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The Bank of England’s base interest rate drop: What to expect in the real estate market

The Bank of England has made a deliberated decision to stimulate the UK’s economy by reducing the base interest rate and increasing the money supply

In an effort to stave off a looming recession in the wake of the Brexit referendum, the Bank of England (BOE, or the Bank) just last Thursday lowered the base interest rate from 0.5% to 0.25%, the first reduction in seven years, resulting in the lowest rate in the country’s history. In addition to the rate change, the BOE announced further quantitative easing (QE) through the purchase of £60 billion in government bonds, bringing the QE programme to a total of £435 billion. The Bank stated it would buy £10 billion in corporate bonds, and that up to £100 billion of new funding would go to banks to help them transfer this base rate cut to households and businesses. Under this new stimulus scheme, the Bank will generate new money to supply loans to banks at interest rates near the 0.25% base rate, and it will penalise banks which do not lend.

This move was expected, and the Bank has announced that it plans to lower interest rates further later in the year. This interest rate change gives rise to many questions. What are the foremost consequences of this change? What does this mean for the British pound? Who are the main winners and losers? What are the likely consequences for the UK’s real estate market — especially property prices — and the market’s participants, including those abroad? Analysts from Tranio offer herein brief commentary on these questions.

The Big Picture

The forecast for the UK’s economy looks rather bleak: the May prediction of 2.3% growth for 2017 has dropped to 0.8%, and the prediction for 2018 is now 1.8%. Moreover, inflation is expected to rise to 2.4%, and unemployment is predicted to increase to 5.4% in 2017 and 5.6% in 2018. Immediately following the Bank’s announcement, the pound dipped 1% on the US dollar. As a result of inflation and the drop in the value of sterling, imported goods will now become more expensive, though exporters will fare better. Inflationary pressures have built up since the June referendum, and inflation will likely continue into 2017 and 2018. Though the Bank remains optimistic about its stimulus programme, it is yet doubtful that these efforts will entirely prevent a recession.

Main Monetary Policy Winners: Who and How?

Homebuilders. There are widespread expectations that lower borrowing costs will trickle down to mortgage rates and increase demand. According to Ben Madden of property management company Thorgills, the cut “can only be positive for the UK property market”. The section “On the Real Estate Market” below discusses this further.

Stocks (including bank stocks). The pound’s depreciation boosted shares of multinational corporations in the FTSE 100 Index; optimism for the future of the economy lifted shares of more domestic, mid-sized firms in the FTSE 250 Index. In addition, the BOE ameliorated the discomfort of reduced rates with a £100 billion loan programme, resulting in higher stock values for British banks.

Government bonds (“gilts”). Public bonds leaped after the announcement of the 60 billion pound stimulus, pushing the 10-year yield to a new low. The securities rallied just before the new monetary stimulus. Raking in returns north of 13%, the UK had been the best-performing sovereign bond market among developed economies this year.

Corporate bonds. The Bank plans to purchase up to 10 billion pounds of corporate bonds in the upcoming year and a half. The bonds of companies such as Tesco Plc surged to new highs at the time of the announcement.

Main Monetary Policy Losers: Who and How?

Savers. The broadest category of losers are those who see direct reductions in returns to savings. While the Bank has intended to help individuals and firms to take out loans to spur growth, it is simultaneously putting a pinch on those with savings. Bringing the rate so close to zero means even poorer returns for those (often older) citizens who have saved cash in their accounts. As inflation creeps ever upward to 2% and beyond, a continued or reduced base rate of 0.25% or less will erode individuals’ savings.

Sterling. The British pound declined at least 1% against all of the major currencies. This drop is fed by inflation. Nevertheless, the currency remains above the pit hit directly following the referendum.

Pensions. Defined-benefit pensions were impaired by the interest rate change, with combined liabilities jumping to a record 2.4 trillion pounds, making the deficit the worst in the nation’s history.

On the Real Estate Market

BOE Governor Mark Carney expressly directed banks to cut their usual rates of 4-6% down to the base rate. Under the current circumstances, tracker mortgages (i.e. mortgages with variable rates following the BOE’s base rate) will perform better, especially those with shorter terms. Longer-term tracker mortgages are still chancy. Notably, however, the vast majority of mortgages taken out in the UK have fixed rates; only about one in six current mortgages will be effected — what is more, only marginally (e.g. £18-22 per month) — by the rate change.

The drop in the base rate is auspicious for buy-to-let investors, as it signifies a better yield. According to Ray Withers, chief executive of investment firm Property Frontiers, “The UK continues to have a severe housing shortfall, meaning demand for new homes is set to remain strong for years…while interest rates have gone down, yields have remained the same, meaning that the buy-to-let profit margin has effectively gone up overnight.”

The referendum forced the pound to weaken relative to other major currencies, and last week’s decision did the same. While diminished returns due to inflation and slower growth will likely dissuade potential investors, a weaker pound will have the opposite effect. While the pound is suppressed — and it seems it will stay so in the short term — investors using stronger and stable currencies will find better opportunities in Britain’s real estate market.

There has been much discussion on the effects of the referendum on house prices (e.g. KPMG predicted that prices would drop by 5% nationally), but a property market with structurally low supply and consistently high demand will almost invariably command higher prices, which are reinforced by low base rates. Thus, the base rate reduction should incentivise many to invest, especially when faced with the alternative of weaker savings. Moreover, it is possible that the rate’s proximity to zero has encouraged investors to shy away from public bonds and favor other types of investments, property among them. We can probably assume with some confidence that property prices will rise in response to this stimulus programme.

Capital Economics has forecasted that UK house prices will likely increase by 2% by the end of 2016, 2% in 2017, and 3% in 2018. There is still little hope that the Bank’s recent efforts will boost the economy, but there is a distinct possibility that they may at least stall the current trend and support the status quo.

Thomas H. Espy, Tranio