The Housing Market, Plain and Simple

The Basics

Fact 1  A property is only worth what a buyer is willing to pay for it.

Fact 2  The price the buyer will pay depends on the amount of money available to him/her. Deposits usually form
              only a small component of the overall purchase price, so the main factor influencing house prices is the
              amount a buyer can borrow.

Fact 3   The amount a buyer can borrow depends on the amount banks are willing to lend to him/her.

              If banks stopped lending money, the average homebuyer, unable to find £200,000 in cash, would not be
              able to buy an average house. House prices would fall as a result, even if land becomes scarce or no
              more homes get built. These factors are completely irrelevant if nobody has £200,000 in cash to buy a
              house in the first place. Conversely, if banks decided to lend more and raise their mortgage multiples to
              40 times salary, suddenly average house prices would be pushed towards £1 million as the massive
              injection of cash allows buyers to borrow more and to chase up house prices.

Fact 4  The amount banks are willing to lend depends on the "supply of money". We learn more about this later
              but in summary, when money enters the banking system, banks are able to re-lend it. What's more, as
              long as they maintain sufficient reserves in order to meet the demands for withdrawals from their
              customers, they can lend out more than the original amount placed with them, creating credit. So the more
              money that enters the banking system, the more credit banks can create and the more they can lend.

Fact 5  If the economy remains healthy, the supply of money will be maintained and banks continue to lend freely.

Fact 6  Since markets are cyclical however, at some point the economy will turn downwards. At this point the
              supply of money will begin to contract. For example, when falling corporate profits lead to loan defaults, or
              when over-stretched home owners default on their mortgage payments, banks will reduce their loan
              exposure and cut the amount of money they are willing to lend.

Fact 7  In this situation a homebuyer can no longer borrow as much money.

Fact 8  If a buyer cannot borrow as much money, then he/she can no longer pay as much for the property he/she
              wants, forcing down house prices until they realign with the lower level of funding available to the buyer.

Conclusion

At present, the property market is simply driven by one overriding factor. The engine of the entire process is “Money Supply”. The higher the supply of money entering the banking system, the more banks can lend, the more people can borrow, and the higher house prices will go.

At this point we therefore need to ask three important questions:

1) What is Money Supply?

2) How much money has been flowing into the banking system recently?

3) What impact has this had on house prices?

Continue to 3: Money Supply...