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For the moment we will put aside government interference (a subject to be dealt with in a later blog) and look at the basic charts that we will need to show us how the housing situation is coping with modern trends. Most people will give you a list of indices that you should watch in order to gauge the direction of prices. Those lists will usually be totally wrong. My list consists of six items. Here they are:

The Affordability Index
The Rent to Mortgage Costs Ratio
The House Price Index
The Indices for Wages and Inflation
The Auction Index
We also need to know the state of the mortgage market

Let's start with The Affordability Index:

The latest figure for the UK as a whole is 5.2. But first, let us be clear about what this means.

I am not sure how precisely the figures are calculated, but the way I originally designed this index way back when I was at college was that affordability was simply put at a monthly mortgage cost of 40% of income after taxes.

It's interesting to note that in Scotland at the height of the affordability crisis in 1991 the level was just short of 40, whereas at the same time in the south east it was just over 70. There appear to be different freak-out levels across the country. In the Midlands it appears to be around 50. In the southwest the level appears to be just above 50. In London it is around 60.

The figure for the South-East I find frightening. Quite simply I don’t understand how people survive when they are paying 70% of their income (or even 60%) on housing. However, what this does is to give followers of this index a good idea of where the danger points are across the regions.

There is another way of calculating the optimum amount payable, and that is to take the mortgage business standard maximum allowable mortgage compared to actual income. That is generally three and a half times earnings for a single wage earner, with an addition of one extra wage for a partner, giving a maximum total of four and a half times actual income.

If we use this latter calculation we find that the figure of 5.2 shows houses to be slightly higher than the affordability figures would indicate to be the optimum.

It is not the case that the figures shouldn't or can't rise above the optimum, after all optimum is not the same as maximum, but what we can say is that house prices are already high enough. After all, in 1995 the figure was 2.2. Clearly that was the time to buy, and the time I was telling my clients to get stuck in.

The really expensive areas are London, The South-East, and the South-West. You can find the full up-to-date figures on the Nationwide web site.

My own rating suggests that overall house prices are at average levels over most of the country, slightly above in the South, and overpriced in London.

House prices have been rising slowly, but in line with wages for most of this century, but over the past quarter they have risen more dramatically. In parts of the country these rises are probably sustainable, but less so in the South, and probably unsustainable in London.

http://www.demographia.com/dhi.pdf represents an interesting view of housing unaffordability. I take their point that there is a difference between mortgage payments/house prices, and income/house prices (mortgage payments are always related to income, but interest rate changes will impact on the mortgage monthly payment, and this is a changeable sum. However, I maintain that a rating of 4 would mean housing costs were affordable. A figure between 4 and 5 would mean house prices were slightly unaffordable. A figure above 5 would mean houses were unaffordable. The higher the figure from there, the more the market would be overbought, seriously overbought, or ready for a crash.

The bottom line here is that although house prices are generally a fraction above an optimum level, they are not overly expensive. We have to see if there are alternative indicators that might foretell a slide in prices.

Price to Rent Ratio

The price-to-rent ratio is a calculation that compares median home prices and median rents in a particular market. We simply divide the median house price by the median annual rent to generate a ratio. At the peak of the U.S. market in 2006, the ratio for the U.S. was 18.46. The ratio dropped to 11.34 by the end of 2010. The longer-term average (from 1989 to 2003) was 9.56. As a general rule of thumb, consumers should consider buying when the ratio is under 15 and rent when it is above 20.

This ratio is used as a benchmark for estimating whether it's cheaper to rent or own property. In other words the price-to-rent ratio is used as an indicator for whether housing markets are fairly valued, or in a bubble.

Rents vary significantly from area to area. This is a ratio that you must discover for yourself. Let me do a calculation based on a small area in West London so you can see how it works.

A two bed property has recently been sold for £300,000 in the designated area. The cost of that property in terms of the monthly mortgage payment is £15,000 p.a. That's the cost of the money at an average mortgage interest rate of 5%.

In the same area a similar property is for rent at £1,100 a month. That works out to £13,200 a year. In other words it's cheaper to rent. Once the figures start to significantly diverge then we are due for a change simply because people will either find renting too expensive and decide to buy, or vice-versa. When the difference between the two figures gets above 20% one can expect more people to prefer renting if that is cheaper.

One does have to be careful to add and subtract all the relevant figures. Using the above figures, the real maths come out like this:

House Sale Price: £300,000; 80% loan to value mortgage, therefore deposit of £60,000.

Outgoings: Cost of mortgage monthly repayment + Cost of deposit (loss of income from that sum) + Estimated repairs and renewals + Local taxes + Insurance.

Rental: £1,100 + Local taxes

It's surprising how the cost of buying a house does rise, sometimes considerably so, above the bare cost of the mortgage.

This indicator is very much a localised one. You need to compare similar types of house in similar areas. Generalised figures will not be indicative.

I will deal with the rest of the indicators in next week's blog. See you then. And do please hit the Like button to give my blog a boost in Youtube's algorithm, and if you subscribe you will be notified when the next blog entry in the series is available.