Taking stock of house prices
In real terms UK house prices are back to the long-run average, wiping out all the overvaluation of the previous six years. The Nationwide ‘deflated’ index even bounced right on the trend line. How neat. Probably too neat to be the start of a new bull run.
Not that many people have any idea what the trend of real house prices is, relative to general inflation. Or how much investment in both maintenance and improvements needed to be made just to keep the ‘average’ house comparable over decades of increasing expectations about the quality of housing.
Most people are more likely to quote what a pittance they paid back in the year dot, forgetting even that back then it was probably a bank that effectively owned most of their equity. So their picture of the property market is something like the chart below, which is for the Nationwide price index for the ‘average’ UK house. It does reflect the improvement in the quality of the housing stock, otherwise the growth curve would be even higher, but it does not allow for general inflation.
This is not, of course, how we look at any asset prices at No Monkey Business. We are interested in real returns, after inflation. We are also interested in what trends in real asset prices over very long periods can tell us about economic sustainability and its corrollary, bubbles.
We have many times shown the chart below which applies the RPI to the index above and then also ‘detrends’ the index to show the cycles around the sustainable growth (which since 1957 has been 2.8% pa).
This is the one that shows the extent of the overvaluation before the credit cruch finally hit and also shows for how long prices defied gravity – something unusual we can put down to binge banking. The bounce at the end has probably been extended slightly further in October and November.
Since the trend itself is broadly in line with long-term growth in real personal incomes, the economy as a whole and also the capital returns from equities, it is probably a fairly accurate measure of economic sustainability. So we can reasonably deduce that UK land and homes are generally (with regional variations) close to ‘fair’ or ‘normal’ value. (Note that this analysis ignores the economic rent from the property, even though about 10% of the housing stock is rented not owner-occupied. It treats the economic rent as part of personal consumption and therefore equivalent to paying rent.)
Apart from the important information that anyone buying today is not being carried away by a bubble, this does not tell us much about what will happen to real house prices in the next few years. This is because we do not know
how much pressure real personal incomes will come under
where and when unemployment will peak
how much credit supply will shrink or improve
what will happen to the supply of new homes.
Short memory, long memory
Even though the recovery in house prices and the pick-up in activity in a number of local markets suggests the return of ‘business as usual’, it is possible that some fundamental changes are occurring to public perceptions about housing investment in lifetime financial management.
It would not be surprising if these changes reflect age and experience and so depend on whether participants in the market are principally influenced by short or long memory. Short memory tends to be dominated by the cycle and long by the combined effect of the trend and gearing.
Short memory has been scarred and may turn into a quite different long memory for several generations, consisting of the excluded young and over-extended young who were buyers within the last ten years. If employment prospects deteriorate further for this group, and money becomes expensive in real terms, they are unlikely to heed their parents’ advice that property is the best route to wealth creation, even if they can access the credit necessary to start the process. It is not a foregone conclusion in the UK that this change will occur but in the US, where the housing mania was a relatively new phenomenon and joblessness is a more present threat, the dream is well and truly dead.
Long memory has several bullish strands that are much more resistant to change, each of which nonetheless is open to question.
The combined effect of the long-term house price trend and gearing
Deep memory of housing as an inflation hedge
Housing equity as a superior alternative to conventional pensions
Our homes as an inheritable estate.
1. The payoffs to gearing
As we have already noted, many people’s perception of their own ‘returns’ from home ownership may well be clouded by the fact that their entry points were below trend, something that our second chart suggests may apply to any purchases in the 1990s, for instance. Clearly, without the benefit of real prices being below trend when each new investment is made, the trend itself will not make anyone rich without gearing and gearing will not make anyone rich unless the cost of money is low relative to the asset returns themselves.
There is some neatness to the fact that in the 1990s, when nominal interest rates were low but real rates were historically high, moving from below to above trend offset the drag on real wealth of owning a mortgaged asset. Prior to the 1990s, when nominal interest rates were much higher, real interest rates were persistently low and turned a high-risk strategy for several generations into an ‘easy win’.
Popular versions of the property bias treat rent as ‘money down the drain’. Are we ignoring this? Yes, deliberately. The buying versus renting decision, when capital resources are insufficient to finance either the acquisition of a freehold without borrowing or an equivalent stock of financial assets, boils down to a choice between renting money and renting property. The outcomes of that choice depend on the two factors we are addressing here: asset returns and the cost of money.
If we are right that what the future generally now holds is mediocre real growth and high real borrowing costs, playing out against a background of perceived higher economic risk, the collective memory of an easy win may start to feel more like a lucky break.
2. Housing as an inflation hedge
The impact of gearing, and its dependence on the asset return trend relative to the real cost of borrowings, should also dominate the second strand: housing as an inflation hedge. However, ungeared property is directly comparable with other assets that have inflation hedge characteristics based on their own long-term real return trends, notably equities. Indeed, an economist might well argue that there is little reason to select between them on return grounds (other than as a function of unusual starting conditions) and that factors to do with personal welfare or ‘utility’ should dominate individual choice.
