Feet up by the Pool

3

'The Property Ladder' - There Are Snakes Too!

In my introduction I contrasted the economic outlook for the post war home-owning Baby-Boomer generation with the likely prospects for our children. We should never underestimate our luck in having been able to afford to buy our own homes, the values of which might be available to enable us to fill any gaps in our pension and savings arrangements. However, if ever there was a prime example of my generation encouraging our children to do something inappropriate just because it worked for us, this could be it.

Let me explain what I believe has changed and why our advice might prove outdated and potentially dangerous. 

'The Property Ladder'

Before sharing my concerns, let's start with a terminology issue. How often have we come across the stated determination to 'get onto the property ladder'? We've all played Snakes and Ladders and know what happens when our counter lands at the foot of a ladder - we go up. But when we arrive on the head of a snake? Herein lies the rub, because the use of this terminology exposes the dangerous assumption that property prices are a one way bet.

If the 'property ladder' worked for us, then why not for our children? Later in the book I will warn against relying on monetary assets to keep pace with price inflation and explain why long-term investors should invest in 'real' assets such as shares and property. To understand how the Baby-Boomers could afford to buy their homes we need first to understand the reasons why the Yield Gap between equities and Gilts reversed, and I will cover this in detail when I fully explain the case for investment in equities.

Inflation is the borrower's friend

I need to explain why it was such a cracking deal it was in the 1970's for the government to borrow, and then repay the loans a decade later after high inflation had eroded the real value of each £1 they had borrowed to nearer 35p. The government had, in effect, used inflation to decrease the value of its debts. Imagine now the benefits that we, ordinary people, also borrowed the money and repaid the bank ten years later after a period of high inflation. 

Like the Government, we allowed inflation to erode the value of our debt, and so, like the government, we also repaid only a small proportion of the real value that we had originally borrowed. But we used the money we borrowed to buy a real asset that kept pace with inflation - our home. Using the same equation, this would mean that we borrowed a pound and repaid the equivalent value of say 35p after ten years, but the house that we bought for our loan of £1 was still worth in real, inflation-adjusted terms, the same as the £1 that we originally borrowed - three times the value of the debt.

Another way of explaining this phenomenon is to describe the actual mechanics of the trade. We borrowed the maximum allowed by banks and building societies in those days to buy our homes, which typically amounted to a multiple of between three and four times our annual salaries. A combination of high inflation and perhaps some job promotions pushed our salaries higher every year, and in turn we were encouraged to borrow three to four times this new, higher amount and buy a larger and more expensive property, and so on.

Over the next two decades, house prices rose with inflation and our salaries and the value of our homes soon dwarfed our debts, so we ended with little or no debt and owned houses that had multiplied many times in value. And the gains were tax free! Property had become a major source of wealth creation, but without help from high inflation many of us could not have built up the capital to buy the houses in which we now live.

So why can't our kids play this profitable game and use their homes as a core part of their savings matrix? Their biggest obstacle is affordability - particularly in the South East of England and the more affluent areas in and around London, where average house prices have risen so far as to be increasingly unaffordable to first time buyers. This has been caused by the combination of two factors - a massive imbalance of supply and demand, with too few new homes being built to cater for those seeking employment in the affluent South East - and record low interest rates which until 2023 had made large mortgages affordable. As a result, the three to four times borrowing multiple of average earnings today would neither buy a garage in central London nor a beach hut in Frinton-on-Sea.

Negative Equity

Irresponsible mortgage lending in the run up to the financial crash in 2008 made the problem much worse - many home buyers had borrowed too high a proportion of their home's value, so when prices fell, if they lost their jobs in the ensuing recession and were forced to sell their homes they could not achieve a price that allowed them to repay their lenders. The situation where the value of debt is greater than the value of a home is referred to as 'negative equity'. Let's hope we're not facing a repeat performance when the effects of higher mortgage rates filter through.

So how did our politicians try to ensure this did not happen again? For once, sense seemed to prevail and banks were discouraged from lending such a high proportion of a property's value. This in turn meant that first-time home buyers would be forced to save more for a deposit before they could buy a house and therefore owned a larger proportion of the value of their homes. As a result if they were ever forced to sell their homes they would be less likely to suffer from negative equity.

Very sensible you might think - and you would be right. But guess what? The Tories decided that their chances of re-election in 2015 were more important than either the fortunes of first time house buyers or the likely state of the British economy after the election. So they tried to buy votes by igniting another inflationary property boom, hoping that the 'feel-good factor' from rising house prices would spill over into improved consumer confidence, more high street spending - and more Tory votes. You don't need me to tell you how the previous credit fuelled consumer binge ended. Strong words, and so I need to explain how the blue touch-paper was lit under the housing market that lasted another seven years - and why.

I must try not to get carried away with a political diatribe, but in 2015 I think it is fair to say that the rise of support for Nigel Farage and the UK Independence Party (UKIP) had meant that the Tories would require a series of unlikely miracles to deliver Mr. Cameron another term in a coalition government, let alone an overall majority of Tory MP's after the 2015 general election. 

So with eighteen months to go, Mr. Cameron and his Chancellor came up with a ripping wheeze. The new 'responsible lending' criteria imposed on the banks after the 2008 Financial Crisis was, all of a sudden, no longer considered to be such a great idea after all. And so they decided to provide guarantees to enable young prospective Tory voters - oops, I mean the hard working, aspirational middle class families - to borrow up to 95% of the value of their new homes. Brilliant, let's replicate the conditions that bankrupted the Anglo Saxon world in 2008!

So the government - or rather you and I the tax payer - offered to guarantee the difference between what the banks would lend and the amount that house buyers actually need to borrow to secure their new home. It is hard to imagine a more foolhardy scheme, but it became obvious that home buyers would enjoy a wonderful party until the inevitable hangover that inevitably follows. Even the banks and building societies thought this was a bad idea - apart of course from the two banks that did agree to join the scheme. Lloyds and The Royal Bank of Scotland have one other thing in common - their largest shareholder was Her Majesty's Government who spent our money to rescue them from bankruptcy.

So there's no rush to get onto 'The Ladder'

Now I've got that off my chest, let's get back to the point. Whether or not I was proved right, record low interest rates have lured many house buyers into borrowing vast sums in relation to their current incomes, which has enabled them to clamber onto this so-called housing ladder. So what can possibly go wrong? As certainly as night follows day, it was obvious that interest rates would eventually rise again, and unless this was accompanied by a dramatic increase in wage inflation, it would cause many first time buyers to regret their high and potentially unaffordable levels of debt.

In 2023 this inevitable outcome came to pass - an explosion of inflation caused interest rates to rise very dramatically and the reasons why we have not seen greater falls in house prices are twofold. Many mortgages have their interest rates fixed and it is only when the fixed period expires that borrowers face increased interest costs. The second is that unemployment remains relatively low and it is when higher interest rates lead to losses of jobs that homeowners really do struggle to keep their homes.

And house prices from here? Even though valuations in London and the South East remain, by any historical criteria, ridiculously overstretched, there is no reason to believe that the supply/demand situation will deteriorate and cause a house price crash any time soon. That is unless or until the UK economy finds itself in recession that leads to job losses. But will we see another period of hyperinflation in house prices? No, not this time and...