A sure sign that market rates of interest are rising is when borrowers begin to try to lock in loans for longer periods, at fixed rates. Anyone with a bank account or savings account will have had emails from their bank or building society, in recent weeks, telling them that they can get a higher savings rate than the current near zero rate, by applying for a fixed rate bond, or other such vehicle, tying up their money for the next three years. Why? Because, the banks know that, in the very near future, they are going to be having to pay much higher rates on savings accounts, and those rates are likely to rise way above the fixed rates they are now trying to tie savers into for three years and more. Already, banks and building societies have begun to raise mortgage rates for borrowers, even ahead of actual rises in policy rates by central banks.
The standard line being pushed, in relation to these higher mortgage rates, is that they do not pose any immediate threat to house prices, because, existing borrowers are, themselves, mostly covered by fixed rate mortgages, extending out for another 3-5 years. That argument is nonsense.
It is nonsense for several reasons. Firstly, the effect of higher interest rates on asset prices, such as that of land and property is not primarily effected through that means. It is effected via the role of capitalisation. That is, with higher interest rates, the capitalised value of the revenues from any asset falls. If a hectare of land produces £1,000 of rent per year, then, if the rate of interest is 1%, the hectare of land produces as much revenue as £100,000 producing £1,000 of interest. But, if the rate of interest rises to 2%, the £1,000 of rent is equal only to £50,000, producing £1,000 of interest. One of the reasons that money started to flow into speculation in buy-to-let properties, was precisely that the interest that could be earned on savings fell to very low levels, meaning that rents from properties offered a better alternative. When, this speculative demand drove up house prices to astronomical levels, the speculators, then, had another incentive. Even the rent, as revenue, ceased being the main concern, as it became the potential for large annual capital gains from rises in property prices that took over.
The more property prices have risen, the more prospective landlords have to pay for additional properties, and the more capital they have tied up in their existing properties. Even as rents have risen, therefore, rental yields have fallen. As interest rates rise, so those rental yields become even less attractive, and as landlords, then, begin to sell to release their capital, so the prospect of capital gains from property speculation disappears, turning into the prospect of capital losses, and, so provoking even greater selling, and further falls in property prices. The landowners who were also keen to try to hold on to their land, begin to want to release it, before its price falls, and, in so doing hasten those falls.
But, even, in terms of the mortgage rates, the argument about fixed rates is false. Nowadays, the limit of how much people can offer for houses is not the house price itself, but how much they can afford to pay each month in mortgage payments. Current mortgage rates vary from around 1% to 1.25%. For ease, let's take 1%, and a repayment mortgage over 20 years. Suppose someone wants to buy a £200,000 house. That means over 20 years, repayment of the capital is £10,000 p.a., and interest is £2,000 = £12,000 p.a., or £1,000 per month. Assume, this is the most they can afford to pay each month. Now, however, interest rates rise to, say, 3% - that is not at all unreasonable as the long-term average for mortgage rates is 7%, for comparison – so that, the amount of interest p.a. rises to £6,000, or £500 per month. Given that the buyer can only afford £1,000 per month in total, this clearly means that the amount they can afford to borrow, and so pay for a house, is severely curtailed.
At this interest rate, they could borrow £150,000, meaning £7,500 p.a. in capital repayments, with £4,500 p.a. in interest payments. Immediately, therefore, the houses that buyers could previously afford to offer £200,000 for, can now only attract offers of £150,000, a fall of 25% in prices. It is not the immediate effect on existing borrowers being unable to afford to pay their mortgages, in respect of those with fixed rates - though some of them will always be coming to the end of their fixed rate periods, and need to renew at a higher rate, which many will be unable to afford – and so becoming forced sellers that causes prices to fall, but the fact that any buyers – first-time buyers or not – will, now be able to afford, and so offer, much less, that causes prices to drop, and, as seen in this example, to drop substantially. If mortgage rate rise to the long-term average of 7%, then that represents, on the above basis, a 50% fall in the price that buyers could offer, and were we to rise to the 10-15% levels seen in the early 1990's, an even bigger decimation of house prices would be inevitable. With interest rates now set to be rising steadily in the period ahead, landlords, in particular, seeing the likelihood of considerable capital losses, will begin to want to get out ahead of the rush. The fall in property prices, will be just the start of the crash in asset prices overall.
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