Why Prices Increase
17 September, 2014
With prices in Fulham going in one direction, the property market feels like a well-oiled unstoppable machine. Just what are the processes at work driving this ongoing escalation?
We like understanding how things work. If you do too, here's a simple paradigm we've invented to help explain how and why property prices in prime central London, and Fulham in particular, continue to rise almost regardless of the economic conditions elsewhere. It's called the four circles (illustrated overleaf) and, put simply, goes like this: they want it, they can afford it, they can't get it, so it's expensive. Let's look a little closer to understand the power of the forces at work, particularly when they're acting together...
The Desirability Circle – they want it Simple Keynesian economics says the price of a good or service (that includes property) is determined by its supply and demand. All else being equal, higher demand means higher prices, and the desirability of an area is a key driver of demand for property there.
The important point with desirability is that rising property prices increases the desirability of an area, which sends prices still higher. This positive feedback can be seen in areas like Fulham, where the high price of property means only well off buyers can afford to move in. This increases the socio-economic status of the community as a whole, leading to a proliferation of bars, restaurants, schools and other amenities catering to wealthy people and families, which in turn increases the area's desirability to those with means. Add to this circle Fulham's natural bounty of green spaces and convenient geographic location, and you have all the conditions necessary for a positive spiral in desirability, and therefore prices, to take hold. This is the first circle driving price growth, and it's going full spin here in Fulham.
The Capital Circle – they can afford it Simply speaking, your ability to buy a property comes down to three things, your deposit, your income and the mechanics of the mortgage market. Of these, your deposit – i.e. your capital – is perhaps the primary element, as this directly affects the size and cost of mortgage you can get. Focusing in on the deposit, we see another positive spiral helping drive up property prices in Fulham, the capital circle.
As property prices rise, the equity in your home increases too, making it easier and easier to afford houses on the next rung up. Increasing your ability to purchase a house on the rung above effectively increases demand for those houses, which in turn increases their price. This positive feedback, as a result of capital gains, means increasing prices actually lead to increasing prices.
Let's put some figures in the frame to illustrate the point. Say you bought your current home for £600,000 with a 25% deposit, or £150,000 equity. Fast-forward and prices have risen by 50%. Now your home is worth £900,000 and your equity has tripled to £450,000. Assuming you stick to a 25% deposit, the equity side of your financing equation could allow you to buy a property up to £1.8m! This property would've been £1.2m when you bought your current home, well out of reach back then. In fact, double the £600,000 you could afford. So a 50% increase in property prices has meant a 100% increase in the value of property you can afford to buy (assuming the mortgage side of your equation stacks up). The lesson is that rising property prices increase demand for higher priced property, which results in rising prices. This is the second circle. The Supply Circle – they can't get it If you had a share that went up 50% in the last three years and whose price was still rising, would you sell it or hold onto it? I'm willing to bet you'd keep it unless you had a very good reason to sell. And it's the same with property. Continually rising property prices actually reduce an owner's desire to sell, thereby reducing the supply of property to the market. Low supply inevitably increases prices, as buyers find themselves having to compete financially to secure the home they want. This phenomenon represents the third positive feedback loop helping keep prices on their upward trajectory. It's one anyone looking to buy in Fulham will be familiar with, resulting in a frustrating lack of property available and a large proportion of sales being agreed above asking price, often via sealed bids. The Improvement Circle - so it's expensive Last, and arguably least, as the value of property rises so the incentive for owners and developers to extend and refurbish goes up. This general tendency for property to be improved and extended over time leads to an upward drift in prices as streets that were once passed over become gentrified, even sought after. It's positive feedback working at a slower rate, gradually increasing real prices over the course of several years. The results of this process can be seen best in areas like the Peterborough Estate, where almost all houses have loft extensions and side-returns, and most have basements, pushing up the overall size and therefore price of property on its streets. Roll on? If these are the four positive feedback loops contributing to increasing prices in Fulham, how could they be stopped? Considering them one by one, it becomes apparent that only a sustained reduction in affordability (i.e. buyer's incomes and/or mortgage fundamentals) could halt the rise. Improvement and extension of property is virtually impossible to reverse, it would take years for Fulham's basic desirability to be undermined, and we've already seen that supply does not increase substantially even if demand drops off for a year or two because, on the whole, people here can afford to wait out a bear market, as they did back in 2008-9. The key risk is a decline in affordability, caused either by a worsening of mortgage fundamentals (i.e. a significant drop in availability and/or increase interest rates) or a sustained reduction in City pay packets, on which the majority of Fulham buyer's loans are dependent. With the apparent volatility of the international financial system and a long-term shift in power from West to East underway, you might argue these risks could come to fruition. But for now, and at least the foreseeable future, the wheels roll on.
