UK: Is London seeding a property bubble?

The average property price in London has increased fourfold since 1995, soaring, slumping and soaring again in a volatile market that economists and commentators have struggled to get a grip on.

To understand the unusual variations in the London housing market we need first to examine the considerable disparity between house price changes in the capital, which have vigorously rebounded, and elsewhere in the country.

Following an artificial hike in house prices in 2008 when the country was awash with cheap foreign credit, national prices plummeted in 2009 and have only recently recovered to 2007 in levels. Some parts of the country have not seen even this modest recovery, with prices continuing to decline year on year.

What’s going on? If you talk to most young people, they’ll tell you they’re about as close to landing on the moon as they are to buying a property, and after the lashing they have received since 2007, the banks have hitched up their breeches and put their mortgage spending on a tight leash. Gone are the days when you can pick up a mortgage like a pint of milk.

Part of the problem is that cash-rich foreign investors looking for healthy returns are faced with a dwindling number of options. As the debt crisis rumbles on in Europe, investing your money on the continent, whether in banks or stocks and shares, is no longer the triple-A safe haven it once was. Even if they weren´t troubled before, then the recent raid on personal bank accounts in Cyprus will have surely given even the most nonchalant investor pause for thought.

You could look further afield to the high-growth developing economies, but these continue to have their attendant risks and are only for experienced investors who can hold their nerve in a tumultuous market.

Shrewd investors recognise that bricks and mortar in the capital could offer a happy medium. As mortgage companies close ranks and Brits struggle to cobble together the hefty deposits required to buy a property, rent prices are on the up.

Rental prices in London grew by 6.7% last year and more than 32% since October 2009. With inflation currently at 2.8%, and wages often failing to keep pace even with that, London tenants are struggling to foot their housing bill whilst landlords clean up: cue the international money men.

At the end of last year, London accounted for a third of total European investment transactions, with investors shelling out 30 billion pounds buying up prime commercial properties in the three months to October last year.

According to figures from property developers de Candole Residential, half of the properties priced at £2m or more in London are bought by overseas buyers. And these international buyers snap up 70% of properties in the capital sold for more than £10m.

It´s a trend we´ve seen develop since sterling weakened after the 2007 crash and made property a more attractive investment. In 2010, Liam Bailey, head of residential research at real estate agency Knight Frank LLP found that Asian investors were buying more than a fifth of all central London’s new properties, and accounted for 49 percent of all investment purchases in central London:

“Of the 7,595 newly built properties completed in the 12 months prior to March 2010, 41% of these were bought by investors rather than owner occupiers. And 49% of all investors were Asian.”

All this has pushed up prices in the capital, particularly for the luxury, high-end properties favoured by the well-heeled new money magnates in Russia, China and the Middle East.

One thing to be thankful for is that investing in property involves a long-term commitment which limits the devastating hot money outflows that we saw with some of the Asian tigers, for example. However, even if it takes effect on a more gradual basis, investors whisking their money out of the UK at the first sniff of a superior yield still has the potential to crash house prices and destabilise the market.

Adding fuel to the fire, the British government recently announced a new scheme to give first time buyers a helping hand on to the property ladder by giving them an extra 20% top-up for their deposit, interest-free for the first five years and later moving to a variable interest rate.

Such a scheme may be laudable in its attempt to help British citizens into their own homes, but it has dangerous echoes of 2007 when thousands of people bought overpriced property at the peak of the boom, overstretched themselves financially and wound up either losing their homes, or bogged down in negative equity when prices crashed.

It also sounds worryingly analogus to the Freddie Mac and Fanny Mae policies of the 1990s and 2000s, which proved so significant in causing the US subprime crisis, and in turn triggered the global economic downturn.

Piling on further demand in a market so tight buyers can´t even get a foot in the door can only lead to spiralling prices, overpriced homes and potentially a nasty crash. It´s precisely what we need to avoid at a time when the UK government needs to restore confidence at home and overseas.

Sooner or later the tide must turn; property prices cannot perpetually rise above inflation without there being a correction at some point. Whether that involves a gentle levelling to more sensible prices or a dizzying tumble into negative equity remains to be seen.