OUTLOOK 2023
Residential
No more ‘lower for longer’
2023 will commence with interest rates at their highest level since late 2008 which marks a paradigm shift for the housing market. The very low cost of mortgage finance since the Global Financial Crisis (GFC) has enabled house price growth to far outstrip earnings growth. It is the most fundamental reason why the median house price in the UK is now over eight times median income.
We have now seen three successive monthly falls in house prices, with November's decline the sharpest since the GFC and it is now broadly accepted that we will see house price falls in 2023. Inter-linked economic pressures are behind this but the jump in mortgage rates is the key reason. Around two-thirds of buyers use a mortgage and the increase in average mortgage rates from about 1.6% at the beginning of 2022 to over 5% at the time of writing will have a severe immediate impact on buying power.
How much will it hurt?
Probably the key question in the residential sector is the extent of the correction in the housing market that this will lead to in 2023.
As the key driver of the correction is mortgage affordability, this should be a good high-level gauge as to the level of house price falls we can expect. In the last two major house price corrections it has proved a helpful lead indicator and the table below shows the relationship between stretched affordability and the level of price falls.
Monthly affordability of mortgage payments and house price corrections
Source: Land Registry, Capital Economics, Avison Young
Chart 1 shows the long run affordability of mortgage payments (monthly cost of an 80% LTV mortgage on average-priced house as a share of median full-time disposable income), with the long-run average, illustrating how strained affordability now is.
CHART 1 – MONTHLY AFFORDABILITY OF MORTGAGE PAYMENTS
Source: AY, Capital Economics
In reality house price falls depend on a variety of factors and while they look heavily stretched in terms of mortgage affordability, other indicators look less stressed. Firstly, recent Bank of England data shows more than half of mortgages are five-year fixes and another quarter fixed for two years. This means that the majority of mortgaged-owners will not see their monthly costs rise sharply in the near-term and the effect will feed through gradually. It enables precautionary saving and spending adjustments which will help households better absorb the increases when they come through.
Along with the much lower prevalence of high loan to value lending than we saw in the GFC, this means that repossessions and forced sales should be limited, reducing downward pressures on house prices.
The other key factor that should limit repossessions and forced sales is the strength of the labour market. The UK’s unemployment rate remains extremely low by historic levels and while it will undoubtedly increase in 2023 as the recession bites, we do not expect it to reach anything like the levels seen in previous recessions. Oxford Economics are forecasting a peak of 4.8% next year and Capital Economics 5.5%, in comparison during the GFC it reached 8.4%.
“Appetite for investment will remain strong as residential offers the best prospects for real rental growth across cycles and investors continue to be attracted by the underlying supply / demand imbalance and will look to reposition towards it”
Richard Stonehouse, Principal, Investment Residential Land
The depth of the recession is also not expected to be as severe as the GFC or the early 1980’s. Consensus forecasts are a GDP fall of -0.3% in 2023 and even if this proves to be optimistic (which we think it is), a relatively shallow recession will help limit house price falls.
So, despite the sharp increase in the cost of servicing debt and falling real household income, the counterbalances from the strong labour market, relatively small GDP decline and limited high risk lending on banks’ books means we think house prices will fall about 10-15% next year.
However, risks are weighted firmly on the downside. If the Bank of England needs to raise rates further to bring inflation under control, we will see more significant house price falls.
Regional disparity
At the national level, the extent of the correction should not be too severe next year but the regional picture is very divergent. Affordability in the higher value regions, particularly London, is much more stretched and consequently these markets will see larger price falls. In contrast some of the lower value regions look well placed to absorb the shock of rising interest rates.
Hover over regions to reveal figures
What does this mean for housing delivery?
There is a good relationship between housing market activity (transaction levels), market strength and housing starts. Essentially, developers don’t want to deliver homes into a weak housing market. The sharp increases in mortgage costs and falling house prices will lead to lower transaction levels. Many buyers will be priced out until values correct and debt becomes cheaper again. Along with this, people are generally less willing to undertake house purchases in a weak market and economy.
As such, we expect new housing starts to fall back significantly next year. This will be compounded by the removal of Help to Buy which has been an important driver for new build activity accounting for 361,000 purchases since its inception. This all provides a challenge for policy makers who will have to address both the shortfall in delivery and access to homeownership.
