Our house…..the place where we live….and die?

Our house…..the place where we live….and die?

9 Jan 2013

Those of us who have lived, nested, spawned etc in and around the South East of England generally consider ourselves to be experts in local property prices. It may be that UK residents do not realise that in some quite civilised parts of the world, houses are primarily regarded as places to live rather than investments. But this is an investment website, so let’s have a look at UK property as a financial investment proposition for 2013 and beyond.

As I point out in the Investment Rules (e.g. the Value section), the easiest way to check the value of something is to compare it with itself over time. From Q1 2000 to Q3 2012, UK house prices are +113% (source: data from the Office of National Statistics at http://www.ons.gov.uk). Overall, despite the financial crisis and the widely reported difficulties of first-time buyers, investment in UK housing has had a sound century so far. The average UK house price stands at £231,000 (£187,000 excluding London and the South East).

We might learn more by extending the time period. When we go back all the way to 1970, we find that average house prices multiplied by a factor of 45 times. In the 1970s, the price of the average UK house rose by 390%; in the 1980s by 203%; in the 1990s (which included a house price “collapse” that saw a large number of repossessions) by a mere 45% and in the 2000s by 107%: all that, and somewhere to live thrown in.

Politicians are fond of talking about “affordable” housing (presumably to distinguish themselves from the radicals who are demanding more unaffordable housing). One might think that they favour a general fall in the price of property but, if they do, they haven’t said so in my hearing. Property owners have votes and tend to use them. There again, I find it hard to believe that anyone wants financial institutions to plunge back into offering 100% mortgages with initial teaser rates in order that new buyers can support current market levels.

No doubt the best long-term answer would be for average earnings to rise more quickly than average house prices. A crude measure of affordability is to look at the average UK house as a multiple of average UK annual earnings. The lowest claimed average earned income figure that I can find for 1970 is £1,080 (the highest is £1,665 which is a hell of a difference) so I will use that in order to make 1970 houses look as expensive as possible. The average house price in 1970 was £5,000 giving a multiple of 4.6x. In 1988, the multiple peaked at 8x, when the average income was £8,850 and the average house price was £71,000. That presaged the house price crash of the 1990s. The multiple of 8x was passed again in 2002 (£17,960 & £161,000) and peaked at 10.6x in 2007 (£22,220 & £236,500). By the end of 2010 it had retreated only to 9.6x. By historic standards, the multiple needs to fall back into the 5-8x range for the average house to be “affordable”.

So much for entry-level analysis. How about the price of houses compared to the prices of other stuff? It is difficult to find good investment comparisons over a 42 year term. I have reluctantly checked gold, which tends to attract bug-eyed conspiracy theorists rather than fundamental investors, and have to report a triumph for the gold bugs – a 45 fold multiplication since 1970, exactly matching the performance of UK house prices. By contrast, the Dow Jones Industrial Average is up a mere 15x over the same period.

Staying in the UK, the Retail Price Index is up by 14x since 1970. Average earnings have multiplied by 24x. The price of bread has risen by 13x and petrol by 39x. Using the Dow Jones and RPI as a fair indicator of how much a decent investment should have performed in the last 42 years i.e. growth of approximately 15 times, we can confirm what we think we already know – that UK houses have been stunning investment outperformers. (As an aside,

the only UK “middle-class” expenditure I can find that has risen by more than houses is private school fees: 61x by my reckoning. The brutal fact, I suppose, is that a club that is perceived as worth buying into must have high entry barriers).

The next level of analysis that we must shoot for is to look at the value offered today by rival investments to UK housing. As we know (see the investment rule called The Big Picture) all investments compete, subject to risk and liquidity. Housing is, on the face of it, relatively low risk given that it has a unique practical use (you can live in it) but it is extremely illiquid and very expensive to trade.

Houses as investments pay out in two ways: through yield (by letting them) and through capital appreciation. As such, assuming that a long-term tenant can be found, they are somewhat comparable to bonds that pay a fixed rate of interest. Given that 10 year UK government bonds currently yield 2%, this looks like better news for housing as an investment. Depending on the location and size of property, the average rental yield in the UK seems to be around 6% (with London tending to be lower). As a rule of thumb, 2% is swallowed by running costs leaving a net 4%. Government bonds yielding 2% are as expensive as they have ever been so, while that 4% looks half decent, we should be wary.

It has been obvious for many years that investors in buy-to-let properties are not necessarily seeking to get rich from rental yields. They are hoping to make capital gains from a housing market that, as we have seen, has mostly given the impression of being a one-way bet. This is why house buyers tolerate rapacious stamp duty, which is now 7% on properties costing £2m. Using average price increases, we can calculate that the cash paid in stamp duty on a £2m house in 2013 would have bought the house outright in 1977.

Buy-to-let investors frequently are not merely trying to put their cash to work. They often borrow in order to make the investment. Such a person would need to factor financing costs into the investment calculation. This means that a capital gain becomes necessary rather than merely desirable. Investing in any market in which many of one’s fellow investors are there primarily because they expect prices to rise is a fundamentally unattractive situation. It is one of the necessary conditions of a bubble.

On that basis, I would only invest in UK property when the rental yields start to be compelling. There are still plenty of reasonably blue chip equities offering 5% yields (e.g. Glaxo, Vodafone, British Aerospace, J Sainsbury). These carry virtually zero management costs and are almost perfectly liquid. What net (after costs) yield would one demand from an illiquid property to compete? I suggest that 7% would be a starting point, implying gross yields of 9%. In terms of house prices, that is way down from where we are now (unless rents rocket).

So much for value. Before I leave this topic, I must revert to the liquidity problem. Buying and selling houses is generally slow, full of disappointments and can be traumatic for some people. The natural reaction to an unmet asking price is to take the property off the market for a while. When prices are considered disappointing, estate agents report that the market is inactive. Repossessions aside, most people can afford to spend a year or two delaying a move.

There is a demographic time bomb that might disrupt this calm. The average age of a first time buyer is now said to be above 35 (and that is likely to increase when you consider the implications of student loans – see my post from last November – “English student loans – the financial violation of children”). It follows that the average age of a home owner is increasing. Some time, these people will either try to cash in their capital gain and downsize or they will die and bequeath their property. In either case, selling the property will be more urgent. This particularly applies to those who inherit.Inheritance tax in the UK is 40% on everything over £325,000. Moreover, HMRC demands its money with extremely unfeeling haste (six months after the month in which the person died). After that it charges 3% interest. Consider the case of a person whose parent dies owning nothing but a house valued for probate at £925,000. The inheritance tax owed will be 40% of £600,000 i.e. £240,000. After the six months are up, the bill will be rising by £600 a month. The beneficiaries of the will have two choices. They can write a cheque for £240,000 and hang on to the property; or they can sell it with speed rather than price as the priority. It seems certain that the second option will be chosen in the vast majority of cases. This could mean an inexorable change in the dynamics of housing, turning it into a buyers’ market of a potentially vicious character.

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