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The Cost of Housing and the General Level of Earnings
Except for the very wealthy, or those who are in receipt of a legacy or gift, most people have to provide a first home for themselves out of the income they can earn. The problem appears then to be that either house prices are too high, or that earned income is too small, or both. In this article we shall consider how both the price of housing and the level of earnings are determined. We may not be too surprised to learn that there is more to these matters than simple ‘supply and demand’ or that a key consideration is location.
Location, Location, Location!
Everybody recognises the importance of location when they choose where to go on their holidays and that it has a major influence on the price of houses. Most people also appreciate the importance of location in relation to the viability of all business enterprises and employment opportunities. In this, they realise that in some places it is easier than in other places to earn a living by farming or mining, or in some other places by manufacturing or retailing, or by banking or insurance, or even by internet trading. Every person, and every form of business, depends upon a range of support, and services provided by others, and on that which is provided, without any human intervention, by nature. Not least among these ‘gifts of nature’ and one that is essential to the wellbeing of all individuals and firms alike, is the land itself. We see then that the amount of benefit that an individual or business is able to gain from society and nature, varies depending on its’ location,.
The Cost of Housing
In considering the cost of housing, the first question that an individual or couple have to address is, should they rent or buy?
If they decide to rent a home of their own, they will find themselves dependant upon the good will and cooperation of the person, corporation or organisation that owns the house in which they live. House owners in general, as landlords, are free to choose to let, or not to let their houses out to tenants. Landlords thus have a power that tenants in general do not have – tenants must find somewhere to live. When landlords choose to let it will be because the rent charge and other conditions of the letting suits them.
They may be constrained by the availability of willing tenants or by relevant legal requirements but, if they actually own the house, they will generally be free to leave the house unoccupied if the available terms do not suit them. However if the house is held subject to a mortgage i.e. they do not completely own it, they may be under greater pressure to accept a lower rent payment rather than none. Even so if the rental income is insufficient to meet debt charges, or provide a suitable return on the equity value that they have in the house, they will be under pressure to sell it. If that equity value is to be maximised by vacant possession, the house sale will be bad news for existing tenants and for tenants in general. If, as in the past the equity value of houses continues to increase over time, there will be corresponding pressure to increase the rental charge that tenants must pay.
The individual or couple that chooses to rent a home of their own may thus anticipate a continuous increase in their lifetime cost of housing.
In evaluating the impact of this, their foremost consideration is likely to be the extent to which the income that they can earn by working, will keep pace with these rising housing costs. Recent experience in the UK as illustrated by the regular publication of the mortage/earnings ratio will not encourage them. These show how the rate of increase in house prices has continued to outstrip the individual’s earnings capability. It is easy then to appreciate the pressure that young adults may feel under as they may see their prospects of acquiring a home of their own diminish with time after they begin to approach their earning’s ceiling.
Under these circumstances it may not be surprising that most people who can afford to own a home of their own, choose to do so.
If our young person or couple decide to buy their own house it is likely to represent for them the first step on acquiring the largest item of wealth that they are ever likely to own. It is however also likely to place them in debt for a large part, if not all, of their working lives. If, over the next few years they are able to maintain their mortgage payments and their house increases in value, their debt will reduce as a proportion of their increasing equity value. If however, due to an increase in interest rates or a period of reduced earnings, or some other reason, they are unable to maintain their mortgage payments they may risk losing their home. If they are fortunate, however, they may eventually join the class of ‘property owners’. The people they purchased the house from may, or may not, have profited from their sale. However the mortgage company or bank will almost certainly have done so, as a result of the income received from the buyers due to interest charges throughout the long loan period. At even a modest rate of 4% or 5%, interest charges are likely to have exceeded the sum borrowed when repaid over 25 years. At higher rates of interest these charges can amount to several times the sum originally borrowed.
In deciding whether to buy or rent, our young householders will have estimated how much they could afford to pay each month for housing out of their earnings. If they are to rent, it will determine their acceptable rent payment. If they choose to buy it will determine their acceptable mortgage repayments. This, together with the prevailing interest rate will determine the sum that could be borrowed and hence, after allowing for any available savings or required deposit, the value of the property that could be purchased.
Few householders choose to live in a house that offers them less than they can comfortably afford and most owner occupiers will spend as much as they can to get their first home of their own. Here we may begin to see the link between the general price of houses and the general level of earnings. In the case of house and flat rents this seems to remain fairly constant at around 30% of disposable income. In the case of mortagage payments however this will vary throughout the persons working life so that at the beginning of a mortgage it is likely to represent a much higher proportion of householder’s earnings than it will later on. Ultimately, by the time most borrowers reach retirement age it is likely to be nil % of their pension income. However, we need to look closer at the effect of market prices on supply and demand to understand this better.
A common understanding of market theory is that the convergence of the supply and demand curves of any item determines that item’s market price. More accurately, it is the market price of an item that determines both how many of those items all businesses in that industry can afford to make, and how many of those items purchasers will be willing to buy.
Plotting price on a vertical scale and the quantity sold in the market on a horizontal scale the normal demand curve tends to slope diagonally downwards to the right showing how the demand for any item tends to reduce as it’s price increases. Likewise the demand for a particular sort of house will tend to diminish as it’s price increases.
The supply curve for most items is based upon the costs that producers of that item must incur in producing it. Thus, where the market price of an item is very low, only a few producers will be able to produce it at such a low cost. As the market price for the item increases, more producers will find that they are able to produce it for sale profitably and they will bring more of them to the market. The normal supply curve then tends to slope diagonally upwards to the right. The supply curve for housing however, is rather different. This is because an important part of the price of housing, the land on which the house stands, has no cost of production at all.
The supply of land for housing does not thus increase automatically with the price of land. With an increase in the price of land, however, owners of land are likely to suppose that land prices might continue to rise. It would then be folly to sell today if, by waiting until later, they could get a better price. A supply curve that is not susceptible to variations in price is described as ‘inelastic’. It does not slope diagonally upwards to intersect with a downward sloping demand curve but rather rises vertically from a relatively fixed quantity that is determined by factors other than market price.
As indicated already an important factor affecting a landowners willingness to sell or let his land is the cost, if any, of not doing so. If he is using it already there may be a live ‘opportunity cost’ to be considered, but if he is holding it out of use he may have no consideration other than its value as an asset, and whether this is likely to increase or diminish in value with time.