The link between house prices and salaries

Neil Faulkner examines the link between how much you earn and the value of your home

In The future of property prices I outlined various gauges forecasters use to estimate how hot house prices are. The most common measure is the house prices to earnings ratio, which shows how many times our pre-taxed salaries that property prices are at: if salaries are £1,000 per year (just pretend) and properties cost £4,000, the ratio is 4.0 times salaries.

I've looked into this measure to see how reliable it is.

How high are house prices compared to salaries?

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We don't yet have earnings data for 2009. (The ONS has published more recent earnings data, but how it's calculated and averaged doesn't work for this exercise.) However, if we assume that earnings in 2009 were roughly the same as in 2008 – maybe a bit more, probably a little bit less – then the ratio at the end of 2009 was 4.3 times.

Often this ratio is calculated on men's salaries only, which is fine, but the important thing is to stick with one method.

So are house prices too high?

Most forecasters say the average long-term ratio is 3.5 times salaries and many argue that, like everything else in economics that can be easily expressed in a graph, it will inevitably go down to that long-term average.

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However, I think the long-term average is lower. Most forecasters calculate from the late 70s or early 80s and some probably use earnings data which I think is misleading. Calculating from 1952 to 2008, I find the average ratio is actually 3.1 times salary.

My estimate will please those who are committed to believing that prices will crash, whereas those who are committed to believing they won't will latch on to some plausible-sounding and potentially plausible-really reasons as to why this average doesn't make sense, such as increasing numbers of dual-income families.

So let's see if we can get more from this data to give a boost to one or other of these camps:

How has the increase occurred?

If the rise in the ratio to well-above average occurred in the past ten years then it's either a bubble, or a big change must have happened very recently in order to push up what the ratio 'should' be.

On the other hand, if the rise is gradual it shows that the ratio slowly rises over time, or at least that it has done up until now.

To visualise what's happened, here's the average ratio over consecutive eight-year periods since 1952:

Look at the data from 1952 to 1991. It looks to me that you could argue either the ratio is flat or it has been trending mostly upwards by very small amounts. Either case is plausible or possible with this data. You could also argue that the average ratio for the next eight years was just a big dip and that the following eight years were an over-compensation – a pattern we see all over the place when boom follows bust.

A temporary phenomenon

However, whether you think the ratio is totally flat or slowly, gradually increasing, the leap from eight-year averages of 2.5% and 3.3% for 48 years up to 4.2% for the past eight years is very steep. Most or all of that rise isn't likely to be caused by such things as more dual-income families sharing the costs and pushing up prices, as that change would have been spread over more years. I think the high ratio is more likely therefore to be a temporary phenomenon.

There is an argument that unnecessarily tight lending policy decades ago kept the ratio artificially low. However, as early as 1973 the ratio rose to close to four times salaries, showing that lenders even then weren't trying particularly hard to show restraint. Also, whether the loose-lending policy of the past ten-plus years is sustainable over and above our rising salaries remains to be seen and believed.

There are other arguments that the ratio should be higher in the 21st century, but they're not so frequently put forward, and I'm not able to research and review the pros and cons of every one of them here.

I don't have strong feelings about property prices, having no connection or expected future connection with the UK market as a buyer, seller or renter (I live in Munich).

However, I do have strong feelings about long-term economic trends, based on years of research as a finance journalist. The long-term trend here tells me house prices are still a fair bit too high.

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Earnings data (and to a lesser extent property-prices data) are unreliable. To do my sums, I had to wade through a load of biased sources, incomplete records, and try to deal with the conflicting and often variable ways these sources use to estimate average earnings and house prices. I've done the best I could, but I think we would be foolish to rely on this measure alone.

Circumstances permitting, I'll try to cover more measures of house prices over the next few weeks, such as supply and demand, mortgage repayments and interest rates. I suspect interest rates, for example, will offer a better explanation as to how house prices have got so high in recent years, but some research will hopefully follow in due course.

And house prices in twelve months will be...?

No idea. Sadly, if this ratio correctly shows that house prices are over-priced, it doesn't mean they're going to crash soon. Indeed, they don't have to crash. There are other ways this ratio could correct itself: salaries could rise rapidly or the market could stagnate until salaries have caught up. I'm not making any guesses about how likely those possibilities are.

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