Save Our Species – S.O.S.

Why Does Property Cost The Earth? November 15, 2008

Image by _moonpie via Flickr

My comments here are based on my experience of the UK property market. Since banking and markets are fairly global these days, I would be surprised if the circumstances vary greatly in the US or any other country around the world.

These days, the cost of construction represents a relatively small proportion of the cost of a property. The major component of the cost being the price of the land. For example, a four bedroom detached house in the area of the UK where I live would cost between £150K – £200K to rebuild in the event of a fire. However, the property value on the open market would be around £600K – £700K. The same house in a less desirable area only 10 miles from where I live costs in the region of £400K – £500K. The difference between the figure to rebuild and the figure to purchase the house being the value of the land on which it stands, which in turn depends on the location/desirability of the land.

It is not availability of property, but the availability of land that is affecting house prices. Because we see vast tracts of green fields covering our countryside, it may not be obvious that there is a shortage of land. However, the requirement for government permission to be granted to build on land creates an artificial shortage. To emphasize this point please check the price differential between land with permission to build already granted and agricultural land in your area. Statistically, in the UK, all but 400,000 of us live on less than 6% of the land (Source: Guardian, August 2003)

Until about 30 years ago, banks in the UK would only lend a borrower up to 2.5 times a single household salary for the purpose of mortgaging a property. When I was a boy this meant the most my family could afford to pay for a house was 2.5 times my father’s salary. The bank also insisted on a hefty deposit between 10-30% of the value of the property to ensure that the buyer had an investment in the property ,thus encouraging responsible borrowing. The requirement for a deposit in a climate of near zero consumer credit meant that the buyer was required to save the deposit money. Having the maximum borrowing limit tied to salary levels coupled with the requirement to save a deposit had the effect of setting a maximum limit on house prices based on a single person’s salary. Buyers only had so much money to spend so there was no point asking more than that when selling, resulting in relatively stable house prices.

Over the last 30 years, for reasons I will explain in my next article, banks have become ever more desperate to lend money to consumers. The first tentative steps taken by banks in this direction were to offer to lend 2.5 times the combined salaries of both husband and wife. So in families where both the husband and wife worked, the amount they could borrow almost doubled, thereby doubling the maximum amount that families with two earners could afford to pay for a house.

This new availability of credit applied a steady upward inflationary pressure on house prices. With the amount of money available to spend on property nearly doubling, so too over a period of a few years did the price of property. Initially people were still constrained by the requirement to save a deposit which acted like an anchor holding down the number of people who could afford to borrow the maximum loan amount offered by the banks. Another factor still affecting the amount that people were prepared to pay was their level of confidence that they would be able to recover their investment when the property was sold. Confidence, in turn depended on other peoples’ willingness and ability to borrow similar amounts of money from the banks. As more and more people paid more and more for property, our confidence in increasing house prices grew, and so so did our willingness to borrow more money for a good investment like property.

The next step by the banks to increase the amount we could borrow was to increase the multipliers used to calculate loan amounts available to borrowers. It became possible to borrow 3,4, even 5 times the joint annual family income. As property price increases grew ever steeper, the banks requirement for a deposit became obsolete. Since the rate of increase in value of the asset was so high, any loss incurred by the bank through the forced repossession of a property was offset by the increase in value of the property by the time the bank resold the property. Basically, all the risk was on the borrower and unless property prices crashed there was no risk to the bank.

Image by Buddhaah via Flickr

It has now reached the crazy situation in the UK where there is no longer any theoretical limit to the amount banks are willing to lend against property. People can now certify that they can afford to pay back any amount of money that they wish to borrow. As long as the bank believes the value of the property exceeds the amount borrowed and the bank’s exposure to risk can be covered by reclaiming the asset/house, the money will be lent to the buyer without too many questions being asked.

What this means is that when buying a house, we are forced into competition with other people for the same resource, that due to planning legislation, is in artificially short supply. Whilst the amount of land available for building is artificially limited, the only limit now to how much a bank will lend is the perceived value of property. In other words the more you are willing to borrow, the more the property is worth so the more the banks will lend.  So we find ourselves in an ever-increasing spiral of property inflation.

The question we really should be asking ourselves is why are the banks so desperate to lend us more and more money. Originally I believed this was just down to corporate greed. Obviously banks would make more profit from increased interest payments. Unfortunately it’s not that simple and the truth is far more ominous and frightening.

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