UK House Prices and Three Decades of Decline in the Risk-Free Real Interest Rate

Abstract

Real house prices in the UK have almost quadrupled over the past 40 years, substantially outpacing real income growth. Meanwhile, rental yields have been trending downwards-particularly since the mid-90s. This paper reconciles these observations by analysing the contributions of the drivers of house prices. It shows that the rise in house prices relative to incomes between 1985 and 2018 can be more than accounted for by the substantial decline in the real risk-free interest rate observed over the period. This is slightly offset by net increases in home-ownership costs from higher rates of tax. Changes in the risk-free real rate are a crucial driver of changes in house prices-the model predicts that a 1% sustained increase in index-linked gilt yields could ultimately (ie in the long run) result in a fall in real house prices of just under 20%.

Sources of wealth and their implications for taxation

“…The authors conclude that 'the rise in real house prices since 2000 can be explained almost entirely by lower interest rates'. Similar conclusions are drawn using different approaches in other recent work (Mulheirn, 2019;Miles and Monro, 2019). These results imply that, as with most pension wealth, to a first approximation we can attribute growth in households' housing wealth in recent decades to capital gains driven by falling interest rates, rather than capital gains driven by growing scarcity of housing.…”

When homes earn more than jobs: the rentierization of the Australian housing market

“…financial liberalisation, increasing household debt, residential mortgage-backed securitisation) that have led to the current dynamics, but how these have interacted with shifts in multiple other policy spheres. 2 Our findings also challenge the economic narrative that rising house prices are primarily driven by the long-term fall in real interest rates creating a divergence between rents and prices (Weeken, 2004;Miles and Monro, 2019;Saunders and Tulip, 2019). Instead, we find that low rates are a necessary, but not sufficient, condition for high house prices.…”

“…One argument that has recently come to the fore is that it is low real interest rates -rather than financial liberalisation or supportive tax policies -that are the key demand-side driver of housing and house prices (Saunders and Tulip, 2019; and see Miles and Monro, 2019 for the UK case).…”

On the long-run solution to aggregate housing systems

“…As noted, equation ( 1) is also consistent with a discounting formula where house prices are determined by the discounted present value of the future stream of rental payments, (3), now written in discrete time. The formula provides the starting point internationally for many (but by no means all) more modern models of house prices (see, for example, Black et al, 2006;Miles and Monro, 2019). Empirically, the model is used less frequently in this form in the UK because new data on market rents only became available in 2005, reflecting the fact that private market renting was significant only from the second half of the 1990s.…”

“…Gallin (2008) also shows that the US rent to price ratio (the rental yield) can be used to explain future movements in house prices, acting as an error correction variable. On some definitions, the UK also appears to have experienced a fall in the cost of capital from the mid-1980s and, indeed, Miles and Monro (2019) suggest that most of the growth in UK house prices can be explained by a longrun fall in the real risk-free interest rate, (i t À p t ). Nevertheless, over the long run, we might expect the cost of capital to be stationary so that house prices rise at a similar rate to rents, even if it is not yet possible to observe this in the UK data.…”