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

Here is a question for you to ponder. If you throw a brick out of a ten-storey building, when will the brick stop falling and what will it do next? Will it stop at the second floor? Or maybe it will stop at the first floor, then rise all the way back up again. Or maybe it will fall for a while, then shoot up to the 20th floor or higher, in a trajectory that disproves the theory of gravity.

Most of us, however, would expect the brick to hit bottom with a thud, and stay there. Maybe it would shatter into pieces too.

Yet this is the strange thing. If you apply that question to house prices, many seem to think the market will follow some kind of extreme gravity defying act.

Take as an example, the National Housing Federation. It commissioned a report from Oxford Economics which has predicted a 25 per cent jump in house prices over the next five years. The NHF does expect prices to fall this year and next, but predicts a 1.3 per cent rise in house prices in 2010, followed by 5.2, 9.2 and then 9.3 per cent jumps in the following years.

It went on to predict average house prices in 2013 by region – with average prices topping £400,000 in London, over £300,000 in the South East, and over £250,000 across England as a whole.

It is quite impressive how they have managed even to predict house price inflation for five years ahead to fractions of a per cent. It is a shame they can’t apply their forecasting nous to the FTSE 100 too.

The NHF is the organization that rattles on about a shortage of houses. It says that right now only 75 per cent of homes that are required are being built. Presumably, with current conditions, the housing shortfall will be even further behind later this year and next.

David Orr, chief executive at the NHF, said: “Our report shows that despite concerns about the current housing market downturn, house prices will increase substantially over the mid to long term.”

But is he right?

And before we answer this question, consider this. Last week, the National Association of Estate Agents (NAEA) said that its members reported a rise in the number of first time buyers buying properties. Apparently, the proportion of sales to first time buyers rose by 1.2 percentage points from May to June to 11.8 per cent. The development was hailed as evidence we are reaching the bottom of the market.

The problem though with both these reports is that the house price growth of the last few years bore no resemblance to underlying fundamentals at all. First time buyers have been on the endangered species list for years, not just since the credit crunch began.

For years the market was pushed upwards by buy-to-let investors who had lost any sense of underlying value. They had lost interest in ensuring their investments were covered by yield. They were just interested in capital growth, and used the capital growth in their portfolio to fund each new purchase. This led to even higher house prices, which meant property portfolios rose even higher in value, enabling yet more leveraged investments in property.

This was only possible thanks to absurdly easy credit.

But house prices hit levels well in excess of what people could afford some time ago. And it doesn’t matter how great the shortage of homes is, there will always be a limit to what people can spend.

The only way house prices will rise by another 25 per cent is if there is a return to irresponsible lending and if buy-to-let investors totally fail to learn the lessons of the last few years, and jump on again, regardless of yield to price ratios.

Besides, the argument that there is a shortage of homes is itself suspect. For one thing, one assumes that as unemployment rises in the UK, immigration flow will go into reverse. In conditions of rising unemployment the government will come under enormous pressure to change the rules relating to immigration too. This will have the effect of reducing demand for property.

Earlier this year Capital Economics produced a report which suggested many home owners lived in properties that were bigger than they needed for no other reason than that they saw this larger than necessary home as an investment.

Over the next year or two this speculative motive for owing a home will dwindle, such that when some life starts to return to the property market, there is a good chance we will see a surge of conversions of larger properties into smaller flats.

The truth is that a brick does fall to the ground, and unless someone picks it up and carries it back to the top, it will stay there.

The main difference though with a falling brick is likely to be this.  With markets we often see more extreme action than that, as prices fall too far on the way down.