I want you to study this equation hard so you really understand it.  The actual price of a property is made up of 2 elements, the real price of the property and the bubble element:

Pactual = Preal  + Pbubble

Pactual  - Current Market Value of the property

Preal   - The real price of a property based on fundamental principles

Pbubble - The surplus or deficit of the actual price over the real price

In a perfect market the actual price of a property should equal the real price of a property.  Unfortunately this never happens!  This is because we live in an imperfect market which is driven by people’s own opinions and views (including mine!) which are impossible to predict.

To determine each element we need to first determine the current market value of the property, then the real value of the property and then calculate the bubble element as the difference between the actual and the real value of the property.

Pactual  - Current Market Value of the property

We determine this as being 95% of the advertised price of a property.  As an average properties sell at 95% of their asking price.  This is the only way you are going to get an up to date value of a property as best you can.  The land registry figures are too out of date to really use as a current market value as there is around a 9 month lag from agreed offer price till published price.

So for example if we see a property advertised for £100,000 then the estimated current market value will be:

£100,000 x 95% = £95,000.

Preal   - The real price of a property based on fundamental principles

The real price of a property is based on fundamental principles.  The fundamental principles that apply to the property price are:

The greater of:

  1. The price willing to be paid by an investor
  2. The price willing to be paid by a first time buyer

So whichever is greater out of these two figures will be the real price of the property.  So we need to calculate both of these prices.

The price willing to be paid by an investor

The price willing to be paid by an investor will be function of what he could get elsewhere in the market.  If an investor wished to take no risk then he could stick the money in the bank and earn interest.  If he were to invest in property he would look for a premium as he was taking on risk.  As property is a long term investment he would look for a comparison of the same timescale that is risk free.  The best rates you would get would be from a:

20 year fixed interest government gilt

A government gilt is a loan to the government.  As it is assumed that the government will not go bankrupt we can assume that it is risk free.  Property is considered to be the next lowest risk investment out there.  As an average property investors require a 2% loading on a 20 year fixed government gilt for them to invest.  This will determine the yield required and hence set the real value of the property.  Lets look at an example:


20 Year Fixed Interest Government Gilt        5.62%

Property Investor Loading                               2.00%

Annual Rental Value of Property                    £5,000

The real value would be:

£5,000 x 1/(5.62%+2.00%) = £65,616

This will be the maximum value an investor would be willing to pay for a property with a rental value of £5000.  If the property price was higher then the investor will place it in a risk free investment like a government gilt.  The property price could be higher due to a first time buyer being able to afford the property.

The price willing to be paid by a first time buyer

The price willing to be paid by a first time buyer will be:

His salary x 4


This assumes that lenders will lend 4 times his salary if he puts down a 5% deposit on the property.  So, in the same example above, if a first time buyer wants the same property and his salary is £21,000 then he could afford a purchase price of:

(£21,000 x 4)/(0.95) = £88,421

So in this example the first time buyer ‘wins’ and thus the real value of the property is £88,421.

Pbubble - The surplus or deficit of the actual price over the real price

The bubble element is simply the difference between actual and real prices:

Pactual - Preal  = Pbubble

So using the example we would have the actual price being £95,000 and the real price of £88,421 then the bubble element will be:

£95,000 - £88,421 = £6,579

The key to property investment is to NEVER buy a property at a price where there is a bubble element to it i.e. make sure Pbubble = 0 or less.  To do this it is important to know why bubble elements exist and what you need to be aware of to ensure that you never buy a property that is over priced.

