The nights are drawing in and the hoped for (hoped for? who ever beleived this?) pick up in US and UK housing markets in the Autumn failed to materialise.

Earlier this month, the UK’s Halifax reported monthly falls of 3% in average property values – a huge decline. Whilst fellow mortgage lender and property price index tracker, Nationwide, reported just 0.1%.

In mid/late October bank stocks began their 3rd quarter reporting season – profits sharply down, concerns over the mortgage book and stock prices taking a hit.

Now then, does this put us in place for a 30% decline in property prices? Should forecasts for 2011 of a 30% property price drop be believed?

No.

It’s not that bad.

Don’t forget that the central banks – US Fed, UK Bank of England and Euro Central bank – have all been withdrawing from their various forms of printing money (know as quantitive easing in some cases or special liquidity rules etc…).

Hence, the first question is this – will the mortgage market become bad enough to tip the central banks back into printing more money?

The answer here has to be yes.

But equally, the purpose of printing more money is to halt or limit the fall.

So, a forecast for 2011 property prices in the UK, US or Europe needs to consider the likely political responses. Most economic models and certainly those economic forecasters don’t have a means of incorporating this uncertain human decision making into their models.

And this explains why you will see many forecasts publishing dramatic predictions – 30% in some cases – yet, this is extremely unlikely to occur.

What we can say though, is that at some point housing must return to its fundamental value. In our calculations property left this measure behing in about 2004 in the UK and therefore, at some point in the next two to three years, the value of UK property will approximate to its 2004 value.

If you are buying a house or, more importantly, looking to invest, the 2004 level should be your rule of thumb – priced above this level – don’t buy.

However, the path to reach this balanced level will take a few more years. Hence, property price falls in 2011 will not be as bad as predicted, but the falls will continue into 2012.

Perhaps them we are looking a price slides in the single digits for 2011. This will be on the back of an annual slip in 2010 and will continue until 2012.

Don’t forget, that the super low mortgage rate environment has lasted longer than expected – mainly to give politicians time and an economic environment in which they can work through the budget cuts.

Until we have a combination of high unemployment and high (3 or 4% base rates would now be considered high) interest rates, then property will not be forced onto the market.

The result is that the volume of sales will fall and this will make monthly price analysis more spiky – but equally, less useful.

Prediction for 2011 house prices? Falling steadily with a few rocky moments.

The rise, of 0.6%, was below the forecast of 0.9% and sits against a 3.2% GDP increase in the first quarter of 2010.

Equally, the spring is a typical time for price rises.

For these various reasons, foreacasters remain cautious about any further increases explaining that there is a still a significant phase of re-adjustment to work through before steady price rises begin. Not least the fact that various mid sized US cities are staring at bankruptcy.

US consumer inflation – not adjusted for seasons – is running at 2.3%.

UK Property Prices - Slowly Sliding?

Nationwide’s index reported a modest increase in UK property prices in the February to March 2010 period.

At the same time, the US Schiller index reported weak US property prices amid growing consumer confidence.

The UK’s chancellor also announce an attempt to reflate the UK property bubble by suspending stamp duty for first time buyers on properties up to £250,000.

So what is happening?

Firstly, property prices are not collapsing or falling significantly (as per the index) however, the  number of mortgage approvals is still very low and there are clear suggestions that only the ‘best in the road’ properties are selling with all other less attractive options unable to obtain a buyer.

This flight to quality means that the indices will in effect compare the prices of the weaker properties (which sold in a strong market) with the stronger properties which are still selling in a weak market (unlike their weaker cousins).

What do we mean by weak property?

Well, simply properties that need work doing to them – or lack basics such as double glazing or where the wiring is a bit old, or it may simply by that the stronger properties are being sold with display furniture from the developer and so forth.

All of these subtleties are lost by the indices and explain why the indices don’t drop as much as it feels they ought to in a weak market. Or, why the indices don’t manage to reflect the real experience of property buyers and sellers.

Secondly, the US is reporting, at the end of march, more positive news on consumer confidence with an expecting increase in employment – however, the US property price forecasts remain on the slightly negative side.

This suggests that we could see growing consumer confidence coupled with stagnant or weak house prices. And, if the much anticipated inflationary pressures get stoked in either the UK or US, then house prices will fall in real terms.

So, instead of 7.2m jobs lost, the figure is now 8m.

It is called a revision and suggests that the figures we read about in the news are not only out of date by the time we read them, but that what we experience ourselves is a more accurate indicator much of the time.

For most of 2009, on the street, US and UK people keenly felt the loss or risk of loss of jobs. The figures in both countries, but especially in the UK, much lower than expected.

Nevertheless, we are beginning to get explanations for this starting with the revised calculations in the US and predictions that the UK’s unemployment rate will rise from 7.9% to 9%, despite the country narrowly escaping recession.

Either way, the higher ‘actual’ or delayed job figures is a clear downward indicator for property prices in the US and UK.

How much will these houses cost in 2010?

At the end of December 2009, the UK Government withdrew its tax relief on home in the first and second time buyer price bracket (125,000 GBP to 175,000 GBP) and it was accompanied by a reported 0.4% price rise in UK property prices in Dec 2009 by Nationwide and a 2.2% drop recorded by Rightove.

Nationwide´s modest rise is slightly down on the 0.5% rise in November whilst rightmove reported a sharper fall of 2.2% against 1.6% in November.

So, the housing market is either weak or weaking.

The question is, to what were he weak prices supported by buyers pull forward their purchases in order to avoid the stamp duty due from 1st of Jan 2010?

Is this the housing equivalent of the cash for clunkers deal for cars?

The answer is probably not. Yes, the volume of property sales in the lower price brackets (below 250,000 GBP) held up well, but it fell sharply in the higher price brackets where sales volumes were much lower and prices softened rather than firmed (as they did in the lower price groups).

