social contract between the generations has been broken.

This disgruntled younger generation was instrumental in the surprise election of Jeremy Corbyn as the new Labour party leader in September. Mr Corbyn has said that housing is a top-three priority, ensuring political oxygen for the issue. In the Lanchester novel, the inhabitants of Pepys Road begin to receive postcards of their houses with the menacing message “We Want What You Have.” With that sort of sentiment rising, the fate of house prices may well be decided in the political face-off between younger voters and the elderly harnessing their political power to prevent price declines to their house-cum-pensions.

It is not that prices cannot rise further. It is that the more they rise the greater the chance of a political backlash against further gains

All of which points to the growing political risk embedded in prime London housing. Perhaps a turning point has been reached in which the marginal policy intervention will favour stabilising or reducing prices. It is not that prices cannot rise further. It is that the more they rise the greater the chance of a political backlash against further gains. Certainly it is hard to imagine, as one consultancy has, a doubling of prices in the next 15 years without explaining how this would not sow the seeds of its own correction given the increasingly febrile politics of housing in the capital and the country.


Hogarthian image of the 1720 “South Sea Bubble” from the mid-19th century, by Edward Matthew Ward, Tate Gallery

London, of course, remains a growing and attractive city with substantial planning barriers, high population growth, rising number of single person households, global cultural and business links, currency stability, low political risk, and no anticipation of a significant increase in supply. But as in financial market jargon – all that is already in the price, and then some.

There are bigger forces at work here too, with London just one part of a global housing boom. Indeed, despite frequent observations that all real estate is local, one of the oddities of the global economy since 1970 has been the persistence of synchronised global housing cycles. This has arguably been driven by two factors.

First, the intellectual victory of financial liberalisation in the 1980s, which led to increased household borrowing domestically and freer cross-border ows internationally. Second, a decline in global real interest rates due to a global “savings glut”, linked variously to an increase in demographic dependency ratios, a structural decline in in ation due to technology and globalisation of manufacturing, and mercantilist foreign exchange reserve policies of current account surplus countries. These factors have caused four successive housing booms since the end of the gold standard in 1971, the most recent since 2008. From this perspective, prime London’s boom is merely at the more extreme end of a generalised global trend. The boom here does not truly end until it ends elsewhere.

No-one knows when these long-term trends will turn. Perhaps other trends will work in the opposite direction, with new technologies such as autonomous vehicles increasing the willingness to live further away or virtual reality devices reducing the premium on physical interaction. Either way, what investors can hold on to is the limited upside in this market. Valuations are high relative to history, falling interest rates cannot provide further support, and given current a ordability home ownership cannot rise materially.3 London’s property is unlikely to enjoy the next thirty years as it did the last.


  1. The estate agent Savills defines prime central London as the areas of Knightsbridge, Mayfair, Kensington, Chelsea, Marylebone and Notting Hill
  2. For an estimate of the unaccounted foreign money, especially from Russia, owing into London’s property market see Oliver Harvey and Robin Winkler’s analysis of the balance of payments anomalies in the Deutsche Bank report “Dark Matter: the hidden capital ows that drive G10 exchange rates,” published March 2015.
  3. For further reading, with emphasis on both upside and downside risks in UK housing, please see Deutsche Bank research reports by George Buckley, “UK Housing: London versus the rest” from July 2014 and “How a ordable is UK housing?” from April 2014. For a primer on the nancial position of UK housebuilders, see Glynis Johnson and Priyal Mulji’s “Strategic Land: Driving better returns for longer,” published in June 2015.

This article first appeared in the October 2015 edition of Deutsche Bank’s Konzept research paper; download the full paper here (PDF).


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