Volatility in the wider markets alongside political uncertainty in the UK would lead one to assume a backdrop for falling house prices.
Indeed, recent data points to a slowdown in house price growth momentum and successful mortgage applications since November 2014. The seasonality of the data as well as the run up to the general election, especially within London, does not create a momentum shift, on the contrary it makes for a realistic and sustainable marketplace. As a sector we are particularly attracted to fringe London development opportunities, with the belief that these offer superior risk-return dynamics, and will outperform the remaining residential sub-sectors.
The UK economy has grown strongly this past year, with the most recent data indicating GDP grew by 3%. The positive economic backdrop has improved conditions in the labour market, pushing the unemployment rate to a post-recession low of 6%. UK inflation hit a new low of 0.3% in January as cheaper oil and food continues to lean down on prices. Falling inflation has raised the spectre of deflation, but on current evidence the deflationary threat is not materialising. Core prices, which strip out energy costs, are rising at 1.4% a year. That is not very fast, but it has crept up in each of the past two months. The UK’s low inflation remains exactly that, low inflation.
The Bank of England’s rate setting committee believes the UK economy faces opposing forces. In the near term the monetary policy committee thinks there is a better than even chance that inflation will dip below zero and go negative. But it will be short-lived. The long-term rests on labour market slack; ie the unemployed and workers seeking more hours. That slack is being used up as we speak. So the MPC will be trying to judge how far it can let that trend continue before it needs to put up rates. Until recently markets thought there was very little likelihood of that happening in 2015, but now they are putting a one-in-three chance on a rate hike by the end of the year.
The housing market has benefited from the improving economic backdrop, with stronger consumer confidence and credit conditions supporting a gradual pick-up in activity. This has fed through to a significant pickup in price growth since the credit crisis started in 2007.
Growth over the medium term is underpinned by the fundamental supply and demand imbalance; estimates suggest there is a 40-year housing supply backlog and the recent Lyons Review calculated that 243,000 houses needed to be built each year to satisfy demand. This is significantly above the average of 137,000 delivered over the past decade.
The most interesting trend in the residential market over the past 18 months has been within London, where we have seen a shift from core markets to outer core locations that is reflected in prices, sales and development activity. There were significantly more new developments started in the outer core markets than in central London, with developers continuing to target land outside central London.
The market has seen particular interest in fringe location sites with values of between £5m-£20m, particularly around the £500-£800 per sq ft price point. This improvement has been bolstered by an increase in lending within the Greater London market. This move to fringe locations has rapidly increased land prices with significant numbers of parties all vying for land – with and without consent. Many developers perceive the margins and the risk-to-return ratio favourable over the traditional Central London safe haven.
Despite a tightening of lending conditions in the underlying market and the prospect of higher taxation targeting the high-value London market in general, the shift in trend to the outer core has only just begun in earnest. For UK first-time buyers, the average house price is 4.4 times average earnings. In London, house prices are 6.8 times average earnings, whereas in the North house prices are only 3.2 times average earnings. Despite recent legislation to tighten the credit supply of mortgages to force the markets to align themselves with earnings growth, London’s population and job growth potential is significantly higher than the rest of the country.
The mean reversion within London while benefiting from renewed infrastructure projects, alongside the growth forecasts for the city in general, makes outer-core residential development our core residential play for the year. The challenge is in delivery of the land not the risk of falling housing prices.
Michel Heller is fund manager at Gowers Fund Management
