Are house prices high or low, and will they go up or down? I’ve been researching this question for houses in London.
The basic concept is that a house is an asset that provides accommodation. Accommodation is a commodity priced by the market (called “rent”). The value of an asset is determined by its future cash flows discounted to today by the interest rate.
To see how this works in practice:
Someone who needs accommodation can either get it from the rental market, or can buy a property (probably financed with a mortgage) and live in it. If the interest on a mortgage is lower than the rent, it makes sense to buy instead of rent.
House Price × Interest Rate = Rent
Of course there are many other factors such as maintenance costs, taxes, ability to access debt, risk, opportunity costs, and regulations, but this is the essence of the calculation.
This explains why house prices in London have risen so much over the last decade: interest rates were slashed after the 2008 financial crisis. Prices will remain high while interest rates are low. Rents will be relatively stable unless the city population shrinks.
Therefore betting whether house prices will go up or down is equivalent to speculating on interest rates.
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