Unexpectedly Intriguing!
June 30, 2014

Has a housing bubble formed in London's real estate market?

Depending upon who you ask, you will likely get one of two different responses. Either: "Yes, and it threatens the UK economy" or "No, and what's more, housing prices in London ought to be even more expensive!"

Now, since we've long since established ourselves as having special expertise in this area, the answer is an unequivocal, yet qualified, "yes".

To understand why we've come to that conclusion, let's start by considering what we would expect a nonbubble-driven housing market to look like. In such a market, we would expect to find a very close coupling between the typical sale prices of homes and the typical incomes earned by those who might purchase them. If we were to make a graph of the relationship between home prices (on the vertical axis) and incomes (on the horizontal axis), we would expect to find a very linear relationship between the two, with home sale prices being directly proportionate to incomes.

Annual Expenditure for Owned Dwellings vs Annual Income Before Taxes for Various Income Ranges Reported in the Consumer Expenditure Survey, 1984-2011 [Constant 2011 U.S. Dollars]

In a nonbubble-driven market, a linear relationship between home sale prices and incomes would also be observed over time, where in theory, we would expect both dwelling sale prices and incomes rising and falling in step with each other. In practice, because changes in home sale prices and incomes aren't fully synchronized with each other, we would observe somewhat of a "stair-stepping" pattern, with a series of linear but largely parallel trends in housing prices with respect to incomes being observed.

When a housing bubble has formed however, the linear relationship between typical home sale prices and typical incomes breaks down as they become decoupled from each other.

We found two key sources for information about the trends of housing prices and incomes in London, England. The first is the monthly and quarterly series of tables for the Housing Price Index [Excel spreadsheet] published by the U.K.'s Office of National Statistics, specifically Table 15, which presents both new dwelling sale prices and the mean household incomes of those who purchased them. The second is the ONS' Annual Survey of Hours and Earnings from 2002 through 2013, where we obtained the mean annual wage incomes earned by individuals in London for each of these years.

Using the quarterly data presented in our first source, we calculated the rolling four-quarter average for both new dwelling sale prices and purchaser household income, which allows us to address any seasonality in the data. For the annual average wage data provided by our second source, we assigned the given value to the second quarter of each year, then interpolated intermediate quarterly values between them. The results of our calculates are presented visually for the periods from 1993-Q1 through 2014-Q1 below:

Trends in London, England Rolling Four Quarter New Dwelling Sale Price and Household Income of Borrower, 1993-Q1 through 2014-Q1

All data in this chart is presented in nominal terms of current year Great Britain pounds (GBP), with no adjustment for inflation. We're focusing on new dwelling sale prices, since these values, almost by definition, apply to the margin of real estate markets, which gives us greater insight into the economic conditions for the market.

Our next chart examines the relationship between the average rolling four-quarter average of new dwelling sale prices and the average annual wage incomes earned by individuals in London for the years where we have that data, from the second quarter of 2002 through the second quarter of 2013:

Rolling Four Quarter New Dwelling Sale Price vs Mean Annual Wages of Individuals in London, England, 2002-Q2 through 2013-Q2

This chart confirms that new dwelling sale prices and the average annual wage income earned by individuals in London are fully decoupled from one another. We can observe that decoupling fully in the trend for London's housing prices from 2010-Q1 through 2013-Q2, where housing prices have skyrocketed while the average wage incomes earned by individual Londoners first rose slightly up through 2011-Q2, which has fallen since.

The phenomenal growth in London's new dwelling sale prices over this period is such that these dwellings can only be affordable for those individuals with increasingly large incomes or for those homeowners who can combine multiple incomes.

Our next chart however shows that there is some degree of rationality in London's real estate market. Here, we're showing the trend for average new home sale prices versus the average household incomes of those who have been purchasing them in the period from 1993-Q1 through 2014-Q1:

Rolling Four Quarter New Dwelling Sale Price and Household Income of Borrowers in London, England, 1993-Q1 through 2014-Q1

To us, this chart indicates that London's real estate market is behaving rationally, since the patterns we observe in the chart are consistent with what we would expect to see in a property market that is not being influenced by a bubble, which we described earlier.

That's why we would describe London's real estate market as being bipolar in nature. It would seem, on first glance, that it both is and is not experiencing an economic bubble.

What tips the scales in our thinking however is that what we do observe, with the escalating incomes of those who are purchasing property at ever-escalating prices, is consistent with the kind of sales-mix distortions that we've observed in both the first and second U.S. housing bubbles.

London's new dwelling sale prices are increasingly only affordable for those with the highest incomes, which tells us that the city's new home builders are largely only addressing the demand for those buyers and abandoning the potential market for home buyers with average incomes, which would explain the U.K's apparent "two-speed" housing market. That supply constraint then is likely a significant factor behind the current escalation in prices.

We therefore find that London's real estate market is indeed experiencing bubble conditions. We find the bubble's origins in the nation's economic recovery beginning in the first quarter of 2010, however its key period of inflation has occurred in the period since 2011-Q2, approximately as mortgage rates in the U.K. hit their lowest level on record. Combined then with an influx of very high income earning refugees fleeing the confiscatory income tax policies being implemented in several European nations (Greece, Spain, France, etc.) since that time, we think that these factors can go a long way to explaining what has caused the prices for London's real estate to grow so much and so quickly.

And not to mention so bipolar. The inflation of a housing bubble in such a limited geographic area is really a fascinating spectacle.

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