The only part of the U.K. real estate market that’s rising faster than London’s luxury homes is the land underneath them.

Housing plots in the U.K. capital rose 87 percent through the first quarter from a trough in 2009, broker Savills Plc (SVS) estimates. That could turn around quickly if interest rates increase, according to Alexander Michaelides, a finance professor at London’s Imperial College who studies the relationship between land and the economy.

Gilt yields have been rising as investors bet the Bank of England will be forced to raise its benchmark interest rate from a record low earlier than the 2016 horizon bank Governor Mark Carney has indicated. Rising rates increase the risk of falling land values as home-buying becomes more expensive. In cities like London, where there’s a scarcity of development land, values are more sensitive to economic changes, Michaelides said.

“Land scarcity makes the response to fundamental shocks a lot more volatile,” Michaelides said in an interview. “It is a risk that the Bank of England should be taking into account when they make their policies.”

Prices for luxury homes have soared in recent years as the debt crisis in the euro region and uprisings across North Africa made London property a haven for international investors. Prime London residences have risen more than 60 percent from their low in 2009, according to broker Knight Frank LLP.

Political Pledges

With rising prices across the U.K. putting home ownership beyond the reach of young Britons, political parties are pledging to ease planning curbs and build more homes. The opposition Labour Party said this week it would allow local authorities to charge developers that don’t build on land that has received building approval.

Chancellor of the Exchequer George Osborne has been promoting home ownership by assisting buyers and making mortgages easier to obtain as he seeks to revive the U.K. economy. Despite those efforts, approvals to build new homes in London fell about 15 percent in the first half from a year earlier, according to data compiled by researcher Glenigan for the Home Builders Federation.

Wider Margins

Homebuilders were the main beneficiaries of the fall in land prices that followed the financial crisis as they boosted profit margins by developing plots acquired at a discount. Development land values for the country overall are 50 percent below their 2007 peak, Savills said.

In London, land prices now exceed the previous high, according to the broker. The 87 percent jump since their trough in 2009 compares with an increase of more than 60 percent for London luxury homes and a 43 percent gain for all residences in the city, Knight Frank estimates.

British Land Co. bought a site in London’s Mayfair district to develop luxury apartments last year, using the proceeds from a 400 million-pound ($640 million) bond issue. The convertible debt, which matures in 2017, has a 1.5 percent coupon.

The Bank of England last expanded its stimulus program known as quantitative easing in July last year and investors are betting policy makers will raise the 0.5 percent benchmark interest rates as early as 2015 as the recovery gathers strength.

In the U.S., the Federal Reserve will take the first step to reducing $85 billion in monthly bond purchases in December, according to 59 percent of 41 economists in a Sept. 18-19 survey compiled by Bloomberg. The 10-year gilt, which yielded less than equivalent Treasuries as recently as Sept. 4, now yields 12 basis points more, according to Bloomberg data.

‘Disorderly Unwinding’

A “disorderly unwinding” of the quantitative-easing program in the U.S. could result in home prices in the best parts of London falling as much as 20 percent, Fathom Consulting wrote in a July research report. Central London residential values “have become somewhat stretched, suggesting that they are now vulnerable to correction.”

Not everyone agrees. “It’s a residential market that’s driven by world city dynamics rather than by ordinary domestic” factors, Simon Rawlinson, head of research at construction consultant EC Harris LLP, said in an interview. “More and more developers are entering the market and are able to make the numbers stack up.”

Developers are building on land at the fastest rate since 2008, Savills said in an August report. London land values are forecast to continue to increase as the home market is less reliant on customers having access to mortgage credit, associate director Paul Tostevin said in an interview. The broker doesn’t include the effects of a potential interest rate increase in its forecasts for land prices, he said.

“You get a magic moment in the cycle which you’ve got land that you’ve purchased relatively cheaply at the bottom of the cycle, your costs aren’t rising and prices are going up so that’s where you get the maximum profitability,” Rawlinson said. “Going forward, in terms of more expensive land, profitability is more likely to normalize.”

(Source: Bloomberg)