A return to normality
"When do you think that the market will return to normal?" is a question that we are often asked. What the questioner is seeking is reassurance that property prices will start climbing once again and that the feel-good factor of everyone ‘making money’ will return – the sort of world that everyone has got used to for pretty well the last fifteen years. The likelihood, however, is that this was not normal. 

It is not normal for lenders not to care whether they get repaid. An interest-only mortgage on six times a first-time buyer’s salary, at a loan to value of over a hundred percent is, in effect, ignoring the uncomfortable need for repayment. The lenders didn’t care too much because it was someone else’s problem – a pension trustee who had bought a job lot of such loans without due diligence, for example. Those pension funds have learnt (too late) to ask the right questions and, as there is now no greater fool in the chain, this sort of mortgage is likely to be filed under ‘ancient history’. 

It is not normal for house prices to double within four years and to go up between seven and eight times in fifteen years when inflation is in lowish single figures. There are all sorts of good reasons for it: London’s dominance of the financial markets, a strong pound, demographics, etc – the list is trotted out too often to bear repetition. But this sort of year on-year real increase of 20% plus simply couldn’t, in logic, go on forever. Indeed, it would seem to be stretching long-term credibility that ordinary family houses in Fulham should trade at in excess of £3m. There are a lot of them and this is not the territory where the lucky recipients of multimillion dollar bonuses tend to cluster.

Then there are those bonuses themselves. With the sub-prime débâcle overhanging the City and the baleful eye of the regulator now casting a shadow over how the compensation structures there might have led to so many of the problems we are now in, it seems unlikely that the huge money-machine in the City and Canary Wharf will be quite so generous in either the short or medium term. This comes as a double whammy where stock options, granted in sunnier times and probably counted into the bank account prematurely, are now so far under water as to be unlikely to see the light of day again. The feel-good factor, on the scale we have seen, is unlikely to be with us again for some time. 

The whole buy-to-let bonanza was not normal either. Banks, until the turn of the century, were very unwilling to lend to amateur private landlords. With the demutualisation of the old building societies into the go-go lending machines like Bradford & Bingley and Northern Rock, landlords found they could borrow pretty much what they liked and it all went swimmingly when prices were heading ever upwards. Commercial and residential properties became asset classes that were mentally put in the same box by investors and lenders alike. Unfortunately there is a flaw at the very heart of this assumption. Commercial buildings are nearly always positively funded – the cost of the interest is covered by the rent; that rent is nearly always upward-only for a long period, and the lease is in the name of someone, or thing, with a track record of paying on time. The value is a multiple of the rent.  When funding became negative (as it did last year) most of the wiser grey-beards in the industry were heading for the exits.  The residential model is almost entirely the obverse of this. Net rents (after voids and agents’ deductions) are well below the cost of interest payments. The lease terms are short – often only a year – and the tenant only as good as his current job. Values are set entirely by supply and demand which is itself distorted by abnormal credit conditions, as we have seen above. When the capital values start falling, the emperor is left looking at the paucity of his clothing. The unwinding of this mis-appreciation of risk is only just beginning.

We speculated in January that it would be over the following six months that we would find out whether the central bankers had lost control. It would appear that they have avoided a financial collapse by flooding the market with liquidity – ‘volume’ of money. However, it is the ‘velocity’ of money, a willingness by lenders to lend and borrowers to borrow, that makes the economy grow – and it looks as if that isn’t happening as banks have made rebuilding their tattered balance sheets the priority.  This is a real inflection point. The era of cheap (and easy) credit is well and truly over for the foreseeable future and this is inevitably going to affect anyone in the property market who is borrowing money – which means just about everyone except the very rich. 

This is reflected in our experience over the last six months. The international market that is fuelled by what is mainly petrodollar money is booming as ever: houses selling for north of £100 million in the vicinity of Kensington Palace attest to that. The market for the fastest jet, the biggest yacht, the best Monet, the most capacious house on Cap Ferrat or the peachiest estate has never been stronger. Cash rules in this world.  Everything below that, in the world of borrowed money and bonuses, is much tougher – with the toughest where you would expect it, in the first-time buyer market. In secondary markets turnover is massively down, almost to the point of lockup. This is beginning to loosen up but at the expense of value – sellers can find buyers, but at levels probably 15% below what they would have considered only a few months ago. In general, the further up the market you go, the less geared it is – and the longer sellers can resist reality. It was ever thus.
 
If this goes on, and it isn’t going to change any time soon, then we will have to get used to conditions that we would all have considered normal in the last century: lenders asking awkward questions about repayment, lower loan-to-value ratios and a more credible link between the amount we earn and the amount we can borrow. In markets that don’t concern themselves with these vulgar questions, the boom is likely to continue as there is a vast quantity of money chasing limited assets. Should you be depressed? If you are a buy-to-let landlord in the lower reaches of the market – very. If you live in the house you own, and can afford the mortgage, it shouldn’t make any difference. If you are looking to trade up, you should have a patient smile on your face.

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