Now the Crisis really begins

The UK property market is unusual. Firstly, owning property is considered the norm: Britain did not have the wrenching changes caused by the second world war that gave a folk memory to much of the rest of Europe of losing everything as borders shifted to and fro. Secondly, the proprietorial feeling of "his home is his castle" made home ownership the social norm. Latterly, as Sterling devalued, Property prices through the 1970s stayed stable in real terms, but gave the illusion of go-go returns. In the 1980s, as inflation cooled and the Pound stabilised, a real boom set in. In the end the boom became a mania. Even after a crash that was largely caused by poor quality mortgages, the UK property market has continued to climb. Now, despite the deliberate attempt to support the mortgage market as well as the wider corporate debt market through ultra-low interest rates and "quantitative easing", the various ratios measuring "affordability" of housing look a bit stretched. If we took interest rates at the 5% that is the average base rate for the Bank of England since it was founded in 1694, then valuation measures are historically stretched.

So, you might have thought that the news of a one month fall in UK house prices would be greeted with something of a shrug. In fact, as we know, and despite the fact that prices still remain (slightly) ahead over the year, there was rather a feeling of shock. The fact is that the Brits are still in deep denial over what has happened to them. Over the course of an economic cycle, inefficiencies and imbalances build up, and eventually it takes a recession to clear inventory, and force restructuring, and that is certainly what has been happening in the corporate sector. In UK residential property, however, there are still significant distortions. Although we are told that there is a shortage of property, it is still estimated that there are 700,000 empty properties in the country. Furthermore, the credit-fed boom in the housing market is coming to an end as the British banks are forced to deal with the consequences of their own profligate lending. The availability of cheap finance has fallen substantially.

Then there is the consequences of the UK government intervention in the banking market. Britain has essentially doubled its national debt and is now running record deficits at levels barely seen even in time of war. Unless the British government can cut the deficit very quickly, it will face drastically increased interest charges and far more difficult spending decisions within 2-3 years. The coalition really has no alternative but to drastically slash the budget. The consequences will take a lot of money out of the economy and in the short run will probably increase debt still faster. But whatever any government says about the current situation there is one unpleasant truth: major cuts are needed, and given the growth in the public sector over the past few years, this means a substantial increase in unemployment.

So there you have it: increasing unemployment coupled with a reduced availability of mortgages means a down swing in the UK housing market from their recent highs.

So how low can it go?

Some of the rise in prices is clearly the result of a classic speculative bubble: people buying-to-let, people doing up older properties for sale- one only has to see the plethora of housing programmes on British television to see a speculative mania in full cry. Of course people do need to have a roof over their heads, but in many other countries that roof would be as likely to be rented as to be sold. There is of course a similar property market to the UK: the US, and here the omens are not good. it is difficult to talk about national averages, but several US regional markets have seen price falls of between 20% and 40%. Even that would only take UK property prices down to the levels of the late 1990s. It may well be that housing suffers a market capitulation, once prices start to fall, and we could go from housing bubble to housing panic.

Even if it does not work out like that, it is hard to be enthusiastic about UK property as an investment. The IMF continues to argue that UK property prices remain substantially over stretched. It seems inevitable, despite every hope to the contrary, that a correction is looming. After all it has happened virtually everywhere- now most spectacularly of all in Ireland. The bursting of the Irish property bubble has been brutal and has destroyed the Irish banking system, and quite possibly even the credit of the Irish Republic itself. Given the large presence of Irish investors in the UK, it would be surprising if their forced withdrawal from the UK market did not have a substantial cooling effect.

OK, I am talking my book: I sold my London flat last year and I have now relocated to Tallinn, where prices fell 60% over two years and where valuation measures now look highly discounted compared to the neighbouring Finnish market. I may return one day, but I have clearly taken the risk that London prices continue to fly and that I am essentially shut out of the housing market, at least in the South East of England. However I think that this is a risk I am prepared to take- the upside is probably low, while the downside is potentially very large indeed. This is one unusual market that I do not see the profit in playing.