Why Bubble Element Exists

Bubble elements exist due to the following:

Self-certified BorrowingIn the UK we borrow at the current variable base rate and not at the long term average rate.  Currently the long term rate is around 5.7% and the variable base rate is at 4%.  This is why we have a boom bust cycle.  When rates fall below the long term rate first time buyers over borrow, as they can afford it, by obtaining a self-certified mortgage thus increasing their buying power.  Their increase in buying power creates the bubble element as their buying power takes them over the real value of the property.
Novice InvestorsDue to the buy to let mortgage also operating under the current variable base rate the same problem occurs here.  Instead of demanding a 2% loading over the long term rate they demand a 2% loading over the current variable base rate.  This means you get novice investors buying at 6% yields and below hence superceeding the first time buyers highest price.
High Income Multiple LendingSome lenders are offering in excess of 4 times salary.  This enables a first time buyer to borrow in excess of the real value of the property thus creating a bubble element.
Speculative InvestorsDue to the poor performance of the stock market in recent years the property market has attracted the traditional stock market investor.  Here the investor will invest for capital growth and so will be happy to take less than a 2% loading.  The speculative investor will make the estimation that the growth experienced in the past will happen in the future over the short term. The speculative investor’s bid then superceeds the property investor’s bid and if this is in excess of a first time buyer’s bid then a bubble element will exist.
Consumer DebtSome people borrow the deposit for the property by way of loan.  This means you can enter the property market very quickly as you do not have to wait to save up for a deposit.  This increases the number of buyers thus increasing demand for property hence pushing up the price of the property.


Now I have made several assumptions in this calculation and I welcome you to challenge them.  Assumptions are drawn to make the theory simple but property is not an exact science.  Understanding that assumptions can be wrong will help you get beneath the theory and allow you to take a practical approach when making an investment decision.  The assumptions I made that need to be challenged are:

95% of advertised price as current market value of propertyThis is an approximation in a rising market.  It may be 100% or even 105% for a competitive market.  Decide for yourself what the market is like by your own experiences.
2% loading for investor on government gilt rateIt could be more than 2%.  I expect a 6.5% loading for my investments resulting in a 12%+ yield requirement but I reckon it bottoms out to 2% loading (equating to 7.62%) but I could be wrong!
4 times salary lendingThis is currently what most lenders offer but there are lenders that offer up to 5 times salary.  Now if this type of lending grows then the real value of property will rise.
First time buyer having only 5% depositYou can buy a property with no deposit.  100% mortgages are popular but do not form a significant part of the market – but they could do in the future.
Including only first-time buyer propertiesI’ve assumed that first-time buyer properties are the type of properties that investors go for.  This is not a hard and fast rule.  Some landlords invest in executive detached properties with lower yields and class A1 tenants.  One needs to incorporate this in our thinking.

Awareness Table

Based on all the theory above we can narrow down what we should be aware of if we really want to understand and thus exploit property price movements: 

Aware of:Description
Global RatesOur rates are restricted by global rates.  We cannot be out of sync with the rest of the world.  This is called interest rate parity.  The formula holds:

Where S is the spot exchange rate, expressed as the price in currency A of one unit of currency B. F is the forward rate, and are the interest rates in the respective countries, and T is the common maturity for the forward rate and the two interest rates.  It assumes that if interest rates were 10% in Europe then we would convert all our Sterling to Euros, place them on deposit in a European bank and then convert them back after a year and enjoy the profit.  This theory states that the profit would be nil as it would be money for nothing and so when you converted back in sterling you would get an inferior exchange rate.  So we are all locked within each country’s interest rate.

The world has been in a recession.  Interest rates have been low in the major economic countries which has kept our rates low even though we are not in a recession.  Once rates start moving upwards over the borders then our rates will rise.  You need to be aware of the financial indictors of the major economic countries.  They will be the same as ‘Home Rates’ see below.

Home RatesTaking into account the interest rate parity above there will still be some freedom within the UK to set rates.  The rate is set by the Bank of England and they use the following reports to set them:

  • Consumer Price Index – This measures price inflation.  The target for the bank is 2.5%.  If it goes over then rates are expected to be risen by the Bank.
  • Employment Cost Index – This measures wages growth.  If wages rise above expectations this causes an increase in spending and thus results in inflation.  Expect the Bank to put rates up.
  • GDP Report – This measures the overall performance of our economy.  If it falls 2 quarters in a row then we are in a recession and expect rates to be lowered by the Bank.
  • Unemployment Rate – This measures the number of people out of work.  If its too low then it causes an increase in spending thus inflation and expect the Bank to rise rates.
  • House Price Inflation – Very under-rated by the Bank!  I don’t know what threshold they set here but they are willing to see massive inflation here and do nothing about it.  However be aware that the Bank do consider house price inflation when setting rates.

