Analysing long-term property value could help predict a major market crash years before it happens, research from the Property Industry Alliance has found.
The study identified a method that calculates the difference between current market value with the long-term, inflation-adjusted average – based on the UK All Property Capital Value Index – which indicates when property is overvalued and the market is overheating.
When the difference, known as the adjusted market value, rises to 20%, there is a “very high” likelihood of a crash within the next five years.
The report said by using the model, lenders would have known by the second quarter of 2004 that adjusted property values were overvalued by 20% based on the long-term average and a crash was imminent.
A similar warning would have been clear by the first quarter of 1988, six quarters before the market peaked in 1989.
How could this prevent another financial crisis?
While the focus of the study was not on ending the boom-and-bust cycle, Rupert Clarke, chairman of the Long-Term Value Working Group, which produced the report, said the hope is it would tone down the size of a market downturn.
“The focus is on finding something that prevents lenders from getting carried away at the end of the cycle, to prevent them from making such large losses that the financial stability of the economy is affected.
“It happened last time round. It happened in 1974 and in the late 80s. It happens time and time again and it has an impact on the economy.”
He said that if lenders adopted this kind of long-term value analysis in their risk management, it would have a “toning-down effect” at the end of the cycle because it would constrain the two or three years of excessive lending that precede a crash.
Lenders would lower their LTVs because they would recognise that property was overvalued and risk was rising.
For example, if banks had been lending against the adjusted market value in 2004 knowing that property was overpriced by 21%, rather than the market value, the maximum fall over the next five years would have been -2%. Instead, they were lending on the market value and a 23% fall was imminent.
By March 2007, the market was overvalued by 40% and was facing a maximum fall of 42% in the next five years. Had lenders used adjusted values taking into account that overheating market, the maximum fall in the next five years would have been 4%.
However, the likelihood of every lender using that kind of analysis is “a long way off,” said Clarke .
How overvalued is the market right now?
According to methodology, Clarke said the UK property market is overvalued by 10% compared to the long-term average.
“Global interest rates are relatively low, so people are paying premiums for income streams, pushing values up, particularly in the international market, including London and the south-east.”
He said values being 10% above the long-term average means lenders should be conscious of keeping LTVs down, although 15% is “when you’re getting very concerned”.
Will this method be used in regulation?
The focus of the study was to find a metric that could accurately determine that prices were overvalued and, by doing so, predict a coming downturn.
Clarke said the next stage of the study would start to look at if and how it should be implemented on a regulatory level.
However, it has already found support among some banks.
Paul Coates, managing director of real estate finance at NatWest, said: “NatWest has been pleased to support and contribute to the Long-Term Value Working Group.
“Over several cycles, lenders have traditionally overextended in late cycle and overcompensated during the downswings and, in doing so, have possibly accentuated the ups and downs of the cycle as well as the volatility of their own returns.
“NatWest remains committed to supporting the UK’s commercial real estate market in the long term so it’s logical that we would support efforts to explore and promote sustainable behaviours.
“We already employ a number of measures to monitor long-term trends in the sector as part of our risk management strategy and look forward to continuing to contribute to the working group during the next phase of the project.”
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