Why House Prices Must Fall

Speculation about the future direction of house prices dominates the media, but this simple explanation shows why they will drop.

In the twelve years from 1996 to 2007, UK homeowners and property investors enjoyed an extraordinary winning streak. As the latest housing boom started to gather pace, here's what's happened to house prices:

House prices rocket...

*Year*	*Average house* *price (£)*	*Yearly* *increase (%)*
1996	66,094	7.4
1997	69,657	5.4
1998	73,286	5.2
1999	81,595	11.3
2000	86,095	5.5
2001	96,337	11.9
2002	121,137	25.7
2003	140,687	16.1
2004	161,742	15.0
2005	170,043	5.1
2006	187,250	10.1
2007	196,792	5.1

Source: Halifax House Price Index

So, over this twelve-year period, the average house price almost tripled. In fact, it rose by 198%, or an average of 9.5% a year compounded.

My next table shows how the average wage in the UK has inched up over the same period:

...while wages creep up

*Year*	*Yearly wage* *increase (%)*
1996	3.6
1997	4.2
1998	5.2
1999	4.8
2000	4.5
2001	4.4
2002	3.6
2003	3.4
2004	4.4
2005	4.0
2006	4.1
2007	3.9

Source: UK Statistics Authority

As you can see, between 1996 and 2007, the average wage increased by between 3.4% and 5.2% a year. Over these twelve years, wages increased by 63%, or 4.2% a year compounded.

What does this all mean?

House prices up 198% versus wages up 63%

As house prices increase at a much faster rate than wages, we are forced to spend more and more on housing costs. Lower interest rates have helped to limit the impact of this trend, but cheap mortgages can't bail us out for ever.

Indeed, if wages and house prices continue to rise at these historical rates, then house prices would treble again by 2029, while wages would climb by less than two-thirds. In this scenario, the average house would cost over £586,000, while the average wage would be under £40,000.

Of course, this absurd situation will not arise, which doesn't bode well for the future direction of house prices.

A lesson from the last crash

No amount of financial flimflam can convince me that house prices can rise at anything like this rate over the next couple of decades. However, some housing pundits and vested interests believe that the housing market will continue to defy financial gravity and go into a `gradual slowdown'. Alas, this smacks of desperation to me, so I'm far from convinced!

When prices peaked in mid-1989 and started to fall, it took until the first quarter of 1998 for the average house price to reach its former zenith. That's nearly nine long years of falls -- and it ignores the depreciation caused by general inflation.

Thus, I believe that prices will not stand still while wages struggle to catch up. It's not how asset-price booms end, as revealed in Edward Chancellor's excellent book Devil Take The Hindmost: A History of Financial Speculation.

So, put on your tin hats and hunker down, because, in my view, the 2.5% fall in house prices recorded in March is only the beginning!

For the record, Cliff sold his family home three years ago and is patiently sitting out the property crash as a tenant.

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