UK RESIDENTIAL PROPERTY MARKET
By FDP Savills. (4 February 2005)

The significant amounts of negative commentary on the prospects for the housing market were over done at the end of last year. There are already signs of improved market activity and modest price appreciation over the first few weeks of 2005. Despite the pick up in values we expect the year on year rate of growth to moderate significantly over the year ahead.

The key influence on the short term direction of the housing market remains the cost of finance. The scale of the weakening in demand last year was surprising and highlights how sensitive the market has become to changing levels of interest rates. What many failed to acknowledge last year, hence all the negative commentary, was the major difference between weaker levels of market activity and falling house prices. Whilst we expect levels of market activity to improve the rate of growth is unlikely to accelerate as it has done previously.

Affordability levels are stretched and some small falls in average values may be recorded by the main house price indices in the next few months. This is to be expected as we move from 'red hot' to more normal market conditions. Overall, we are forecasting that average house prices will rise by 2% over 2005. If interest rates start to move down in the first half of the year then we believe that house price growth could be closer to 5%.

Whilst our overall prognosis is for slower house price growth over the next few years we expect above average growth in the most supply constrained markets, in particular London and the South East. High house prices mean continued demand for rented stock and the 18 month old recovery in the rental market is good news for investors, especially those looking for income stream investments. Indeed, as the investment markets matures so we expect more residential cashflow investment products to emerge. There are still long term investment opportunities in the residential market.

The key to successful investing involves investors being clear on their motives and their required target returns. Those that do best will think laterally and keep their 'owner occupier' perceptions of housing well away from their investment decisions.

RESIDENTIAL MARKET OUTLOOK 2005

We expect mainstream house prices to rise by +2% in 2005. This could be higher if interest rates move down faster than expected. The prospects for housing in the prime markets will vary between property type, location and price band. The top end of the prime market is likely to lead the recovery in price growth, as this has been the weakest part of the market recently. Ultimately, only those vendors with realistic asking prices will achieve timely sales over the next 6-12 months.

2004 was a year of two halves. Strong momentum from the final half of 2003 carried over into the first half of 2004. The driving force for double digit house price growth over this time was values rising quickly off a low base in the high volume, lower value parts of the market i.e. sub £100,000. The net result was 25%+ price growth in several northern regions and Wales. High house prices and affordability pressures resulted in below average growth in London and the South East, a trend that has been in place for the last 2 years. The net result was headline house price growth averaging around 18% per annum over the first 6 months of the year.

The strength of house price growth saw a revival of doomsday forecasts for the market with various predictions for falls of between 20% and 40%. This is the third year that we have seen predictions for a collapse in house prices with the first coming in May 2001. Since this time average house prices have risen by 75%. Most of these forecasts have come from those who work in the City where the price to earnings ratio is a key benchmark of value for equities. If one carries this price to earnings benchmark of value to the housing market then house prices do look over-valued against the historic long run average. However the price to earnings ratio makes no allowance for the shift to a lower interest rate environment that has had a profound effect on what households can pay for housing.

We believe that the affordability picture should be informed from a debt servicing analysis rather than a price/earnings one. To us, the key statistic is identifying the proportion of disposable income that households will allocate to housing over the property cycle. We believe that we have found this figure for the UK and all the constituent regions. Looking at the key indicators moving forward it is why we believe that there will be a major slowdown in house price growth rather than a crash.

Perhaps unsurprisingly our analysis of housing affordability shows that the housing market has become very sensitive to higher interest rates. As we have seen in previous cycles high interest rates have led to a fall in house prices and there is no reason to believe that this could not happen again if rates increased dramatically. What is apparent is that higher interest rates over the over the second half of 2004 have led to a significant deceleration in housing market activity and the rate of house price growth.

The strength of the slowdown has led us to revise the shape of our forecasts over the next 3 years. Back in the Summer we thought that the strong momentum in many parts of the market would continue into early 2005, perhaps leading to an over-shoot in house prices in some regions. Higher interest rates appear to have bitten much harder than we anticipated. The net effect is that the various indices and lead indicators for the mainstream market are likely to remain weak for the next few months with further small price falls likely on a month on month basis. We expect a moderate bounce-back in market activity early next year as the perception that rates have peaked filters across the market.

The net result of the latest trends is that headline house price growth will be sluggish for the next 12 to 18 months. We are forecasting growth of +2% in mainstream house prices in 2005 rising towards 3% in 2006, with slightly higher rates of growth in London, the South East and Scotland. Headline growth in 2005 could be closer to 5% should interest rates start to move down faster than is currently anticipated. We are most optimistic for the prime housing markets over the next few years. Market sentiment and equity have more of an influence on values rather than interest rates. Very sluggish growth over the last few years in the prime markets in the south of the country leads us to believe that above average growth is likely.

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Click here for the Knight Frank UK Property Investment Report - Autumn 2004 (PDF)

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