Property is one of our clients favourite topics and what I’ve always found interesting is how adamantly property owners defend their decisions to buy and the unashamed belief that property will always go up in value.
It’s hard to argue with property’s track record. In the UK, one of the worlds hottest property markets, prices have risen >4000% since 1970 well above inflation and at an average annual nominal rate of >9%. However in real terms (adjusted for inflation) house prices rose at ~4% per year. In comparison nominal annual returns for commodities were 8%, stocks 10% and cash 5%. However in real terms commodities were 4%, stocks 6% and cash 1% respectively.
Here we will try to outline our thoughts on property prices, reasons for investing or not and what else to look out for when making a decision.
Drivers of house prices include:
- An increase in prosperity and disposable income
- An increasing population of homebuyers (demographics)
- Lack of supply of housing
- Low interest rates making loans less expensive (particularly short term rates)
- Easy access to credit and mortgage products
- Excessive risk taking or property speculation
Many of these drivers tend to work together to cause speculative bubbles.
What causes prices to fall:
- Increasing interest rates (making borrowing less affordable)
- An Economic downturn leading to less disposable income
- Exhausted demand or an increase in supply
- Credit supply constraints and mortgage defaults (as witnessed in 2008)
In falling markets these too tend to be self perpetuating leading to bubbles bursting rather than gradual declines.
So whether you believe in mean reversion of property prices or not there are certain things to watch out for when buying property.
Benchmarks and property price graphs
- Understand which period of time the graph includes. A one year property price chart may show steadily increasing prices, however a longer period of time may show a downward trend. Make sure you are comparing apples with apples over the same time period.
- Understand what price means: Property indices are often calculated based on the price of the latest transaction in that area. Practically that means that if a buyer desperately wants to live on a street then the value of all prices in the area go up. However if there is a forced seller and there is little demand prices go down equally as fast often causing panic selling. If you have ever seen the phrase “past performance is not an indication of future performance” (a usual disclaimer that regulators suggest investment professionals use in the ‘small print’ and is often overlooked) then you should understand that history is a poor indication of performance, yet in real estate as with other investments, salesmen use the fact that human psychology drives us towards positive affirmations. Hence contrarian investing is usually more profitable than trend following over the longer term as contrarians buy at lower prices while assets are unpopular or cheap. Volume of transactions, how long the property has been on the market and whether the asking price has been changed all give a helpful indication of real demand.
- Beware of averages hiding specific risks – from complex mortgage derivatives to nightmare neighbours, sales agents often disguise key issues by discussing average numbers
When comparing countries, a very useful tool was created by the Economist that allows you to compare house prices in Real terms and against wages over different periods since the 1970s. It can be found here: http://www.economist.com/blogs/dailychart/2011/11/global-house-prices
Clearly price rises in Britain and Australia have been significantly greater than the US, Germany or Canada. In the case of Germany this may be due to investors attitudes to ownership and their preference to rent being vastly different from Asia where a number of investors prefer tangible ownership.
For the most part over the last 20-40yrs property bulls have been correct as, prices seem to have defied the laws of economic gravity (mean reversion) at least in major cities such as London, New York, Hong Kong etc. The main argument given by property brokers is that demand far outstrips supply, often backed up by the idea that the global population is increasing.
Let’s take a look at this demand/supply argument in the UK in more detail:
In the graph above house prices are rebased to 100 and start in 1997. Just to show we are not trying to mislead you, if we went back further between 1980 and 1997 house prices in Britain had already gone up >300% and nearly 500% between 1970 and 1980.
The main demand driver, at least according to this graph, is not an increasing population but more the availability of cheap credit allowing for more people to purchase properties whether as homes or investments and could be partly due to an increase in foreign investor demand. Fuelled by a deregulation of the mortgage market in the 1980s that allowed an increasing number of property owners to borrow at low interest rates and due to readily available mortgages. Supply of new housing appears to have not kept up with demand as it failed to take into account the number of investors buying property for investment purposes rather than as their primary abode. Over the longer term supply is likely to be rectified as developers look to make the most out of high prices leading to a correction in overall prices.
