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Low rental yields suggest house prices will fall

Buying a house in Britain today costs a lot more than renting it. Fair enough, you might think: Home owners have seen prices triple in the past decade, so it’s understandable that it should cost more to buy your suburban castle and so potentially profit than to merely rent it. But wait a minute: If renting a house is cheaper than buying, how is the landlord going to make any money?

For example, let’s imagine mortgage interest rates are a constant 5% and keep deposits out of the picture for the sake of simplicity.

Then: A landlady buys a house a few years ago for £100,000, and rents it out for £600 a month (£7,200 a year). Her interest only mortgage costs him £5,000 per annum. As a result she pockets £1,200 a year for her trouble.

Now: After five years, the price of the house has doubled to £200,000. With an eye on global warming, our canny landlady decides to sell up and invest in an ice-cream van. The new owner is a landlord who pays the same mortgage rate, which means buying the property costs him £10,000 a year. However, rents have only increased to £750 a month in the interim, bringing in £9,000 a year. The landlord is paying his tenants £1,000 a year to live in his house!

That might sound far-fetched, but it’s exactly the situation across the UK, where new Buy To Let investors are effectively subsidising the rent. Why would anyone do that? Because they expect prices to go up in the long term, and so don’t mind some short-term pain now for future gain.

Of course, prices will only go up if an even more optimistic would-be landlord comes along to buy the house who is prepared to subsidise the tenants even more, or if rents increase faster than house prices and so reduce the shortfall. The trouble is, rents have been growing much more slowly than house prices for years, and with the Bank of England targeting a 2% inflation rate and thus curbing wage growth, there’s little chance of any major spurts.

Anyone renting in London, for instance, can do the maths themselves. Indeed, believing house prices are too high, I choose to rent a three-bedroom, two bathroom, two reception room flat in a fairly typical central London location (a hideous stabbing one week, a celebrity snapped having a mocha latte around the corner the next). NetHousePrices.com reveals my landlord bought the place in 2002 for £400,000. A less appealing three-bed flat on the same street (about 30% smaller overall, odd kitchen next to a bedroom rather than the living room, one bathroom compared to my two, and no garden) is on for nearly £600,000, which suggests my rented flat is worth £700,000 in today’s market.

I pay £2000 a month rent. Assuming that £700,000 sale price, a £100,000 deposit and a currently competitive five-year 5.99% fix, a buyer would pay:

  • £2995/month on an interest only mortgage (Buy To Let Interest Only mortgage)
  • £3907/month for a repayment mortgage (Repayment mortgage)

Before we even consider the cost of maintenance, void periods when the flat is empty and so on, a new landlord would have to subside the mortgage by £995 a month, which means my flat looks between 40-50% overvalued by the price-to-rent measure. But don’t just take my word for it – The Economist cites an OECD study suggesting British homes cost 30-50% too much on the same metric. Australian property is also judged to be 50% too expensive. In the United States, where prices are already falling, property is reckoned to be 20% too pricey.

My landlord paid £300,000 less in 2002, and so my rent more than covers his costs. It’s the present yield on a property that should determine its current value, however, as that’s the calculation a new buyer would have to make, whether it be a landlord working out his returns or an excitable young couple comparing the price of buying to renting.

If my landlord put his flat on the market tomorrow, I’m sure he’d sell it for £700,000 by October. Does that mean houses are correctly priced? Yes, in that something is worth whatever someone will pay for it. Alternatively, perhaps the market believes rents will increase long-term fast enough to reduce new landlords’ need to metaphorically stuff tenners through their tenants letterboxes.

Perhaps the market is right – but I think it’s more likely buyers are prepared to pay what seems a high price in the belief that a higher price lies around the corner. This is called the ‘Greater Fool’ theory, and it’s been at the root of many asset price bubbles from Tulipmania to the more recent dotcom boom and bust.

Personally, I believe that eventually the music will stop and prices will fall. The sub-prime mortgage crisis unfolding in the US might be the trigger, but after several years of house price inflation confounding expectations of a slowdown, it’s more likely we’ll need to see a real recession in the UK to dent confidence in house price growth.

{ 2 comments… add one }
  • 1 The Accumulator May 19, 2011, 8:56 pm

    So this is where it all started? Gee…

  • 2 Will March 29, 2016, 2:00 am

    Well that turned out to be a pretty prescient post given that it was written in 2007! I’m currently wondering whether to invest in shares/ETFs or property and it seems like rental yields are quite low which might indicate that property is overvalued.

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