Keep abreast, where possible, of the UK and Global reports surrounding their economies.  Here is where you will be able to see the triggers to movements in the UK and global interest base rates.

20 year government gilt figureBeing aware of this will make you able to calculate the real value of the property as the real value is a function of a 2% loading of this rate.
Differential between long term rate and current rateIf there is a significant difference between the long term rate and the current rate then the property prices can abnormally rise or fall from their real property value.  At the minute there is nothing to worry about and the differential is reducing.  However close inspection of the differential will keep you ahead of the pack as you will see how the lenders react and how property prices change.

Also be aware of heavily discounted mortgage products coming to the market.  They can distort prices if these deals become popular forcing other lenders to reduce their rates and making the whole mortgage market even more competitive than it already is!

Rental Value of PropertyFor you to really exploit all the possible opportunities then you need to be aware of the rental values of property.  Based on this you can calculate the real value of a property in conjunction with your required return which you can then compare to the actual asking price.  If the real value is in excess of the asking price then take a look at the property!
Current Market Value of PropertyFor you to really exploit all the possible opportunities then you need to be aware of the current market values of property.  This involves searching on the net, looking in local papers and talking to estate agents.  Based on your real value of property calculations you can see if the current market values look attractive.
Negative EquityIf there are a significant number of property owners in negative equity then this reduces the feel good factor.  In turn it reduces spending and productivity.  This can trigger a recession which results in higher unemployment and a fall in property prices.
Ratio of earnings to property valueIf property values are in excess of 4 times salary then you know that there is a bubble element to the property price.  Try to get local data on people’s earnings to help you determine the real price of the property.
Lending multiplesCheck to see if lending multiples are increasing.  Currently the standard is 4 but there are a growing number of lenders offering 4.25 times salary which is causing the real price of property to rise.
Number of First time buyersThis needs to be a healthy number to keep the market buoyant - especially where the investors have refused to invest.  If these stop buying then prices will fall in that area to the price that an investor would buy at.

So Are We Heading For A Crash – Will The Bubble Burst?

The short answer is no.

The reason is because the size of the bubble is small and will only burst for a small section of people.  Let me explain.

There are only 3 parties involved within property that can cause a crash:

  1. The lender
  2. The investor
  3. The first time buyer

The Lender

The lender can cause a crash by over lending.  All lenders set parameters for lending criteria.  Their key lending criteria is 4 times salary for owner-occupiers and 130% of the mortgage payment for buy-to-let investors.  Based on these parameters mortgages should never become unaffordable.  They only become unaffordable if interest rates rise sharply or we enter in to a recession.  See below about interest rates and likelihood of a recession.  As the lenders are willing to lend then buyers are able to buy thus keeping the market active.

The investor

The investor can cause a crash by miscalculating his returns.  If an investor has done his homework then this will not occur.  He will never buy over the real price of a property.

The first time buyer

The first time buyer can cause a crash by over borrowing.  To over borrow requires the first time buyer to mislead the lender to obtain higher borrowings than he is entitled to.  The majority of first time buyers are unable or unwilling to mislead a lender.

The only people for who the bubble will burst are the people that hold a property where a bubble exists.  That is the table above.  Namely:

  • First time buyers on self certified borrowing
  • Novice investors
  • High Income Multiple First time buyers
  • Speculative Investors
  • First time buyers that have borrowed the deposit

This is a very small section of the market! 

Even where bubbles exist the size of the bubbles are small.  There will be the professional investor or the standard first time buyer that will purchase their property off them at the real price which will only be a fraction less than what they paid.

Outside The Property Market

The basis of this thinking is because interest rates will not rise beyond affordability and we are not heading for a recession for some while.  There can be shocks to the market which no-one can predict but based on the information we have at hand now there will be no crash like the 90s.  The main reason is that we will not see the days of 15% base rates in the UK for a long time or any major unemployment figures of the past.

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