Britain’s housing market is valued at approximately £7 trillion. Just recently London real estate prices experienced the biggest drop in 10 years. The recent drop came in the wake of Theresa May’s efforts to deal with criticism over ever-increasing prices and lack of housing. In case you are wondering what the recent fall means in regards to employment, investment, housing consumption, government deficit, etc. here’s what you need to know.
The ”Greater fool” mechanism
London’s real-estate prices have been fuelled by what is known as the ”greater fool” mechanism. Although London’s real estate buyers have known that property prices were ridiculously high for a long time, they continued to buy counting on the
fact that they would sell the property at a profit to a ”greater fool”. This phenomenon has been displayed in many instances the most notable being the free markets crisis. Although the ”greater fool” mechanism works, the upward usually reverses violently if the prices show the slightest indications of a fall. This happens when property investors start trying to sell in a hurry before property prices fall further. In the ”greater fool” mechanisms, property values which have been built over decades can collapse in months, and the slum is based purely on expectation.
London relies heavily on international property investors who view property as a commodity which can be sold readily for the sole purpose of maximising profit. International property investors accounted for approximately 82% of London’s property activity back in 2013. The ”greater fool” mechanism is a real threat in London now that the expectations are set.
Housing consumption and the Wealth Effect
Although real-estate prices in London are subject to the ”greater fool” mechanism, it’s important to note that most properties belong to households, mostly families who don’t need to sell. Nevertheless, a fall in property prices means that pension funds, as well as investment bonds, will suffer since they rely heavily on the property market to generate returns.
It’s also important to understand the Wealth Effect. Economists have shown that there is a strong relationship between spending behaviour and perceived real estate wealth. What this means is; property owners feel more financially secure if they believe their property is worth more. As a result, such property owners spend more and save less. This is evident given the number of people willing to subsidise their retirement using property generated wealth.
Considering 64% of England’s homes are occupied by owners, the negative effects of the wealth effect are dire if households start spending less. The Wealth Effect is crucial in most developed countries more so the UK which is heavily dependent on ever-increasing consumer spending for growth. A small drop in the value of homes/properties in the UK would result in a catastrophic loss of wealth. With the housing prices experiencing the biggest drop in 10 years, things don’t look good for UK households.
Ripple effects (Trade deficit and foreign direct investment)
The falling housing prices come with additional problems for the UK. Britain has been having a trade deficit for over two decades now. The effects of the deficit haven’t been dire since Britain has been enjoying hundreds of billions of pounds as foreign direct investment channelled to the property market over the same period. In a nutshell, the trade deficit has been manageable.
According to Bank of England statistics, over 50% of all commercial real estate deals since 2013 have been done by overseas companies. Since international investors expect a fall in prices, foreign direct investment inflows may slow down or stop soon. Britain may also see a sharp decline as foreign property investors choose to sell property instead of holding when there is a clear expectation of a decline.
A drop in foreign direct investment in the long-term will have a negative effect on the UK GDP and trade deficit. Britain will no longer have a cushion against its longstanding trade deficit when foreigners stop buying property. Britain’s credit rating would also fall which would, in turn, make UK government debt more expensive to refinance. When this happens, the UK government may be forced to tax its citizens more to handle an increasing deficit. Increased taxation would cause other effects such as increased unemployment.
The recent fall in housing prices has created a need for new policies to reduce Britain’s property addiction. There is also need to boost confidence in this single asset class considering it accounts for approximately two-thirds of Britain’s wealth. Theresa May’s efforts to push for more affordable housing are a step in the right direction although it has been politically challenging trying to push for such policies. The effects of targeting the UK real estate market are huge currently. Theresa May risks scaring away investors and triggering the ripple effects discussed above. Considering Brexit has introduced many risks, Britain may face a long period of economic stagnation.