2010 is likely to find that sales volumes in the lower price range will fall and prices will soften as Goverment support is withdrawn and the modest effect of home purchases brought forward takes its effect.

However, the real question we need to ask when forecasting short term property prices (ie upto 1 year) is what will happen to interest rates?

We don´t know, but we do know this about 2010

• Government debt default (perhaps by Greece or Dubai or another hidden gem) is a real possibility that we will live with all year (even if it doesn´t happen)
• UK and US Governments will come under increased pressure to deal with their debt
• The dollar may rise as it is seen as a safe haven, which might mean US interest rates lift
• UK Commercial property refinance needs could derail two major UK banks and create a new banking crisis and forcing UK interest rates higher and derailing UK residential property prices
• UK Tax hikes will not take affect in 2010 but in 2011, thereby putting further downward pressure in UK property towards the end of 2010.

Okay, we can only conclude that the risk for interest rates is an upward move. Essentially, if something really good happens, then interest rates will rise – in both the UK and US , and if something really bad happens, interest rates will rise.

Therefore, low and stable interest rates are dependent on a very stable and low growth economic scenario.

Therefore, the best that might be hoped for is a modest 3 to 4% increase in property prices, but with the equal risk of a fall of 10 to 15%. Albeit, you can expect the wide divergence in property price indexes to continue.

The result is likely to be somewhere in the middle, but the risk for property prices is clearly on the downside.

Commercial Property Time Bomb?

The affect of the commercial property sector – which is linked to the health of companies using warehousing, offices or retail space – on the residential property sector should be negligible.

Sadly, this decoupled effect isn’t going to work in this property recession.

Here’s why:

Residential property values are closely linked to the ability and willingness of banks to lend or issue residential property mortgages (okay, also known as home buyer mortgages).

The growth in prices in the US and UK and other developed western European economies since 2004 has largely been a result of increased credit and not fundamental shifts in demand or capacity to purchase.

Therefore, the role of finance in determining property prices has grown significantly in the past 5 years such that what affects the banks now directly and significantly affects the availability and price of residential mortgages and therefore house prices.

Remember that at the peak in 2007,

the average loan was 5 times annual salaries where as the typical average was closer to 2.5. Therefore, we argue that the level of lending was double the normal rate and therefore needs to reduce.

So, if banks get hit with bad loans, then they will retrench to a lending level closer to the long term average.

And what might hit the banks? Well, initially not residential property and probably not companies loans, so what might cause the problem?

The answer is commercial property.

As this FT article skillfully points out, the amount of commercial property debt maturing (ie needing to be refinanced) in 2010 is nearly 170% of the 2009 rate of US$65 billion.

In fact, the situation will continue to get worse in 2011 with US$164 billion worth of commercial property loans requiring refinancing.

And the question is, will the banks be willing and able to offer new loans and will the terms of the loans offered keep the commercial property owners in business or force them to sell at distraught prices?

Curiously, this question fits neatly with the view expressed by economist Roger Martin-Fagg that a bank’s balance sheet is at its worse in year 3 following the onset of a recession – that is around 2011.

And, this negative view is backed up by Martin-Fagg’s comment that the CEO of HSBC is attempting to hold onto cash in order to improve the capital ratios of his bank – in preparation of further impairment and debt write-downs in 2010 and 2011.

So, the banks are forecasting a worsening situation and slowly withdrawing credit or offering credit on worse terms for the borrowers.

By any measure then, we are facing a ticking time bomb in which the fundamentals for residential property are getting worse and will reach a nadir in 2011.

The question now is not what is the property price forecast for 2010, but what state will the property market reach by the end of 2011?

One economist is predicting 35% property price declines by 2011 for UK property. We still believe that is unlikely, but do agree that over a longer period – to 2013 – the real decline in property prices will be around 30%.

The current glut of property price rise news from developed economies’ property markets is, therefore,  a temporary bubble and will shortly be reversed as banks deteriorating credit position moves back to centre stage. This view, however, has to be tempered with the fact that today’s property market is much smaller and made up of much cheaper properties than the comparable market of a few years ago.

US Property Prices Sept 09 - Case-Shiller

The slowing growth rate was accompanied by a down grade in US GDP figures as the broader US economy was incorporated into the earlier growth estimates which are largely based on international businesses.

David Blitzer of S&P commented that “the gains in the most recent
month are more modest than during the seasonally strong summer months. Fewer cities saw month to month improvements in September than in August in both seasonally adjusted and unadjusted figures.”

However, these figures mask wide variations with “Las Vegas remaining the most depressed market. Prices have declined for 37 consecutive months, with a
peak-to-trough reading of -55.4%.

“Detroit has seen some positive movement in recent months, [yet] the market is still at only 73% of its 2000 value. This compares to regions such as Los Angeles, New York and Washington, which have maintained values of 70-80% above their 2000 averages, in spite of the market downturn.”

The gap between the successful and unsuccessful locations and regions appears to widening although it is worth noting that Government car giant bail outs has almost certainly prevented Detroit from a property price freefall. However, there is no respite for Las Vegas speculators and the market shows clear signs of a flight to quality.

Reported in the Economist last week we had

Home re-sales up by 9.4% in September
New home sales dopped unexpectedly

Why? Simply, the resales spike was caused by a rush to complete in time to take advantage of a tax credit that is about to expire.

So, what will happen next month? Almost certainly there will be a sharp fall in re-sales as any sales in the pipeline would have been brought forward to meet the tax credit deadline.

Therefore, next month expect dire new and re-sale house data from the US.

The October results will give us a clear picture of how sharply a market falls once the government induced stimuli disappear.