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House-warming – It is not just The Value Perspective that thinks the housing sector is heating up

23/12/2013

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Regular visitors to The Value Perspective will know how keen we are on the strength of a prospective investment’s balance sheet. Too much debt makes us nervous and, when we analyse any liabilities a business may have, we will consider not only current affordability, but also the affordability under a more normal interest rate environment.

That being the case, why should we think any differently about debt owed not by a company but by a household? Take the current situation with residential mortgages in the UK. Housing is currently affordable because interest rates are so low but a lot can happen over the 25-year life of the typical mortgage and what happens when rates move up towards their longer-term average?

To judge from the latest Financial Stability Report, published in November 2013, the Bank of England would appear similarly concerned about the UK housing market. The report is always a must-read for The Value Perspective but the one published last month – the first to appear under the regime of new governor Mark Carney – has proved especially interesting.

Take the fourth paragraph of the executive summary, which observes: “Several actions are in train that will guard against a build-up in vulnerabilities, including higher capital at banks. The Bank’s stress-testing initiative will look at bank resilience to housing and other shocks …” – and it is immediately worth pointing out that housing is the only “shock” specifically mentioned by name.

The sentence continues: “…and tighter underwriting standards are being introduced as part of the Financial Conduct Authority’s Mortgage Market Review.” In case you were in any doubt about the subtext of “be careful”, the report also notes the Bank and HM Treasury “have decided to modify the Funding for Lending Scheme to remove direct incentives to expand household lending in 2014”.

The executive summary also notes one further “proportionate and preparatory step” that sets out “to enhance the range of tools available to authorities”. This is that the Financial Conduct Authority should require mortgage lenders “to have regard to any future Financial Policy Committee recommendation on appropriate interest rate stress tests to use in the assessment of affordability.”

Could this be interpreted as the Bank sharing our belief that, while most people seem comfortable with the state of the UK housing market, it has actually gone up a long way, is only affordable because interest rates are so low – and, if those rates move up, then all bets are off? Well, we will not put words into the Bank’s mouth so instead let’s look at some charts from the Financial Stability Report.

Take Chart 1 below, which shows the ratio of house prices to earnings stands at 7x, compared with a long-term average nearer 5x. That may not sound that elevated but note also that high loan-to-income ratios have become more common (Chart 2), with 17% of all mortgages in London at greater than 4.5x, while first-time buyers are also stretching themselves (Chart 3).

Forward Guidance chart

As at 28th November 2013.

 

Forward Guidance chart

As at 28th November 2013.

 

Forward Guidance chart

As at 28th November 2013.

 

Chart 4 below shows where UK house prices stand compared with selected other countries – for example, they are significantly higher than the US and Ireland, which clearly have had some issues in the last five years, but are in line with some markets, such as Australia, that are considered quite elevated. Interestingly, they remain well below Carney’s former stamping-ground of Canada.

Forward Guidance chart

As at 28th November 2013.

 

Arguably most interesting of all, however, is Chart 5 below, which shows that, at less than 1%, UK mortgage losses since the credit crisis have been historically low compared with what both this country (1.5%) and Sweden (3%) experienced in the early 1990s and what Ireland (5%) and the US (7%) have suffered more recently.

Forward Guidance chart

As at 28th November 2013.

 

In other words, the UK has got off very lightly and, because of that, people think there are no lessons to be learned – but that is certainly not the case. House prices are undeniably elevated and it is clear from the Financial Stability Report, its various housing-related recommendations and all its charts on the subject that concerns are by no means confined to The Value Perspective.

From an investment point of view, we would note the stockmarket tends to get excited when things are hot and things are certainly heating up in the housebuilders sector. They currently trade at significant premiums to their tangible book value, which means they are already factoring in a significant amount of good news. While the environment today is good, nothing lasts forever and investors would do well to pay attention to the Bank of England’s concerns.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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