“When will the term structure of interest rates change? That’s the question to be worried about” - Ray Dalio, Founder and CIO, Bridgewater Associates.
By any measure, inflation in the UK has increased dramatically, with latest figures being around 9%, depending on which metric you use. How much of this is domestic and how much of this is imported is largely irrelevant in the short term when it comes managing an increased cost of living. To manage this inflation, we believe that the quantum and frequency of Base Rate rises will increase which will have an impact on the Housing Market. Our comments below serve for the market in general rather than just for Prime Central London, where, as we conclude, there will be a drag effect when our neighbouring markets start to feel the effect of these interest rate increases.
Governments have several tools at their disposal to keep inflation in check and to reduce it. Some tools are tried and tested and some have historically failed. Price and wage control is an option, and this was tested in the USA in 1970’s. Whilst initially popular and considered effective, the plan failed by 1973, due in large part to increased fuel costs. The most common method today is a contractionary monetary policy: the goal to reduce money supply in an economy by increasing interest rates. Realistically, this is what is likely to happen in the UK, however the question is by how much and over what period.
In October 2021, the OBR started talking about interest rate increases and projected a possible base rate of 3.5% by the end 2022. At that time inflation was at 4.5%. The OBR also warned that mortgage interest rates could rise to 14% in Q1 2023. To give these numbers some context: In 1990, inflation was at 8% and the BOE rate at its highest was 15%. The average mortgage rate was 10.13%. Whilst the make-up of our economy has changed somewhat since then, these figures do give some flavour of what might happen – and we say might as we simply don’t know. To contrast the view from the OBR, Savills today maintain that housing prices will increase by 12.9% from now to 2026 (-0.1% in 2023) based in part on a report by Oxford Economics who in turn maintain that the BOE base rate will not exceed 1.75% by the end of 2026. We will have to wait and see.
What we do know is that the Mortgage Market Review (2014) has tightened up lending criteria so that affordability, via a “Stress Test” is a key driver in the mortgage application process. When assessing affordability mortgage, lenders are required to ensure that borrowers can still afford their mortgages if at any point over the first five years of the loan, the BOE rate were to be 3% higher than the prevailing rate at the time the mortgage was written. Therefore, the stress tests for mortgages written in March 2020 was 3.01% where the base rate was 0.1%. Today the base rate is 1% so borrowers , taking into account the additional cost of living, will have to demonstrate that they have enough funds to afford a mortgage with a base rate at 4% - a 32% increase in a year. We have also seen an increase in the income multiple that applicants have been offered and we have seen a significant increase in house prices as a result of this. We believe that this may change: Banks are heavily incentivized to keep loan to value ratios low to avoid increased capital charges under capital adequacy regulations so they may be unwilling to take on many mortgages with a Loan to Value (LTV’s) of over 60% today.
We believe that further significant increases in the BOE base rate are likely. Might a rate of 5% or higher combat today’s inflation or does it need to be higher? Added to this, the stress tests applied by mortgage lenders will be more severe with the cost of living increasing. This means there will be less money available for mortgage payments and therefore lower mortgage loans. This is likely to start the fall in house prices we are expecting in areas with high LTV’s.
At the same time, the rate that Lenders are likely to charge will increase. As we will see below, the average rate for 2 or 5 year fixed rate product at the moment is ~2.80% plus fees depending on the Loan To Value. This is a 55% increase from loans originated less than a year ago. The question for us in the residential property market is do we expect a dip in the market (yes) and if so, when.
Historically banks have securitized mortgages as a means of funding them and they produce investor reports which allows us to peek inside their mortgage pools to see what is going on. I have chosen one at random and the purpose of the exercise is to look at the weighted average interest rate being charged and the loan maturity profile.
In the pool I have reviewed (from a high street lender) The Weighted Average Loan to Value at origination (WALTV) according to the latest investor report was 73% and is now 44%. This shows the increase in the average house price and takes into account borrowers paying off some of their loan balances. Of the £8bn or so of mortgages in the pool, approx. 30% are variable rate and 70% fixed rate. Of the fixed rate, 93% of the pool have interest rates below 2.99% and 67% of the pool will move to a variable rate before December 2023. With borrowers being able to refinance their mortgages up to 6 months in advance of the end of their fixed term. We expect that borrowers in this pool to will seek to refinance between July and December 2023 and will, in our opinion, likely see an increase in their mortgage payments. Potentially a high increase. Today this high street lender is offering 2 and 5 years mortgage products, subject to specific Loan To Value bands, at ~2,80%. The weighted average rate in this mortgage pool is 1.80%, so these borrowers can expect, all things being equal, a 55% increase in monthly payments on average if they were to refinance now. Which they cannot. The increase they will experience next year is likely to be higher.
We therefore expect house prices to remain relatively static in the short term (because buyers will start to struggle to borrow enough to meet Vendor’s price requirements initially and there is no pressure for the vendor to sell as they are still on a fixed rate mortgage) and then start to fall because the cost for the vendor servicing their mortgage exceeds their financial ability and / or buyers are not able to borrow as much.
Zoopla have recently published figures showing that the rate of house price growth is falling and that 1 in 20 sales now require a price reduction (1 in 22 in April). This is not dramatic, but we see it as a start. The Government will have to start to contemplate some financial alchemy to deal with this, possibly via mortgage guarantees. For our Prime Central London market, where debt on average is a minor component of any given property, there is no affordability stress which will cause price reductions today. If, however, our surrounding neighbours see house price reductions, then it is only normal to assume that PCL will also dip, but to a lesser extent as our market is vendor led: PCL is an expensive club to join, and owners do not give up their membership easily or cheaply. It is however early days in this cycle.
Authors: Ray Dalio, Founder and CIO, Bridgewater Associates.