Housing affordability is crucial to the fortunes of the residential housing market – and the wider economy. Yet its measurement isn’t necessarily as easy to grasp as one might think. Hamptons International’s new Ability to Buy Index provides a more accurate measure on the movement on true affordability over time by taking not only the cost of finance, but also the cost of households’ essential expenditure into account.
Ability to buy is now significantly better than at the start of the financial crisis but the rise in the cost of essentials has hindered further recovery. Ability to buy is still lower than it was in 1997 when the Bank of England took responsibility for setting interest rates and targeted low inflation.
Overall the average ability to buy has worsened for the last two quarters, but this is only partly due to the recovery in house prices. The inflation rate on essentials, particular utility bills where prices are rising at an annual rate of five per cent, has eroded the amount of available income households have to service a mortgage.
That erosion of available income has contributed to the deterioration. Indeed the amount of income now available to working family with two children after paying for essentials is about six percent lower than at the time of the financial crash.
Compared with 2007, the Index shows that ability to buy is in fact higher in most of England and Wales, but in London it has deteriorated. This is due to rapidly increasing house prices in the capital, which have vastly outstripped any rise in earnings, even ignoring the effect of inflation on available income.
The Ability to Buy Index allows us to explore how rising interest rates would impact purchasers and home owners. Overall for ability to buy to deteriorate to 2007 levels, mortgage rates would have to increase by about 4.5 percentage points at current house prices. This differs across the country though. In London rates would actually have to fall by 1.5 per cent where as in the North East they would have to increase by about 7.5 percentage points. The East region stands out as being relatively stretched as rates would need to rise by 3.25 percentage points to get back to 2007 levels. But for a family with children, they would only need to increase by less than one percentage point.
Commonly used housing affordability measures show an incomplete picture
Housing affordability is crucial to the fortunes of the residential housing market – and the wider economy. Yet its measurement isn’t necessarily as easy to grasp as one might think. There are several ways to do it, and each can give a different picture of how easy or difficult it is to buy a home. The house price to income ratio (HPI), a widely used benchmark, tells us how much more, or less, house prices have risen in relation to earnings over time. This is a broad general measure but it only tells part f the story. Its big flaw is that it doesn’t explain or help predict movements in the market that are driven by the cost of finance.
Research shows, the house price to income measure exaggerated the extent of the deterioration in affordability from the early part of the century by neglecting how much cheaper finance had become as a result of low interest rates. In contrast, an alternative measure, the mortgage payment to income (MPI) measure does take this into account. Between 1997 and 2002 house prices grew at an average annual rate of about eight per cent, but interest rates fell from seven per cent to 4.6 per cent in the same period, keeping affordability broadly stable. This explains why house prices were able to continue to rise despite historically high house price to income ratios.
While the mortgage payment to income measure is superior to house price to incomes, it still only tells part of the story. Using gross income as a base not only neglects the effect of tax and national insurance on affordability, but more importantly it ignores the other calls on household incomes that cannot be avoided. Spending on essentials like food, transport child care and utilities take up a significant proportion of income. As a result changes in their costs can have a big effect on households’ ability to buy. Research shows the rise in the cost of living means that conditions for buyers haven’t improved as much as the mortgage payment to income measure suggests.
A new approach to affordability gives a more accurate picture of market performance – and the risks
To provide better insight into affordability for different households in different parts of the country Hamptons International Research has developed an ability to buy index. The index tracks the debt servicing burden of a mortgage as a proportion of income available after spending on essentials. Using this measure gives a clearer insight into the real prospects for the housing market.
Using data from government sources Hamptons International constructed an index comprising on the average ability to buy of four typical households. Household one has two full-time workers. Household two has two full-time working parents and two children in full-time nursery care. Household three has one fulltime working parent, the other part-time. This household also has two children, but in part-time nursery care. The fourth household is a first time buyer, assumed to be a single person working full time and aged under 30.
Spending on essentials has a bigger effect on the Ability to Buy on families with children
There are differences in ability to buy at any point in time depending on the household type and region. Households with children have the most difficult time, largely due to the cost of childcare, which accounts for about half of essential spending for a two child household. Of the remaining essential expenditure for a family with two children, food is the largest proportion of the essential spending budgets at 39 per cent, transport takes up a further 27 per cent, 23 per cent is taken up by utility costs and the remainder with council tax.