3. Housing as a pension
Long-term bulls also repeat the mantra that housing is a better pension than financial assets. The typical middle-income British family has certainly put its money where its mouth is. We know about the economic research that suggests a long-term savings gap and we know about survey evidence that most households see debt repayment as a more pressing priority than pension savings. Put the two together and you would probably see that the cash flows represented by the gradual purchase of housing equity from the bank (ie repayments rather than debt service) substitute for the savings they should be making to meet income replacement expectations in retirement.
Because they believe that gearing pays off, they are acting entirely rationally. Had they made a more informed judgement of risk-adjusted payoffs, allowing better for the risks to the household of gearing, they might have chosen differently. But what is also clear is that, believing what they did, they would never have been able to take as much risk from an ungeared financial asset portfolio, in or out of a pension fund. Nor would they have found an adviser willing to recommend such a high level of risk for a financial asset portfolio, since advisers (and product companies) were in this department much less smart than the average household. In fact, the typical investment recommendation was the same as the one used to fund debt repayment when an endowment was preferred: a balanced, managed fund with real assets diluted by nominal assets like gilts. That hardly suggests joined-up thinking about balance sheet strategy.
In retirement too there are many reasons to prefer to live off the CGT-free proceeds of a house sale than pension income trapped by GAD rates and taxed at 82% on the last survivor. The last one is very recent and was not foreseeable except that people are generally sceptical about the direction of pension taxation.
The only thing wrong with the ‘house as pension’ idea is that people seem to be overlooking the exit strategy. If we are right about housing filling the savings gap, households will need to consume a big chunk of their ‘house as pension’ and if they cannot do so via debt it will have to be via sale of equity. Where, then, are the forecasts of this or its effects on house prices?
If households are not yet being realistic about the need to consume housing capital, will waking up to the reality also encourage a shift in popular perceptions and long memory? Ironically, the main impact is on their heirs, where we think short memory effects are anyway much more bearish about property. This is because home owners who underestimate their capital consumption needs correspondingly overestimate their bequests.
4. Housing as a bequest
I believe the bequest motive was always one of the welfare benefits that drove middle-income families to make either one or both of two ‘sacrifices’ for the sake of their children: education and their home as an inheritance.
For early acquirers, the bequest element of a freehold, as in the cost of the property accounted for (in present value terms) by the years beyond their own life expectancy, was in fact low or negligible because of high nominal interest (or discount) rates. With lower rates over the last decade, however, there has been a real cost to the bequest element, of between 10 and 20% of the market value. The later people invest, the greater the capital inefficiency inherent in a freehold provided only that their bequest utility is weaker than their consumption utility. If they have no bequest utility, such as because they have no children, home equity is always going to be irrational if it constrains lifetime spending.
For the present generation of first-time buyers, starting out in their mid or late 30s, the conflict between trying to satisfy occupancy benefits and building up an inheritance for children they may or may not have, when the two are bundled, is itself a factor likely to influence perceptions. The problem is of course resolved by being able to unbundle the two, so they only have to meet the capital requirement for lifetime occupancy in the form of a lease of, say, 50 years. The structural inefficiencies of the inflexible UK housing market are one of the attributes overlooked by people who think property is better than financial assets.
When I first started measuring real house prices over a decade ago, the trend was 2%, not nearly 3%. If real prices now stagnate or fall, the regression trend will gradually work its way down. But behind the dry statistical measure I suspect will be a genuine shift in collective perceptions about the nature and payoffs of a massive leveraged bet on bricks and mortar. I see this as a shift to something still potentially good but also much more realistic and dependent on individual situations instead of general to all people.
What would prove this wrong? If, within say the next five or more years (before long memory can shift), we both avoid a second leg of this bear market and enjoy a new cyclical surge upwards in real prices. Be in no doubt that if this happens it will be nothing to do with supply and demand for housing and everything to do with money and credit. Money always explains the booms and busts better than fundamental changes at the margin of the total housing stock.
In today’s climate, a new boom is a pretty brave forecast. It is also a fundamentally bearish one, suggesting we have learned nothing from the credit crunch and are willing to risk an even bigger collapse in household and national solvency in the future. We would probably not have long to wait.
Finally, if reading this you realise I have introduced you to some aspects of home ownership you had not appreciated before, you might want to consider whether this is a vacuum in which bad ideas have flourished by never being exposed to proper review. If I compare the level and scope of analysis of both property economics and behavioural biases to housing decision making today with my experience of the same in financial assets, it is vastly more primitive now than investment was when I started my career in the late 1960s. After the shock to home owners in this global bear market, I would like to think vacuity will be one of the main casualties.