The Desirability Circle – they want it Simple Keynesian economics says the price of a good or service (that includes property) is determined by its supply and demand. All else being equal, higher demand means higher prices, and the desirability of an area is a key driver of demand for property there.
The important point with desirability is that rising property prices increases the desirability of an area, which sends prices still higher. This positive feedback can be seen in areas like Fulham, where the high price of property means only well off buyers can afford to move in. This increases the socio-economic status of the community as a whole, leading to a proliferation of bars, restaurants, schools and other amenities catering to wealthy people and families, which in turn increases the area's desirability to those with means. Add to this circle Fulham's natural bounty of green spaces and convenient geographic location, and you have all the conditions necessary for a positive spiral in desirability, and therefore prices, to take hold. This is the first circle driving price growth, and it's going full spin here in Fulham.
The Capital Circle – they can afford it Simply speaking, your ability to buy a property comes down to three things, your deposit, your income and the mechanics of the mortgage market. Of these, your deposit – i.e. your capital – is perhaps the primary element, as this directly affects the size and cost of mortgage you can get. Focusing in on the deposit, we see another positive spiral helping drive up property prices in Fulham, the capital circle.
As property prices rise, the equity in your home increases too, making it easier and easier to afford houses on the next rung up. Increasing your ability to purchase a house on the rung above effectively increases demand for those houses, which in turn increases their price. This positive feedback, as a result of capital gains, means increasing prices actually lead to increasing prices.
Let's put some figures in the frame to illustrate the point. Say you bought your current home for £600,000 with a 25% deposit, or £150,000 equity. Fast-forward and prices have risen by 50%. Now your home is worth £900,000 and your equity has tripled to £450,000. Assuming you stick to a 25% deposit, the equity side of your financing equation could allow you to buy a property up to £1.8m! This property would've been £1.2m when you bought your current home, well out of reach back then. In fact, double the £600,000 you could afford. So a 50% increase in property prices has meant a 100% increase in the value of property you can afford to buy (assuming the mortgage side of your equation stacks up). The lesson is that rising property prices increase demand for higher priced property, which results in rising prices. This is the second circle. The Supply Circle – they can't get it If you had a share that went up 50% in the last three years and whose price was still rising, would you sell it or hold onto it? I'm willing to bet you'd keep it unless you had a very good reason to sell. And it's the same with property. Continually rising property prices actually reduce an owner's desire to sell, thereby reducing the supply of property to the market. Low supply inevitably increases prices, as buyers find themselves having to compete financially to secure the home they want. This phenomenon represents the third positive feedback loop helping keep prices on their upward trajectory. It's one anyone looking to buy in Fulham will be familiar with, resulting in a frustrating lack of property available and a large proportion of sales being agreed above asking price, often via sealed bids. The Improvement Circle - so it's expensive Last, and arguably least, as the value of property rises so the incentive for owners and developers to extend and refurbish goes up. This general tendency for property to be improved and extended over time leads to an upward drift in prices as streets that were once passed over become gentrified, even sought after. It's positive feedback working at a slower rate, gradually increasing real prices over the course of several years. The results of this process can be seen best in areas like the Peterborough Estate, where almost all houses have loft extensions and side-returns, and most have basements, pushing up the overall size and therefore price of property on its streets. Roll on? If these are the four positive feedback loops contributing to increasing prices in Fulham, how could they be stopped? Considering them one by one, it becomes apparent that only a sustained reduction in affordability (i.e. buyer's incomes and/or mortgage fundamentals) could halt the rise. Improvement and extension of property is virtually impossible to reverse, it would take years for Fulham's basic desirability to be undermined, and we've already seen that supply does not increase substantially even if demand drops off for a year or two because, on the whole, people here can afford to wait out a bear market, as they did back in 2008-9. The key risk is a decline in affordability, caused either by a worsening of mortgage fundamentals (i.e. a significant drop in availability and/or increase interest rates) or a sustained reduction in City pay packets, on which the majority of Fulham buyer's loans are dependent. With the apparent volatility of the international financial system and a long-term shift in power from West to East underway, you might argue these risks could come to fruition. But for now, and at least the foreseeable future, the wheels roll on.