Supplement 29 Oct 23 – Pricehead revisited

Oct 29, 2023

If one does not know to which port one is sailing, no wind is favourable.” – Seneca, Stoic philosopher.

Welcome to the Supplement everyone. It was time, this week, to revisit the revelations which seem to have now made it into the FT (and little or no other press, sadly) that I first spoke of nearly four months ago. House prices are DOWN, double digits. Now – regular readers will know I am no sensationalist, and what I’ve done there is deliberately leave out the phrase “in real terms” (i.e., adjusted for inflation).


It amused me this week when I saw a couple of major headlines on one of the leading property news portals claiming what was “going to happen” to house prices in 2023. Now, listen. It’s a bit late to be forecasting that – we are 10 months in, after all – and the most side-splittingly amusing part was that they were almost certainly wrong, with only 2 months to go! The quotes were from a couple of the large banks – they see a 7% drop in 2023 (where’s that coming from, then?) or perhaps 5% – the ONS still isn’t playing ball on that front, showing almost no movement for the year and we are already up to the end of August on the ONS numbers – as once again there’s an abject failure to remember that first, transactions decline significantly – before prices are really compromised.


So – I’ve revisited the July piece which had data until the end of Q2, and tried to get it to Q3. I also have (as always) gone a little further into the data, and might have one of the more interesting stats for you to quote when considering just how far prices are going to “crash!” (yawn, yawn). I also go into the refinancing problem that is creeping into the picture as the rates stay high – a bit like walking towards a cliff edge. That makes up today’s graph. 


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Before getting stuck into the meat, though, the macro appetiser will follow as normal. The bigger news – some are predicting now that 5.25% is the top of the base rate hiking cycle. This looks a bit convenient to me, if I am honest – there are wobbles, there are reasons to pause (indeed, it was very close last time out when the Bank met), but there are few reasons to really call the top. The US pricing in another 0.25% with their CPI where it is – sub 4% (yes, their economy is a lot hotter) and ours expecting no further rises when our CPI is closer to 7% – given that the main reasoning here is to control inflation – makes limited sense, you would think.


I’m sticking to my narrative – the risks remain to the upside. The 5-year gilt had a calmer week, with 0.1% or more coming off it. Snaps the trend of two upward weeks on the bounce, which is nice. The 30-year gilt, which I think represents incredible value at >5%, spent most of the week still up there, with some 5.2% yield available on Monday. Juicy. 


Unemployment also ticked down slightly this week – although that was based on a more experimental way of calculating it. The cynics will say they are cooking the books, but given this originates at the ONS, I’m inclined to give them the necessary rope. They see unemployment at 4.2%, rather than the national measure at 4.3%. There seemed to be plenty more unemployment claimants in September than forecast, so let’s see how that continues to play out – but currently, the trend is for firing, not hiring.


The composite PMI – a snapshot of purchasing managers’ experiences – stayed below 50, and also below where the forecasters thought it might be. This has to be interpreted as a bearish sign as to the direction of the economy, although Christmas is approaching fast, so let’s see how that goes from the spending side of things!


The CBI Business Optimism index was also well below expectations at -15 – forecasts thought it would be positive. Whilst some of the larger forecasters are expecting a reasonable economic performance in the next 18 months, it seems a lot of the larger industry players do not agree. 


The spread on the swaps (how far the swap rate is above the gilt rate) stayed tight this week, as the expected drift in that spread has not yet happened – however, anecdotally I wanted to share a few stories.


Firstly – there’s just a certain taste in the water – difficult to measure – that credit is tightening. This is a very tough set of circumstances:


Banks are well capitalised and the US “crisis” of 2023 was contained to the US. They want to lend. Banks are also enjoying excellent margins (cue the windfall tax chat, at some point soon) thanks to interest rates rising. I.e., this is not a skill dividend, but a chance dividend. The public love to hate the banks at the best of times……and the bonus cap is also now lifted. What a lovely bit of timing that is……


Refinancing is difficult. It is slow – far slower than ever before, and that’s one problem – but difficult because if you owe 100k, or 100m, or 10bn depending on your size – if you borrowed it 5 years ago at a 1.1% 5-year gilt yield, or 1.4% swap rate – plus margin – you likely paid around 3.5% including arrangement fees amortised (let’s say 3.3% plus 1% arrangement). Those were the days, eh?


It has therefore cost you £3,300 per annum per 100k to service that debt.


That debt now, IF you can renew it, costs more like 6.5% annually. Sure, you might pay 5.25%, and a 7% fee kicked to the end of that loan – but that’s where you are. It’s reasonable to assume that instead you will be able to borrow 7% less (because of the arrangement fee) – assuming you have sufficient debt service coverage.


