UK House Prices and Three Decades of Decline in the Risk-Free Real Interest Rate

Abstract

Real house prices in the UK have almost quadrupled over the past 40 years, substantially outpacing real income growth. Meanwhile, rental yields have been trending downwards — particularly since the mid-90s. This paper reconciles these observations by analysing the contributions of the drivers of house prices. It shows that the rise in house prices relative to incomes between 1985 and 2018 can be more than accounted for by the substantial decline in the real risk-free interest rate observed over the period. This is slightly offset by net increases in home-ownership costs from higher rates of tax. Changes in the risk-free real rate are a crucial driver of changes in house prices — the model predicts that a 1% sustained increase in index-linked gilt yields could ultimately (ie in the long run) result in a fall in real house prices of just under 20%.