Sunday, March 23, 2008

Idle Thoughts on Correlations With House Prices

I have a few ideas I want to write down with the intention of filling out details in later posts.

1) Residential Property Prices as a Multiple of Income.

Jeremy Grantham, Chairman at GMO ( uses this metric often in his 'Letters to the Investment Committee'. In the UK the mean residential property price is currently about 6x mean salary. The long term multiple is around 3.5 and plotted on a graph this metric screams bubble and has been doing for the last few years.

The thinking behind this metric is simple - that the value of a house is strongly related to (and ultimately bound by) how much people can afford. That said, multiples greater than the number of years typically worked can't be completely ruled out if we allow mortgages to be handed down through generations. OK, but the only reason to do that is if the holder thinks that house prices are going to substantially increase in value over time, over and above inflation and personal earnings growth. Since we can always build new houses (where there is land available) that doesn't seem to hold - house prices will always be related to replacement cost.

A casual observation here is that the multiple of six is close to the reported multiple of 5x salary used by some mortgage lenders up to the sub-prime crisis kicking off. Typically a lender will calculate the maximum amount they are willing to lend using a multiple of 2.5 to 3. The gradual shift up to 5 was symptomatic of the disconnection going on in the debt markets between percieved or calculated risk and actual risk.

Now that salary multiple is a pretty crude calculation anyway. At the very least they could subtract tax and some basic cost of living from the gross salary and then assign a new multiple to what remains. In fact a glance over some mortgage web sites shows what they actually do is use different multiples depending on a small set of salary ranges. Better but still pretty crude considering this is a fudge to avoid doing some basic algebra here guys. No doubt more accurate calculations are performed in the 'back office'. Well maybe.

2) Employment Rates.

I need to check this out in more detail but I've read that another correlation exists between employment rate and property prices. Easy to see for sure, the economy slows, people lose jobs and ability to pay a mortgage. Or at least there are less new buyers around. Perhaps a stronger correlation would be found between total employment level rather than employment rate, since we are currently (in the UK) taking in many overseas workers, all of which add to demand for existing housing stock. You could argue that the construction industry expands along with the working population and demand, sure, but there is some lag there I would say. It also raises the possibility of recent immigrants swiftly departing the UK on an economic downturn, reducing demand for accomodation fairly sharply.

3) GDP per head.

This is related to the above comments about employment rate versus employment level. Last week The Economist discussed how GDP per head is often a very different number from overall GDP. E.g. Japan's GDP per head is actually very strong due to a shrinking population, The US on the other is already in a recession on the per head scale because of a rising population through immigration.

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