For a couple with no children the essentials are pretty evenly split, except for council tax at 14 per cent. For a first time buyer looking to buy a home, food would take up about 35 per cent, transport 32 per cent utilities 21 per cent and council tax (with a single person 25 per cent discount) 12 per cent.
Taking essentials into account shows that mortgage payments on an 85 per cent loan would leave a full-time worker household with children with two thirds of their available income left after mortgage payments, while the household with one full and one part-timer with children would be left with 42 per cent. The first time buyer would be left with 38 per cent of available income. In London conditions are much more stretched. Here the full time worker household with children is still left with about 40 per cent of available income, but for the full and part-time household with children and the first time buyer, mortgage payments exceed the amount of available income left after essentials, showing that for average earners, buying the average priced house there is a real affordability constraint which limits the opportunities for households to enter the market in the capital.
Of course these are based on average spending and average earnings in each region, and there will be room for some economies, even on essentials. Nevertheless, the results show that the effect of spending on essentials makes a big difference to the ability to buy – and hence to the amount of housing market activity which can take place.
The cost of living has a real impact on the ability to buy, in addition to house prices and mortgage rates
Wage growth is crucial to the performance of the economy, but the rate of inflation has a really important effect on the amount of free income households have left to service a loan. Actual wages have been increasing throughout the recession, albeit at a low rate, but once general inflation is taken into account their real value has been falling for about five years. Even this doesn’t give the full picture though. The cost of many essential items has risen much faster than the general rate of inflation, and that means that the amount of available income to service a loan or save a deposit is depleted even more.
Higher inflation on essentials means that the spending on them has increased by about a third, while post tax income has only increased by about half that much. The result is that the real available income households’ with children have left after unavoidable spending is actually about six per cent less than at the time of the crash. The most recent Bank of England Inflation Attitudes Survey shows that the rate of inflation that individuals ‘feel’ is 3.4 per cent, much higher than the actual general rate of 1.6 per cent. This is a clear reflection of the fact that the cost of essentials, which take up a larger proportion budgets, particularly of lower income household, have risen faster and are felt more acutely by households.
Taking the cost of living into account in an affordability measure therefore gives a more complete picture of the pressures faced by home buyers. It is more in line with the approach that lenders have to take under the new Mortgage Market Review (MMR) regulations and therefore should be a better indicator of the health of the market and a better predictor of housing market prospects.
Ability to buy appears not to be a problem outside of London
Compared with 1997, a lower inflation and modest interest rates meant that ability to buy improved up to 2002, even when house prices were rising very fast. This helps explain why the market could still expand, despite double digit price growth.
In contrast a big fall in house prices and the collapse in interest rates since the financial crash should have meant a faster improvement in ability to buy, but it has been hindered by the effect of the rising cost of essentials on households’ available income. The research shows very clearly that real ability to buy isn’t a problem outside of London. Since the start of the recession in 2008 ability to buy improved everywhere as house prices and interest rates fell. But it has continued to improve in the North and has deteriorated only slightly in the South as prices have begun to increase. In London however ability to buy has deteriorated sharply as wage growth has fallen even further behind the rate of growth of prices.
Overall the average ability to buy has worsened for the last two quarters, but this is only partly due to the recovery in house prices. The inflation rate on essentials, particularly utility bills, where prices are rising at an annual rate of five per cent, has eroded the amount of available income households have to service a mortgage. That has contributed to the deterioration.
The good news is that the Ability to Buy index clearly shows that the big pressure on the housing market affordability is confined almost entirely to London
It is here where the new prudential regulations governing higher risk lending are already beginning to bite. In the rest of England and Wales the average position is much less stretched, but as house prices continue to rise and wage growth remains low, ability to buy will deteriorate elsewhere too, cooling both activity and price growth in the market.
However the continuing recovery in the wider economy should generate an improvement in ability to buy across most of the country. As the Governor of the Bank of England stated, wages are expected to begin to grow faster than inflation in 2015 which will improve the position. Even though interest rates are expected to increase next year, the pace of their rise will be small. The main risk is then that the cost of essentials rise faster than the general rate of inflation. The exchange rate will have implications for this as will the growing geopolitical tensionsin oil producing regions which could affect not only fuel costs, but would also feed into food, transport and utility costs.
However these are risks, not guaranteed and as the UK economic recovery gathers pace there are plenty of reasons to believe that the prospects for a balanced recovery in the housing market will also improve.