Property Investment: Affordability Matters - The North/South Divide
Mortgage interest rates appear to have peaked, with many lenders now offering better deals on their longer-term fixed-rate products than they were just a few weeks ago. However, interest rates are still significantly higher than they were at the same time in 2022, and the extra costs are hitting hardest in the UK’s most expensive regions. The result, according to a number of recent house price indices, is a new north-south divide, and it has some profound implications for property investors.
Mortgages and Affordability
A key issue here is the way that higher mortgage costs have tended to amplify differences in affordability between the regions. More expensive homes clearly demand bigger mortgages, and the bigger the loan, the more the repayments are affected by rising interest costs.
Historically, average values have generally been highest in London and the South East, so it’s no coincidence that here is where prospective buyers seem to be facing the greatest problems with affordability. This is a point made very clearly in the August House Price Index from Zoopla. It states:
“There is a clear north-south divide in house price inflation. Every region in the South of England has seen house prices fall by up to -1% in the last year. But all other regions and countries of the UK are posting low single-digit house price growth… This pattern reflects the greater impact of higher mortgage rates on higher-value housing markets. Buyers in the South of England need bigger mortgages and deposits as well as higher incomes. This prices more buyers out of the market in the South, weakening demand and pushing prices down.”
Zoopla is not alone in identifying a well-defined regional pattern. In its latest index, ONS ranks the nine English regions in order of capital growth rates and the four most southerly of them – London, the South East, the South West and the East of England – all sit at the bottom of the table. According to Land Registry data, the gap between the strongest and weakest regional growth rates is a sizeable 5.3%.
Other sources report similar findings. Rightmove’s figures suggest a gap in growth rates of 6.0%, while the Home Asking Price Index for August highlights a 9.2% gap between the strongest performer (Scotland, at +5.5%) and the weakest (the East of England, at -3.7%).
Home.co.uk writes:
“Price growth at the regional level has shown significant variation over the last year… London and southern regions have taken most of the hit while those further west are relatively unscathed and the northern regions have actually prospered… What is clear is that, thus far, sufficient demand remains in the North to support prices despite the rise in mortgage rates.”
Prospects for Capital Growth
Such variances obviously matter to investors. For anyone who wished to sell over recent weeks, a 5%, 6% or 9% gap in capital growth rates would have made an appreciable difference to a property’s overall returns. However, this regional split is not just about looking back at how prices have already changed; it also looks set to affect investors’ returns well into the future.
Zoopla, for example, notes that it expects the regional divide “to continue throughout the rest of 2023 and into 2024.” Many others agree. In its Five-Year Residential Forecast, Savills predicts that between now and 2027, the fastest price growth will occur in the North West, the North East and Yorkshire & Humber. By contrast, it expects average values in London to fall by -1.7% over the same period.
Once again, affordability is a significant contributing factor. For well over a year now, household budgets have been tightly stretched by high rates of inflation, higher mortgage costs and a rising tax burden. That has left prospective buyers with less to spend and, accordingly, house price growth has slowed to a virtual standstill. That trend has been most pronounced in regions where average values have been highest. Conversely, where house prices have traditionally been lower, they have also tended to be most resilient.
Looking ahead, there is little reason to expect the regional divide to close any time soon. Prices in London and the South East have been higher than the national average for many years and they may well always remain so. But that imbalance, combined with the present conditions of higher mortgage rates, is almost certain to constrain regional price growth in the years ahead. Where household budgets are so severely stretched, there simply isn’t the headroom for rapid growth. By contrast, housing affordability never became quite such a challenge in other UK regions, so as conditions improve, it is the property markets outside of the South that look likely to return to earlier and faster growth.
Cash-Buyers and Borrowers
It’s important to recognise that price and affordability don’t measure exactly the same thing. The difference is about how investors intend to pay for new investment properties. If they plan to buy outright, then they can be reasonably certain about the total cost they’ll be expected to pay. Faced with a given price, they can then make an easy judgement about its affordability. On the other hand, if they intend to buy with a mortgage, then the total costs they’ll pay are less certain because they could vary with interest rates over time.
This gives rise to differences in market sentiment – between cash buyers and those planning to use finance. Cash buyers enjoy more certainty and, consequently, they have tended to be a little less price sensitive over the course of the last year or so. Borrowers, meanwhile, have been understandably more cautious.
This might be one reason why the house price indices published by mortgage lenders tend to suggest poorer rates of house price growth than other indices – i.e. because they tend only to reflect transactions that involve price-sensitive mortgage applicants.
To illustrate the point, when Halifax published its price index in August 2023, it suggested that average house prices were falling by -2.4% year-on-year. By contrast, ONS data showed that values were still growing at a rate of +1.7% year-on-year. That’s quite a difference, and it might well stem from the fact that while the lender’s figures are based mainly on valuations and mortgage agreements, the ONS bases its results on the prices actually transacted, and those included cash-based sales.
The same dichotomy is evident in Zoopla’s most recent prediction about housing market activity. It states that it expects “the number of mortgaged sales to drop -28% on last year. On the other hand, cash sales will fall by just -1% compared to 2022.”
Measuring Affordability
In recent years, while mortgage rates were at historic lows, most sources tended to measure affordability in terms of a “house price to income” ratio. That metric is useful but it’s also fallible when it relates to purchases made using mortgage finance. That’s because when interest rates rise, the actual affordability of property tends to decline, even if the ratio of price to income is improving.
The difference between price and affordability is examined in an August report from Halifax, which notes that the cost of a typical home is now “6.7 times average earnings, down from a peak of 7.3 last summer.” Thus, house prices have become less expensive relative to average earnings but, at the same time, the actual costs payable by many mortgage holders will have risen. In other words, higher mortgage rates have a kind of “multiplier effect” that increases differences in affordability.
