Tuesday 29 August 2017

What’s happened to rents in London and the UK after the Brexit referendum? Evidence from a new rental index.

Everyone talks about house prices – either rising or falling – as a vital indicator of local and national economic health, and a range of indices frequently make the headlines. Rents get less robust attention, largely due to a scarcity of good timely information on the current state of the market. This is clearly a problem, since now nearly 20% of households are private renters in England, and nearly 30% in London, a figure that has nearly doubled from what it was 10 years go (Survey of English Housing). It’s also a gap in our information about the economy, because rents are likely to be more responsive than sale prices to current conditions, local and national, and so a better barometer of pressures in the market. Turnover in the sales market is much slower, since people keep owner occupied homes for longer and properties can spend a long time on the market. In general prices reflect people’s expectations about long-run trends and will be sluggish to adjust to unanticipated shocks.

Last year I spent a bit of my time developing new rental indices for HomeLet based on their private rent data to try to address this omission. The index aims to carefully adjust rents for changes in the types of properties being rented out and their location, just like the leading house price indices. Fortune telling based on price indices can be a futile exercise, but these new rental indices are starting to reveal some fresh information and interesting patterns.

Figure 1 plots a range of different trends spanning June 2014 (the start date for reliable rent data) to July 2017. The trend in blue is the publicly available monthly Nationwide House Price Index for the UK. The red line is a version of the new HomeLet index of private sector rents, based on new rental agreements for the UK. At the bottom, in green, is the ONS ‘experimental’ rents index.

Figure 1: Rents and price indices for the UK

There are some intriguing features here. Unsurprisingly, all the indices agree rents and prices have risen in general over this period. Broadly speaking rents for new agreements and house prices follow similar patterns, and, up until June 2016 followed each other reasonable closely. These new rents exhibit a marked cyclicality, rising over the spring up to July and then tailing off a bit in the summer and autumn. The fall-off in rents in June 2016 looks dramatically deeper at the end of 2016 and beginning of 2017 – more on which later.

The broad similarity of the patterns in rents and prices is quite reassuring for people who like their economics simple, because the fundamentals of housing should be similar for both renters and owners. To an approximation we would expect prices to roughly reflect the value of the rents the property could generate in the future (plus expected capital gains, less depreciation, maintenance etc). 

Even so, it is often said that prices are rising much faster than rents in the UK, perhaps something to do with constraints on development making land scarce and pushing up property prices in anticipation of future capital gains, or some other form of speculative bubble or incentives that favoured buying, such as “Help to Buy”. As it turns out from this - admittedly short - time series of data, that wasn’t actually true nationally between mid-2014 and mid-2016 if we compare new rents with prices.

One reason underlying the perception that prices rise faster than rents might be that the main point of reference has been the ONS rental index – the green line – which indeed suggests rents have climbed in a sluggish plod, showing a 7% rise since June 2014. Prices, on the other hand, increased by over 12%. These comparisons – if they represent the long run picture, rather than a short term blip - would mean that renting a home is an ever-increasingly cheaper option than buying, or else the expected percentage capital gain on housing sales is ever-increasing. Neither of these possibilities seems very plausible.

But this comparison is misleading. The ONS index is based on valuation data and reflects average rents in the stock of private rental accommodation. This ONS index is based on data on rents for occupants of all lengths of tenure – those that have just begun a rental agreement, and those that have lived in a property for many years. This gives a poor indication of what a landlord can ask and what a tenant can expect to pay when setting up a new rental agreement. If new rents are rising. but landlords are less willing to raise rents for existing long tenure tenants than new tenants, then the rent in the stock will rise more slowly. Although this behaviour can be hard to rationalise, it is a commonly observed feature of the rental market.

I we look at new tenancy agreements, as in the HomeLet data, things look more in line with what simple theory would suggest. But something dramatic seems to have happened in mid-2016. New rents fell sharply and stagnated right up until May 2017, while prices continued to rise, with just a brief dip early in 2017. What could have caused this drop in rents? While it is impossible to attribute causality with a simple time series like this, some more insights emerge if we split out London from the rest – see Figure 2.