Let’s assume you do – so you now borrow £107k to pay back that £100k. Problem? Not in and of itself. That £107k today is worth a lot less in real terms than the £100k was in 2018 – in fact, it would be worth £86,411 5 years ago. That’s a win, of course.


The nominal price of the asset itself (assuming secured against property) is also up 25.5% in that interim period – so the £150k house you had the loan against (let’s say) is now worth £188,250 presuming that you’ve maintained it reasonably. Another win.


The rent in 2018 was 14% lower than today (using ONS figures). The average weekly earnings were 25.3% lower. Let’s say rent at the time on a £150k house in 2018 was £800 (feels roughly right, of course it would have varied by area) – so today on that £188,250 house the rent would be £930. The gross yield is therefore down from 6.4% to 5.9%. That sounds less good, given rates……


The tenant for minimum affordability (ex-London) at the time would have needed a household income of £2,400 per month. Let’s say they were in at the end of their affordability and that was the income. That income is now £3,213. Not sounding so bad for the tenant……relatively. Although cost of living has of course increased significantly, so this is not to suggest they are better off – however, they don’t immediately sound worse off.


All well and good – but back to the borrower. Let’s assume 25% costs (as many banks do) – the £800 original rent netted £600 before mortgage, and then mortgage was around £275 per month. Cashflow £325, in 2018 money.


Now – let’s assume the £107k is the option plumped for. That is £468 per month – a cashflow difference of £193, or an increase of 70% in the cost of the debt – although the debt is no larger (other than the arrangement fee). Now rent is up £130 – and let’s say we hold £97.50 of that (75% of it, 25% in costs as they have increased too) – that makes up for about half of the cashflow deterioration, but we are still £95.50 worse off each month.

Plus – that’s £95.50 less in nominal terms. Our £325 in 2018 money is £403 in 2023 money – and instead we are getting £229.50 in 2023 money, or a drop of 43%. The same work – or more – and less money……


The astute will be able to draw all the threads together there – because the messages are mixed and indeed, it is complicated. Let me summarize:


In 2018 you had £50k gross equity in the property and £100k debt. That £50k was earning around £3,900 per year cashflow (this is no section 24, and before tax also) – and also has grown into £88,250 today. A “cashflow return on equity” or yield, if you prefer, of 7.8%. It also represents a 12% compound growth rate on the £50k – a stunning return, when you look at the running yield also. Combine the two and you are hitting private equity territory – without doing anything special at all. The mythical 20% IRR (internal rate of return) over a 5 year period. 


That’s the way when there is some leverage, and the market moves in the right direction. Today, you have a 5-year price expectation at say half of that – let’s say 12.75%. You have equity of £81,250 – and cashflow of £2,754 per annum. The combination of the greater equity and the lower cashflow provide a return of 3.4% (more than halved). The equity (based on the 12.75%) moves to £105,250 (2028 price £212,250) and a compound growth rate around 5.4% (under halved). More like a 9% return – still very respectable, and the longer time goes on, the more the risk goes down – but a far cry from the private equity territory.


This analysis of course ignores a few things. The chance that prices go downwards. The rental growth expected in the next 5 years – after all, if we are picking a rental growth figure, instead of 16.25% which was the ‘18-’23 figure, we might double that to 32.5% (that might be overly bullish, but wages will dictate what the market can afford, of course). That would leave us sitting quite pretty in 2028 – particularly if we can refinance, which we would expect to, at a lower rate than 5.25% with a 7% fee!


The figures can also change if you can pull more out, or pay some down, depending on your overall debt strategy. I didn’t cherry pick a particularly great example – note, we were not leveraged to the hilt in 2018 but instead to 67%, and so there was room to leverage harder (and get better IRRs), but going “to the well” every time is not a sensible tactic, of course.


This is all well and good. Let’s then try to apply that to a corporate debt situation. Larger companies – those listed on a stock exchange – will tend to issue debt all the time. Debt is almost “never” paid back, really, but simply recycled. That’s very similar to our example. Their spread is likely to be tighter than ours in the buy-to-let markets – let’s say 1.5% above the swap rate, rather than 2%. That would be less for very large loans, and more for smaller loans – but it is a fair proxy for a company of a reasonable size.


Thus – in 2018 they would have paid around 3% for their debt. They are unlikely to have large arrangement fees that will be flexed in the same way the mortgage debt has been – the same effect, but less magnified. That means that in 2023, they are (on a 5-year cycle) looking at around 6% – not a 70% increase, but a 100% increase.


Their £10m borrowed was costing £300k per annum, and the same amount today now costs £600k per annum. Luckily – they tend to have longer time horizons, and can and do borrow for a decade or more at a time. Still, today’s graph shows just how much debt drops off next year – 20% or so of outstanding European small company debt – and 40% by 2025. “Higher for longer” soon causes problems at those levels. Some companies will of course have grown their revenues significantly since the debt was taken out – but they are unlikely to have doubled them, given that even “small” caps tend to be of a significant size.