One avenue for limiting the impact of the removal of Help to Buy would have been to increase the availability of higher loan to value mortgage products. Indeed, there was a move toward this early in 2022 with the removal of the requirement that borrowers be able to afford a 3% rise in interest rates.
However, the economic developments since means banks are retreating from higher risk lending and reducing the range of products.
The First Homes scheme, which came into effect in 2021, is currently in pilot phases which are only delivering small numbers. We have reservations about how effective this programme will be both from a developer and consumer perspective. The value caps are so low that in London and the South East even with a 30% discount homes would struggle to fall under the price caps, meaning developers would have to add further subsidy. For consumers, despite the 30% discount, the size of the deposit required is still much higher than either Help to Buy or Shared Ownership, so is still a major obstacle for would be first-time buyers.
Where could help come from?
We expect there is a good chance we will see new policy intervention over the course of 2023 to assist with home ownership, especially with the prospect of an election year in 2024. While it is highly uncertain what form this may take, what is certain is that delivering additional Shared Ownership homes looks to be an opportunity in 2023. There will be a significant hole left by the end of Help to Buy and the tenure will be an alternative option for those now priced out of the open market because of deteriorating mortgage affordability.
One of the avenues for delivering additional Shared Ownership that we expect to increase is bulk sales between housebuilders and Registered Providers (RP’s). This enables house builders to achieve advanced cash inflows and certainty in a challenging operating environment. For RP’s this enables them to use grant funding to acquire additional homes at discounts to market value and switch them from market sale to Shared Ownership.
Rather different for rents
The outlook for rents next year is very much a contrast to that for house prices. 2022 has seen remarkably strong rental growth so far, with the most recent Zoopla asking rents measure reporting a 12.3% increase in Q3. This has been driven by significant supply/demand imbalance. The chart below shows the gap between new tenant demand and new landlord instructions reported in the RICS residential survey since the start of the pandemic.
CHART 2 – TENANT DEMAND VS LANDLORD INSTRUCTIONS
Source: RICS
There is now likely to be additional demand pressure in the sector as would be first-time buyers will be either unable or unwilling to undertake their desired house purchases next year and will remain renting. Along with this, the relatively strong labour market and high wage growth will support rental increases.
There will be some counter-weight from wage growth being outstripped by inflation and the squeeze on disposable income. But households tend to sacrifice virtually every other area of spending before their housing costs.
What does this mean for residential investment?
Despite slowing down significantly in Q3 because of economic volatility, 2022 has been a record year for Build to Rent (BTR) transactions so far. Although debt is increasingly expensive, we expect that the relative income security and prospects for rental growth offered by residential rented assets will underpin continued strong long-term demand for the sector next year. However, the first half of next year is likely to see subdued transaction volumes as investors wait for land values to show some correction and build cost pressure to ease. We expect this to lead to slight yield softening, the extent of which will vary with quality of opportunity and location.
Ultimately, residential has the best prospect for real rental growth across cycles (Chart 3) and the negative structural change affecting retail and offices combined will mean investors continue to reposition toward it.
CHART 3 – LONG RUN REAL RENTS (1982=100)
Source: AY, Capital Economics
They also like the strong demographic story behind living assets – the fundamental supply/demand imbalance in UK housing shows little sign of improving. Delivering housing is also increasingly appealing to investors from an ESG perspective.
Housing is a basic societal need and there is synergy with environmental objectives; lowering the carbon footprint of housing both in construction and operation is a fundamental requirement if we are to meet COP goals. It also reduces energy bills of households, one of the biggest near-term socio-political challenges.
Within the residential space, the sector which offers the strongest security of income and ESG impact is affordable housing. The attraction to the stability of the sector’s cash flow will heighten as we move into a period of economic uncertainty and the depth of demand means that absorption of new (rented) homes is virtually instantaneous. We expect to see appetite to invest in the sector remain strong in 2023 although challenges in effectively deploying capital will remain.
Having said all this, the year will likely get off to a slower start than 2022 as investors wait for clarity on pricing and yields across the residential sector. It will also continue to grapple with high build costs and shortage of labour. Given that the majority of activity in BTR is still development funding, it is particularly exposed to these pressures.