The blue line is the Nationwide quarterly house price index for London (unfortunately they do not publish a rest-of-UK index). The solid red line is the HomeLet rental index for London. The dashed red line is the HomeLet rental index for the rest of the UK. The green lines show the corresponding trends in the ONS rental index.

Here it is clear that the trends in prices and rents in London departed company some time back in 2015. But what is more striking is that London rents nose-dived in mid-2016 falling about 4 % in the May-May year-on-year comparison. Indeed it is this fall in London that explains the drop in the national index in Figure 1. The fall over the summer in the rest of the UK is not much different from what it was in 2015. Rents have recovered in the last few months, but only to about where they were this time last year. 

Figure 2: Rents and price indices for London and Rest of UK

House prices haven’t fallen (much, yet) in London – at least according the Nationwide index. But they have flattened off a lot over the period when rents started to tumble.

What can explain this sharp fall in rents in London and why haven’t prices done the same? There are many candidate explanations, which surely have something to do with a fall in demand relative to supply of rental accommodation.

The Brexit vote might seem like an obvious candidate. But it is a dubious explanation on its own. Although there is some recent evidence that net migration decreased over this period (mainly due to EU-8 emigration), there are still many more workers, both EU and non-EU, entering the country than leaving (net migration between March 2016 and March 2017 was +246,000). Based on recent years of data, London accounts for about 40% of net international migration which means an additional 100,000 foreign workers arrived in London between March 2016 and March 2017. By the way, if you wonder how these international workers are accommodated, some relevant facts to consider are that net international migration into London in 2015-16 was 126,000, net migration from London to other UK regions was 93,000 and the number of new dwellings completed was 24,000.

The longer run economic outlook and exchange rate changes might be relevant factors too, but would expect house prices to be more responsive than rents if people were anticipating a future economic downturn or were concerned about exchange rate risks to their investments.

So perhaps it is less to do with demand for living in London, and more to do with supply of rental accommodation and incentives for ownership versus renting. An associate of mine who is an expert in property valuation and knows the London market intimately, believes this is at least part of the story. Non-resident owners in London are letting their properties rather than selling, given the low interest rates and the low cost of holding property, which is has been increasing the supply of rental accommodation and pushing down rents.

Whatever the explanation turns out to be for these patterns, this new index promises some unique insights into the rental market that have previously been quite obscured by lack of timely data. Deeper analysis is obviously required to properly understand the causes.

Declaration of interest: I was given some remuneration for developing the code to estimate the HomeLet index, but have no other interests in the company.

How the index works:

Simply looking at average rents in sample in new rental agreements is potentially misleading if the composition of the sample – in terms of the location, size, type and quality or properties being let – is changing over time. For example, in recent years the share of homes that are privately rented relative to owner occupied has increased but these changes are not evenly spread geographically. So changes in average rents will reflect both changes in the rent you can expect for letting a property in a given location, and changes in the number of properties being let in different parts of the country or different parts of a city. The changing patterns of rental locations and changes in the type of property being let can lead to misleading long run trends and to short run volatility in average rents.

The ONS rental price index addresses this problem by estimating rents for a fixed ‘basket’ of properties – in much the same way as a retail price index looks at a basket of consumer goods, or house price indices such as those produced by the Nationwide and Halifax adjust for changes in the types of houses being sold. These are called ‘hedonic’ house price indices. The disadvantage of the ONS index for many users is that it estimates rents in the stock, rather than the price of newly agreed rents.

The new HomeLet rental index combines elements of the ‘hedonic’ approach, with some ‘smoothing’ of the series over time. The source data contains information on 20,000 new tenancy agreements each month, across the UK. The index is estimated by looking at estimated changes in rents from one month to the next for lets within the same small geographical area (e.g. postcode sector). The method applies statistical techniques (regression) to adjust for changes over time in the types of property being let (like the ONS and Nationwide indices), but in addition smooths out short run volatility by using information on trends in rents in recent months, rather than only a single month (it uses local cubic polynomial smoothing). The index therefore offers a big step forward by providing the first index of new rental prices that is properly adjusted for changes over time in the characteristics of rental properties.