Is there a UK residential property bubble?

2013 saw the start of a full recovery in the UK housing market. The government has done everything possible to resuscitate the market and last year its efforts finally worked. According to the Nationwide prices rose by 8.4% in 2013, that compared to a 1.1% fall in 2012. Price changes continue to vary widely across the country. London prices rose over 15% last year compared to a rise of just 1.9% in the North of England where the increase was lowest.

Outlook for 2014

The market is being driven higher by government policy but also because of a lack of housing supply. Those predicting an imminent collapse in prices often ignore the current supply shortage. It's true that the government is artificially inflating demand but the supply shortage in UK housing is real and unlikely to be resolved any time soon.

Demand

Demand for property was first boosted by the Bank of England when it introduced the funding for lending scheme in the middle of 2012. This helped to push mortgage costs down and boosted demand by making buying a house an affordable possibility for many more people.

At the budget in 2013 Chancellor George Osborne announced the help to buy scheme and it had an immediate impact. The first part of the scheme allowed people to get a 20% interest free loan towards buying a new build property and this has helped stimulate the construction market. The more controversial second part allowed people to buy any property with just a 5% deposit.

In 2014 demand will be predominately driven by three factors. Government intervention, interest rates and wage growth. The first two factors are closely related. Some fear that as interest rates rise homeowners will be unable to afford their monthly mortgage repayments and this will lead to another collapse similar to 2008. But with an election on the horizon in 2015 the government will be keen to keep interest rates low and the housing market booming.

Even if a small rise in rates does happen it is not something the market should fear since it will only occur with lower unemployment and stronger economic growth. And this leads me on to the third factor – wage growth.

In recent years wage growth has been anemic and actually below the rate of inflation. Thus far it has been the biggest factor slowing down faster house price growth. If the UK recovery and lower unemployment rate can translate into higher wages, this brake could be removed. Higher wages would lead to higher demand and potentially higher prices.

Another factor affecting demand is population growth. Birth rates are now at the highest level since the 1970s and the ONS predicts the UK population will grow at 400,000 a year until 2020. We are currently not building enough homes to meet this extra demand.

Supply

Just 107,950 homes were built in 2012-13. That’s less than a third of the homes built in France and a long way from the 250,000-300,000 some think tanks think we should be building. Britain has some of the smallest homes in the western world. In many areas, particularly in the South East there is severe overcrowding. 1.7 million people are on government waiting lists and council houses have become like gold dust.

At the same time the UK has some of the toughest planning laws in the world. The low housing supply is pushing up both rents and prices, forcing people to pay a higher amount of their incomes towards housing costs.

Some steps have been taken to resolve the supply problems. Planning laws are being relaxed and the first part of help to buy has encouraged more building. The results of building companies out last week showed a big rise in output but building levels are still well below their peaks in 2007 and new homes cannot just be built over night. The situation will take years to resolve.

Conclusion

It's probably too early to worry about a housing bubble this year with the only major concern being London where prices are now far ahead of wages. The London market is also now heavily dependent on buyers from outside the UK. It may be affected by other factors such as a strengthening pound (which would make property relatively more expensive for foreign investors) or the recent capital gains tax introduced on foreign owned property.

However outside London prices remain below their pre-crisis levels and supply remains short in many areas. Prices have further to rise in 2014. A bubble is threatening to start but we are at the start of that bubble. The combination of government inflated demand and low supply has the potential to drive prices much higher over the next couple of years, especially if wages improve. In a few years’ time, as more supply becomes available and prices and consumer debt levels increase, the conditions will potentially exist for a big crash but we are not at that stage yet.

By James Yardley, senior research analyst, Chelsea

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested,and tax rules can change over time. James' views are his own and do not constitute financial advice.