The following figures from Halifax take no account of mortgage interest repayments but they do provide an interesting insight into the ratio of average house prices to average earnings across the different regions.
Region Ratio (2023)
North East 4.9
Scotland 5.0
Northern Ireland 5.3
North West 5.7
Yorkshire 5.7
East Midlands 5.9
Wales 6.7
West Midlands 6.8
East of England 7.8
South West 8.0
South East 8.0
London 9.3
UK average 6.7
In every region, the ratio for 2023 is better than it was in 2022, but that doesn’t necessarily mean that properties have been more affordable. The improving ratio will have been good news for cash buyers but, for mortgage holders, the extra interest costs payable over the last 12 months would have offset any beneficial effects.
This matters to investors because many of them will be using buy-to-let mortgages to finance their acquisitions and they will inevitably want to maximise their returns. Looking ahead, their money should buy more in Britain’s more northerly markets, which are also likely to produce superior rates of capital growth.
Signs of Improving Affordability
High mortgage rates and the cost-of-living crisis have supressed house price growth for many months now but their influence should gradually diminish. There are several reasons for this.
First, inflation is now waning and the last two reports from ONS have shown larger-than-expected falls in the Consumer Prices Index. That trend is likely to continue and it seems increasingly probable that the rate will fall close to the Bank of England’s target of 2% some time in 2024. That, in itself, should ease pressure on household budgets, leaving prospective buyers and tenants with more money to spend.
Second, average earnings have risen strongly over the last year. In August 2023, ONS estimated the annual growth rate (i.e. in regular pay, excluding bonuses) at +7.8%. That compares to an annual inflation rate of 6.8%, which would suggest that real-terms earnings have finally begun to improve.
At the same time, house price growth has been extremely modest in many regions and, as we noted earlier, average values have actually fallen in some parts of the South. This too should slowly help to close the affordability gap.
Finally, given the realistic prospect of falling inflation, the Bank of England will feel less pressure to keep the official base rate of lending so high. It won’t reduce it immediately, of course; indeed, it has signalled that it could announce at least one small further rise this year. In the longer term, however, it will want to reduce that rate in an effort to encourage economic re-growth. That’s certainly what the UK’s major lenders are expecting and, accordingly, many of them have already begun to introduce more competitively priced mortgages.
That would be a welcome move but lower mortgage rates will take time to affect market sentiment and sales rates, as Zoopla notes in its latest report on affordability:
“In terms of mortgage rates, they’re starting to drift lower and we expect them to fall below 5% later this year. (But) any falls to mortgage rates are unlikely to impact the market and improve affordability further until at least the first half of 2024.”
Nevertheless, inflation trends and mortgage rates certainly appear to be moving in a positive direction and, consequently, the conditions that we can expect in 2024 should be notably better than they have been this year.
Implications for Investors
The longer-term indicators are looking good. Demand for housing continues to outstrip supply in both the home-buyer and rental markets, and this imbalance has always tended to drive values higher. Similarly, as affordability pressures abate, so we should see a return to stronger market activity. Growth in sales volumes has typically gone hand-in-hand with growth in average property values so it seems reasonable to expect that house prices will grow again, in line with historical trends. But that won’t happen at a uniform rate across the UK; as we’ve seen, it’s likely to take hold most quickly in the UK’s more affordably priced markets.
Yields
We have focused mainly on the question of how affordability might affect prospects for capital growth but, of course, it also has important consequences in terms of rental yields. That’s because yield is a measure how much rental income is generated as a proportion of a property’s purchase cost. It’s directly affected by property prices and, here again, regional variations matter.
Rental demand is strong in most parts of the UK and, in fact, over the last 12 months London has seen some of the fastest rates of rental growth in the country. However, high asking prices in the city still mean that the ratio of rental income to purchase price is lower than in most other regions. In short, investment money often works considerably harder elsewhere.
In its August Asking Price Index, Home writes that:
“Home values in the North are much lower than in the South and, for some time, landlords have refocused their acquisitions northwards due to the better yields available. Moreover, the increased acceptance of working remotely allows homebuyers the opportunity to purchase a more substantial property for much less money. COVID accelerated this trend, which could be described as a ‘levelling up’ between the affluent South and the underinvested North. This trend, driven by pricing disparity, is likely to continue for some time.”
In its Rental Price Tracker for Q2 2023, Rightmove lists rental yields by region. Its results show a familiar pattern: better investment returns in the UK’s more northern and more affordable regions.
Region Gross Yield (%)
North East 8.3
Scotland 7.9
North West 7.0
Yorkshire & Humber 7.0
Wales 7.0
West Midlands 6.3
East Midlands 6.2
South West 5.7
East of England 5.6
South East 5.6
London 5.3
UK average 6.7
Summary
The cost-of-living crisis is not going to vanish overnight. Inflation is still well above target, mortgage rates are still unusually high by recent standards, and UK residents are dealing with the highest domestic tax burden in many generations. Consequently, affordability is likely to remain a crucial consideration for millions of Britons for some considerable time to come.
Faced with these conditions, investors must consider affordability as part of any strategy for building or restructuring their portfolios. It seems all but certain that the UK’s more modestly priced regions will best withstand any downward pressures on average values and that they will emerge soonest and most strongly from the present hiatus in the market. Consequently, for those investors who are prioritising long-term capital growth, more northern markets look to be a safer and more promising choice.
Often, investors must make choices that depend on their priorities – i.e. whether they want to maximise capital growth or rental returns. Now, however, all the key data sources are pointing in the same direction: the country’s more affordable regions not only hold the greatest promise of capital growth; they should also deliver the best rental yields over the coming years.
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