Soaring mortgage rates will weigh on the real estate market

A decade-long party for homeowners is coming to an end. The cost of servicing mortgages in the UK, Europe and the US has soared as disposable incomes have been squeezed, and predictions of a slowdown or even a fall in mortgage prices real estate are now common.

Last week Knight Frank predicted house prices in London would fall by 10% over the next two years – a highly unusual move for a property firm, adding to independent analysis and bank forecasts of falls at least across the UK.

How could housing markets, which felt only rising prices for a decade, slip into crash territory?

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The 2008 financial crisis offered a humbling lesson in the dangers of excessive borrowing against housing.

At the time, about one in seven mortgages were highly leveraged with loan-to-value ratios at or above 90%. In the years that followed, banks tightened their lending criteria with only 4% having the same borrowing levels.

Borrowers today must raise relatively large deposits and demonstrate that they can withstand rising interest rates. Imprudent lending has largely been brought under control, reducing the risk of homeowners sliding into negative equity.

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The other key feature of the past decade has been the lowest interest rates, allowing buyers to take out large mortgages at low monthly costs.

In turn, anyone able to put up a deposit could afford a more expensive property – betting on paying it back as long as rates stayed low and the mortgage term was long enough. Low rates have in effect made larger homes affordable, driving up house prices in turn and crowding out those who can’t raise funds for a deposit or tap into “mom and dad’s bank”.

But rates have soared this year – with the Federal Reserve raising the base rate by 0.25% to 3.25% and the Bank of England and ECB following suit – and markets expect ‘they continue to rise sharply next year as central banks try to rein in runaway inflation.

Suddenly, this image of affordability has changed dramatically.

“Only 2-3 months ago we were saying that interest rates [in the UK] up to 3 percent would be a challenge, given affordability. Markets now expect mortgage rates to rise to around 6%,” said Noble Francis, chief economics officer of the Construction Products Association.

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Rising interest rates had an immediate impact. Mortgage lenders in the UK rushed to withdraw proceeds after Chancellor Kwasi Kwarteng’s ‘mini’ tax cut budget last month raised expectations of a rate hike.

Anyone buying a house today in the UK will therefore face much higher mortgage costs. Mortgage payments, as a proportion of income for first-time buyers, average around 17%, according to data from consultancy BuiltPlace.

However, it’s not just those who are at the start of home ownership. There is also an effect that will be felt more gradually. Every month tens or hundreds of thousands of homeowners in the UK enter into fixed term contracts and have to remortgage. When they do, they will face far higher costs than they are paying now – and some may be pressured to sell.

“At a time when the majority of people are likely to experience real wage cuts, this is a perfect storm for homeowners who have purchased in the past 10 years and are unaccustomed to high mortgage rates,” he said. Francis said.

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There are signs that higher borrowing costs are already impacting demand for new homes, with property portal Rightmove reporting that potential buyer activity has fallen last week from recent averages, albeit modestly. .

Lower demand will reduce transactions in the UK from an already weak base by historical standards. Falling demand generally puts a damper on property price growth and the scarcity of transactions means data can be skewed by a limited number of transactions.

“What you’re going to see is clearly a much weaker transactional housing market, dominated by needy movers and the cash rich,” said Lucian Cook, head of UK residential research. at the realtor Savills.

In the United States, there are already signs of heat coming out of the sales market, with declining transaction volumes in several major cities.

FT analysis of data provided by real estate firm Zillow through the end of July 2022 shows monthly US home sales growth fell 4.4% at the height of the post-pandemic rebound amid 2021, at a low of -2.2% over 12 months.

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Outside of necessity — death, debt, and divorce are frequently cited as the top three drivers of sales by real estate agents — there’s little incentive to sell in a down market. But higher remortgage costs could prompt some homeowners to negotiate at a discount, driving down average prices set by recorded transactions.

Falling sales numbers, stretched affordability and pressure on mortgage homeowners could precipitate painful price corrections in the UK, US and elsewhere.

Following the Kwarteng Budget, several forecasts now indicate that average UK house prices will fall by more than 10% on a nominal basis over the next two years. Thanks to the surge in prices during the pandemic, even such a steep drop would only bring prices back to the levels seen in May 2021.

But the consequences could nonetheless be disastrous, especially for recent buyers. Given that inflation is at such high levels in the United States and Europe, a 10% fall in nominal prices would represent a decline in real terms of nearly 25%, a bigger drop than the painful correction that followed. the financial crisis.

Data visualization by Steven Bernard and Patrick Mathurin