(Bloomberg) --

The end of cheap money. Soaring energy prices and crippling inflation. A recession on the horizon. For the UK housing market, that toxic mix is fueling concern that a sharp correction is on its way. 

Cracks are already appearing amid the mounting pressures. Home values in London are flat or falling in almost half of the city’s boroughs, according to an analysis by Bloomberg News of preliminary Land Registry data. They’re also down in Yorkshire and the Humber on a monthly basis.

Surveyors are becoming less optimistic about prices and say fewer people are starting to look for a home, according to the Royal Institution of Chartered Surveyors. Declines in each metric typically portend falling values.

Money managers have already signaled their worries, with shares in some homebuilders down more than 35% this year, lagging the broader stock market. That echoes a selloff at the end of 2006 and into 2007 that preceded the decline in house prices that accompanied the financial crisis.

“The outlook for both rates and real incomes is as bad as I can recall since 1960, as are consumer confidence indicators,” said Paul Cheshire, emeritus professor of economic geography at London School of Economics. “There will be significant pressure on money as well as real house prices in coming months.”

Bolstering Demand

The mounting pressures mean more than a decade of almost non-stop -- and at times rampant -- housing inflation may be coming to an end. UK property values rebounded in the aftermath of the financial crisis as cuts to interest rates and cheap borrowing programs made banks keen to lend to buyers. The government then added fuel to the market by bolstering demand through the low-deposit loan programs and temporary tax cuts. That’s left home prices in England at their least affordable ever.

Now, property is facing a storm: 1.8 million people need to refinance next year amid surging interest rates, real wages are plunging at a record pace and a recession appears more and more likely. Adding to the pain, a low-priced source of credit for some buyers will disappear from the market.

Help to Buy, a much-criticized program that allowed home purchases with a deposit of just 5% and provided lenders with a government guarantee on part of the borrowings, ends next year. 

That will have a negative impact on first-time buyers in London in particular, “widening inequality” within the housing market, said Alla Koblyakova, who lectures on property finance at Nottingham Trent University.

Developers have already begun pulling back on construction of less expensive new homes in the capital, according to researcher Molior London, because Help to Buy was a key driver of that market.

Housing starts in London were the equivalent of just 63% of new home sales in the second quarter, the lowest ratio since 2009. The firm cautions the data can be lumpy and excludes smaller projects.

The smorgasbord of negative news means the share price of UK homebuilders have suffered this year, and missed out on the recent rally in stocks.

Another headwind will be the surge in energy prices. Bills will triple this winter compared with a year ago, based on the new cap issued by energy regulator Ofgem on Friday. They are set to go even higher in January amid the squeeze on gas supplies.

That will make it harder for renters to save for a down payment for their first home, damping demand. Buyers who stretched their finances to afford the record prices in recent years will also be hurt. 

The worsening outlook means UK house prices will probably fall 7% over the coming two years, Capital Economics forecasts, with London dropping about 12% in the period. Rising mortgage rates will cause many homeowners to opt against moving, it said, and will contribute to the lowest housing activity in a decade next year.

Rate Warning

As consumers fret more and more about their personal finances and the economy, they’re also facing a sharp increase in interest rates. Traders are betting the Bank of England will raise its benchmark by 250 basis points to 4.25% by May.

UK homeowners are more vulnerable to rising rates than those in the US because borrowers typically fix their mortgage deal for two or five years. 

Researchers at Zoopla have warned that home prices will turn negative if mortgage rates rise above 4%. The average two-year and five-year fixed rates have already reached that level, even before the next round of central bank hikes.

Values are likely to be in flux until the end of this year as it’s taking several months for sales to complete, according to Zoopla. In the short term, prices may show year-on-year gains because of a drop in 2021 when the stamp duty holiday ended.

Recession Risk

Predicting the future of the UK property market can be a mug’s game because for nearly two decades various governments have continually intervened to bolster prices when growth has slowed.

This time could be different. The cost-of-living crisis will cost the government billions of pounds in aid spending, while an economic downturn will erode tax revenue, limiting its ability to support homeowners. Businesses could also become insolvent because of spiralling energy bills, pushing up unemployment.

“To control the majority of our inflationary pressures will require the Bank of England to implement dramatic rate increases much faster” than the Federal Reserve and ECB, said Mayad Rassam, a real estate derivatives expert at Vedanta Hedging. “That will bring inflation under control temporarily, but it will almost certainly drive the country into recession.”

For now, credit remains freely available, and the BOE may also have to reverse course on borrowing costs if the economy tanks, though for now it appears focused on the inflation fight.

Even if home prices do fall, the boom since the pandemic, driven by a stamp duty sales-tax cut, has been so ferocious that a near-20% decline in prices would only take values back to late 2019. That would affect the buyers of about 3.4 million properties that sold in the period.

Large-scale repossessions are highly unlikely as the central bank introduced stress tests for buyers in the wake of the financial crisis to maintain borrowing standards. Lenders are also likely to show forbearance, as they did during the pandemic, allowing households to get back on their feet. More than a third of homeowners have already paid off their mortgage anyway. 

At the other end of the property ladder, it’s a different story. With home prices in London up almost 120% since 2009, a flood of buyers decided to leave the city over the last 20 months as the soaring cost of living and a desire for more space made moving out of the capital more attractive. 

About 28% of those leaving London who bought outside the capital this year were first-time buyers, more than double the rate a decade ago, according to Hamptons International. 

The exodus mirrors 2007 when homebuyers, frustrated by the cost of everything from housing to schools, decided to abandon the city. The crash came months afterward. History may be about to repeat itself.

©2022 Bloomberg L.P.