What REALLY determines rents and house prices?

Last updated: 13 March 2017

This article originally appeared in Issue 6 of The Property Hub Magazine.

When it comes to house prices and rent levels, everyone has an opinion. But given the number of column inches and dinner party conversations devoted to the subject, it's surprising how little thought most people dedicate to why things are they way they are – and for evidence to support their assertions about what might happen next. Vague ideas about “not enough houses” and “greedy landlords” are often trotted out – and while both of those play some part, the true picture is a little more complicated.

As part of the annual renewal of my geek badge, I've given some thought recently to why prices and rents move as they do. Although the model I've built in my head is incomplete, untestable and likely inaccurate in places, I still think it has value – as a more reasoned approach than decision-making based on dogma or hearsay – even if I can't tell you exactly what's going to happen and when.

What determines rents

Contrary to popular/media belief, rents aren't set by landlords on a whim – and with thousands of individual owners making up the property market in each town, they can't act as a cartel. In reality, market rents are determined by two main factors: local wage levels, and the balance of supply and demand.

Local wage levels are important because they determine the practical maximum the average person can afford to pay in rent and still have enough left over to pay their other bills: if the average wage in a town is £1,500 per month, you're not going to get many takers for a luxury one-bedroom flat priced at £1,250 per month. In another town with an average wage of £3,000 per month, it'd be a different story.

The common recommendation is that only 30% of an individual's disposable income should be taken up by rent, so if supply and demand are in balance, we might expect rents to settle somewhere around this level. Perhaps surprisingly, this is the case in much of England and Wales.

But when demand exceeds supply, prices get pushed up. If you imagine two people chasing one house, it's easy to see why this happens: the landlord would be acting rationally if she increased rent to the point at which one person is forced to walk away. This is what's happening in London, where some studies suggest that nearly 70% of take-home pay is taken up by rent.

So as a rule, rents tend not to swing wildly: they rise and fall in line with wages, unless something in the local economy causes people to move in or out in droves.

The same, however, can't be said for house prices…

What determines house prices?

House prices are driven by three main factors: rent levels, the cost and availability of borrowing, and expectations of future price changes.

For owner-occupiers, rents and the cost of borrowing are the primary factors in the decision about whether to buy. It’s pretty simple: if the mortgage payments aren't much higher than what they'd pay in rent, they're likely to buy. This also explains how house prices can rise in spite of stagnant wages (and therefore rents), when cheaper financing is available.

For investors, the same factors (rents and interest rates) are at play. Let's say an investor is willing to buy a house as long as they can earn a 5% annual return over and above their mortgage costs. We'll also assume that they borrow 75% of the purchase price, and the annual rent is £7,000.

In this scenario, if the investor is borrowing at a rate of 6%, they would be willing to pay £68,000 for the house: I won't bore you with the maths, but this is the price at which they would still make a 5% return on their money after paying their mortgage. But if the cost of borrowing was 3% rather than 6%, they would be willing to pay £120,000 for the same house: the lower mortgage payments mean they’ll make exactly the same percentage return on their investment, even when paying more.

If rents increased rather than borrowing costs falling, we’d see the same effect. Following this example along and imagining that the rent rose from £7,000 to £9,000 (and the cost of borrowing was still 3%), an investor would then be able to pay £156,500 for the house and still make the same 5% return on their money.

This is extremely simplified, of course (it doesn't factor in running costs, the availability of mortgages and many other things), but it does show that house prices aren't random: they're driven by rents and interest rates.

Another factor that injects a sizeable dose of unpredictability into the system is the influence of individuals' expectations of future price changes. Investors may be willing to accept a lower return on their investment if they believe that the capital value of the house is likely to increase. Homeowners, too, are more likely to stretch themselves in terms of repayments and scrape together bigger deposits if they think they'll be “left behind” by price rises. When these expectations become extreme, bubbles form: people are willing to buy based on no return at all (or even a negative return), purely because they think prices will rise further.

What does this tell us?

Depending on your tolerance for economic theory, this might have all bored you senseless, but there is a point: understanding what drives prices can help us to make better investment decisions.

Firstly, it tells us what would need to happen in order for house prices to collapse: we'd need a major change in the supply/demand balance (affecting rents), an increase in the cost of borrowing or reduction of mortgage availability, or a change in sentiment. None of these factors is easy to predict, but – barring government intervention to restrict borrowing – it seems likely that conditions that support high property prices will remain in place for quite a while yet.

Importantly, it also tells us that prices can't just go up indefinitely. There comes a point when borrowing can't get any cheaper, expectations can't get any more bullish, and people can't afford to pay any more of their income as rent. To me, this looks a lot like London in 2016.

Analysing what drives prices can also give us clues about where to buy…

Is that all there is to it?

Because I'm simultaneously greedy and tight-fisted, I want high yields and a high probability of prices increasing when I invest. Looking at the underlying causes of price movement allows us to focus on where these factors are most likely to be in place.

Finding areas with high yields is pretty easy, but in many cases they're high because prices are held down by lack of buyer demand. This is the case in parts of the North East: you can buy and collect a good return, but there's little prospect of prices increasing.

For there to be the prospect of price increases too, we need to look for additional characteristics:

For reasons we've already seen, these factors will push up both rents and the prices that owner-occupiers are willing to pay. They will also attract more investors into the market, putting further pressure on prices.

Cautious optimism

Having gone through a whole load of maths and economics, we've reached some thoroughly non-astonishing conclusions: steer clear of areas where there's little room for rents (and therefore prices) to grow, and opt for places with strong fundamentals paired with relatively high yields. But while none of this will come as a great revelation, it can help you to stick to your guns and unearth promising areas when you know why (as an investor focused on a blend of growth and income) you probably don't want to be buying in Hammersmith or Hartlepool right now.

It should also give you confidence that – while measures like a piece of government legislation could throw a spanner in the works at any time – the outlook is promising. Interest rates are low, banks are keen to lend, and in much (but certainly not all) of the country there's a lot of room for prices to grow.

There's undeniably going to be a bust at some point, and it's likely to be a big one. But right now, it seems a fair way off – and by keeping an eye on the underlying factors, you'll be better able to see it coming.

This article originally appeared in Issue 6 of The Property Hub Magazine.