Indeed – this factor (compared to the giants in the S&P 500, who have 2-3 years before even 20% of their existing debt matures) perhaps goes some way to explain the weak performance of small-caps and the stock market in general if you strip out the “big 7” as they are now called, or the AI and tech stocks if you prefer. 


My attempt to estimate the path of the UK property market debt (with the drawing skills of a small child) is also included on the graph – which tells you that the problem is indeed creeping up on us. Fairly quickly, and property is more likely to be affected more quickly than businesses – just on the debt basis.

Of course – rents are rising, as I’ve said – and are likely to keep rising, since wages are still hot and they have lagged this inflationary cycle (as they always do). Rents may well keep rising in a recession – whereas businesses are likely to be more affected, more quickly, in a recession (depends on the type of unemployment – it isn’t unthinkable for job losses or rationalisations to happen, but talent to continue to be well-rewarded at what is now above the rate of inflation – for a while, anyway). It would be foolhardy to suggest that property will move for the same reasons as stocks, or businesses – that is generally not the case, and there are different time lags as well. Still – it shows you why there may have been a lack of impact on debt pricing on the very large stocks, and why many smaller enterprises are more at risk in this rate environment. Always the little guys, eh…….


I hope that was thought-provoking and goes some way as to explaining why I’ve been comparing this more recent period in the post-covid cycle as “moving through treacle”. The credit tightening is almost so small as to be unnoticable – but everything on my radar tells me that it is there. This is why, as I said last week, I’m NOT an advocate of waiting to fix debt. If you can afford to – fix now, and work on the next deal. Or – perhaps better put – if you CAN’T afford NOT to – fix now. Price of credit is one thing, availability is another. If you do, or are looking at doing, salty-style deals, then the financial support for them could evaporate quickly.


Back to part two of this week’s analysis – real pricing. We’ve moved on a calendar quarter since my July piece of work and – perhaps unsurprisingly – that trend has continued, as predicted. In Q3, according to Nationwide’s rarely quoted UK house prices adjusted for inflation – the real price of a UK house was £260,181. This is down another 1.1% on the quarter. 


This is also the furthest from the trend line since Q1 1997, which was the start of a roaring boom. Am I predicting a roaring boom? No. We are 23.29% lower than we should be using the past 40 years of data as setting the trend. This could be folly for a number of reasons – one being that interest rates have been falling for almost all of that time, whereas they are rising today (or at their peak, as some are saying). Another is that old classic – the market can stay irrational longer than you can stay solvent – and I’m not saying we’ve hit the real bottom yet – not at all. The market has stalled a fair bit, and inflation is another 12 months away from being under target, let’s face it. Even if the market went up 2% next year, if inflation is 4, then the real house price still goes down.


The real house price is nearly guaranteed to go down yet further for the next three quarters at least, if not more. Does all this mean “don’t buy”? Don’t be crazy. As I’ve said many times before, there are deals in every market, and whilst you’ve got so many potential leads out there, the challenge becomes sorting the wheat from the chaff. The point is that at the moment, the market in terms of long-term pricing, adjusted for inflation, is favourable for buyers and should remain so for a period, probably 12 months long or so (possibly 18 months). Buying well takes time, and an ability to fire 50 bullets to make 2 kills. When it is time to take the risk – take it. Inaction (the easy option, right now) could be one of the great regrets – considering there hasn’t been this much deep value on this measure for 26 years, it could soon be gone in the blink of an eye. Inflation opportunity!


Weekly earnings are up 1% further since my last piece of analysis – more firepower to pay the higher rents. Rents in the same time period are up 1.6% in England – so they are rising faster than wages at the moment – but remember, they are still 15% lower than 2005 (the start of the data series) when looked at as a percentage of wages. The cotton buds are needed in the ears to ignore the screaming press on this issue – but the data has no bias, makes no friends (well, I love it), and takes no prisoners. 


Real wages haven’t moved in the 4 months since I updated the figures last – meaning, with lower real house prices, the real house price as a multiple of real earnings stays under 10 times, with it having retreated slightly (from 9.96 times) to around 9.9 times. 


It may feel like hard going at the moment – but to the victor will go the spoils. The rental sector is shrinking, buy to let mortgage approvals are simply going to remain low while rates remain high, and we might only see 1% come off rates in 2 years at this rate – it is very difficult to tell. The barriers to entry are going up – be on the island, or outside on the moat looking in, wishing you had improved your position when others were fearful……


Keep that motivation and work rate up – deals are coming through. There is only one way forwards……. Keep Calm and Carry on!


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