May 28, 2008 | posted by Michael Baxter in House prices |

Imagine this.    You are a married couple with say two children – a boy and a girl.  You live in a four-bedroomed house.  What happens when the children leave home?

Do you sell up and move to somewhere smaller?    Do you say we will keep the house because it will be useful at Christmas time when the kids come home?   Or do you say we will hang on to the house because it’s bound to go up in value?

Alternatively, rewind the clock a few years and your kids are still at home, and you are looking to move. You see a house with five bedrooms – more than you need, but you buy it anyway.  No doubt a number of factors were taken into account – but maybe the clincher was this one.     Maybe you reasoned that while the house was bigger than you needed, and you could have got something more appropriate for less money, at least it would go up in value faster. At least you would make money out of it in the long-term.

In the UK, the idea that house prices go up in value seems to be so entwined into the British psyche that we sometimes don’t even question this reasoning.    We make assumptions about how the house will rise in value, in the same kind of way we assume the sun will rise tomorrow.

Capital Economics has released a report suggesting that actually many homes in the UK are under-occupied, and maybe, therefore, the argument that house prices are likely to be driven upwards over the long-term is contradicted by this finding.

It seems that actually there are two financial factors that could lead to a home being under-occupied.  Firstly, it’s the belief that house prices always go up – that there is this property ladder – always moving upwards – presumably, like Jacob’s ladder, all the way to heaven.

Secondly, there are tax advantages too.  If we were to sell our home, and invest the profit in stocks and shares, then we would pay capital gains tax when we sold the shares, and income tax on the dividends.  If we put the money in a savings account, we would pay income tax on the interest.  But, for as long as our money is tied up in our home, which is rising in value, then our rising wealth is tax free.

Now, those tax advantages disappear if house prices stop rising, or fall, but then, in the UK, we have just got used to the idea that house prices always go up.   Capital Economics put it this way: ”Many owner-occupiers are engaged in a form of speculation, in that whether, when, and how much space they buy is heavily influenced by their beliefs about the future course of house prices.”

So that’s the theory.  How does it work in practice?  Capital Economics defines under-occupancy this way.   It assumes one bedroom for every married or co-habiting couple, a bedroom for every single person over 21, and a bedroom for every pair of adolescents of the same sex between the ages of 10 and 20.  But, and this is the key bit, if there is one extra bedroom, the layout is described as “comfortable.”     The house would only be defined as under-occupied if there were two or more excess bedrooms. The house would be considered over-occupied if there was one or more bedroom under the standards described above.

Apparently, according to the Survey of English Housing, no less than 47 per cent of existing owner-occupier dwellings – that’s 6.8 million homes, are under-occupied.  Tellingly, only 18 per cent of private rented properties are under-occupied.

This discrepancy between owner-occupied homes and private rented homes is important, because there is no financial benefit to a tenant under-occupying a home, so maybe the difference is explained by this speculative motive.

In an environment of falling house prices, this could all change. 

But it will take a lot to shake the Brits of the belief that house prices always go up in the long-term, and it seems that it is not likely home-owners will start downsizing in significant quantities unless house price inflation proves to be very modest or negative for a number of years.

Mind you, if house prices were to stay flat until the ratio of house prices to GDP per capita returns to the historical average, we would have a long wait, because according to our estimate this would take 8 years.    That might just be long enough to drive an exodus from under-occupied homes – and maybe solve the so called under- supply problem.