More recently the argument for London price increases are due to an increasing interest from foreign buyers who see London as a relatively safe haven due to its fair rule of law and relative strength of the currency.
Looking at the UK in broader terms it would appear that there is an increase in regional income inequality. Perhaps due to growth in London’s service sector targeting trade and investment from the global economy leading to central London home prices reaching an all time high when compared with earnings.
UK House prices are not the only asset class affected by the availability of cheap credit although arguably it has made up the greatest percentage of consumers expenditure. According to the ONS the cost of a packet of cigarettes rose 20x between 1971 and 2008. However RPI and CPI have also been at historical lows since 1993 partly due to cheap production of goods via globalisation. This enables a greater amount of household income to be spent on property. However taking a closer look, individual household debt has increased significantly during this period which may account for the boom in ownership of second homes for investment purposes given the negligible growth in wages since the financial crisis in 2008.
With this in mind here are a few tips when buying property
Work out the real costs of owning property as an investment
When you own the property that you live in then it makes sense that you would pay off your own mortgage rather than paying someone else’s via rent as long as you can afford the mortgage payments.
Watch out for management costs: When it comes to investment property whether residential or commercial the cost of management is key to your overall return. This is an area often ignored to the purchasers peril. For example, a friend invested wisely into residential property in Germany based on the relative high income (9-11%) and low borrowing costs in Euros (~1%) only to find out that property management companies were charging up to 7% essentially negating much of the income of the investment.
Prepare for renovation costs: Property renovation costs can be expensive and take away from your overall return. As properties are a depreciating asset in real terms not provisioning for new boilers or larger long term renovations can cause investors to suffer cashflow issues and potentially have to sell at an inopportune time. In the case of Hotel owners renovation costs can be signifciant and have a direct affect on income so it’s important to plan for these appropriately. Well planned renovations can add significant value to a property in the right market environment.
Work out your real return: Most property investors quote the difference between their purchase price and their sales price as their total return but fail to mention their costs (stamp duty or local taxes, sales commissions, legal and surveying costs and maintenance and management costs). Clearly this is misleading and not an indication of total return.
Illiquidity risks: Property can under certain market environments be extremely illiquid. For examples you only have to look at Spain after the financial crisis, where property in certain areas fell to 10% of it’s pre crisis value as banks ceased lending activities and looked to offload bad debt. Although prices have bounced back a little since then they are still a long way off their pre-crisis levels.
Here are some basic rules as outlined by Peter Churchouse, a well respected HK real estate investor and market commentator:
Rules 1,2 and 3 : Location, Location, Location
Rule 4: Save a Fortune with a conversation (talk to people in the area for unbiased opinions)
Rule 5: Buy the worst house on the best street, then add value
Rule 6: Never buy site unseen
Rule 7: Leverage debt wisely (if you can’t afford to double the mortgage payments and then you probably can’t afford the house). Low short term mortgage rates may end up being more expensive.
Rule 8: Use your head not your heart when buying (recreational property and holiday homes can be very illiquid and take a lot of upkeep therefore increasing costs and stress).
Rule 9: Do your homework (Transparency, law and property rights)
Rule 10: Buy when there’s blood in the streets
If you’d like to elaborate on the rules you can find more detail here: http://www.okay.com/en/property-news/Property-Investment-Strategy-Peter-Churchouses-10-Key-Rules/153?nid=85#.Vq7zzLQRqu4
There are a number of alternative much more liquid ways to gain indirect exposure to real estate without the need for large down-payments including Equities and REITs to specialised lending funds. Equities of property companies often trade at discounts to book value allowing investors to enter the property market while maintaining liquidity at discounted valuations.
When trading these instruments it’s important to understand the risks, costs and tax implications associated with financial investments.
In conclusion, the concept that everyone must get on the ‘property ladder’ is not without significant risks and if you over leverage yourself, don’t manage cashflow correctly or don’t truly understand the local property market you are just as likely to slide down a snake as climb a ladder.
However if you follow some basic rules and invest wisely, property is one of the only asset classes where you can receive fairly cost effective leverage as an individual investor so there are big gains to be made.
For more information, independent advice or queries on local property markets BSP would be happy to connect you to trusted partners within our network.