Property

Back in late 1998, I was trying to buy a flat.  At the time, house prices had been rising for a couple of years as property emerged from the stagnation of the early 1990’s and there was lurid talk of the possibility of a house price crash.  This talk, ridiculous in retrospect, seemed all too reasonable when memories of the recent crash were fresh.  Now seems like a good time to reflect on property prices and their prospects for the future.

The word Crash, itself, is rather dramatic and serves to excite rather than inform but what exactly constitutes a Crash?  Official statistics show that house prices (based upon transactions) fell by about 10% during the last slump and rather more in real terms when the effect of inflation is taken into account.  Of course, at the margin, some people are very severely affected by this size of price drop.  It will hit those divorcing, downsizing or becoming unemployed especially hard but I challenge anyone to value their property within 10% of its true value.  So, if you do not know you have it, how will you miss it?

What it may do is stop us being overly optimistic about the value of our property.  Perfectly rational people seem to believe that property can increase in value by 20% every year.  We also tend to forget that the near tripling in values over the last ten years has not been a smooth rise, at all; I seem to remember 2003 as being a pretty poor year.

The property market was overdue some sort of shakeout and an injection of rational behaviour, although, I am not convinced it will get either of these, and some people will rue the day the bought, unfortunately.

Also, I have long been of the opinion that London had become under valued in relation to the rest of the country, to say nothing of the Spanish Costas.  This may come as a surprise to anyone familiar with the stratospheric prices in the Capital but I am convinced that London will rise relative to the provinces.  It may still fall but may do so by a smaller amount.

I am fascinated by the fact that the pecking order of London property values, as illustrated by the Monopoly board, has remained pretty much the same since the 1930’s, and probably for quite a bit longer than that.  If you had bought in Mayfair then, it would still not have been caught in value by Old Kent Road and its like, despite all the gentrification poorer areas have experienced.  The same goes for Britain as a whole.  Hull, where I am from, has probably always been cheaper than London.

If we believe that the past is indicative of the future then any deviation from trend will be reversed, a process statisticians call reversion to mean.  From time to time, there will be permanent changes in trends, the change in fortunes in the Twentieth Century of once wealthy ports such as Liverpool, for example.  These are so difficult to spot in advance that it hardly serves any practical purpose to try, but they do occur.

If, like me, you look to the past to help you divine the future, you can expect property in London not to drop or slow as much as the rest of the country and pick up more quickly when the recovery happens.

In any case, most of us will not be affected by any drop, we shall just have to get used to a change in our dinner discussions, by no means a bad thing.  If property drops by, say 25%, and inflation rises to 10%, then we would be in for some real pain.  If you believe that is likely, sell now and rent, preferable abroad.

Lehman Brothers, the US investment bank, have been running their slide rule over the UK economy and coming up with their view for the coming two years.  Amongst a number of predictions, they have come up with an implausibly precise figure of 8% for the size of the drop in house prices.  These organisations are never shy of revising their figures as they are proved wrong but they serve the purpose of gaining column inches and provoke a discussion.

It did get me wondering about the real impact that this would have on most people and, in truth, it would probably be none at all.  I doubt that many people could value their home to within 8% of what someone would be prepared to pay so the real impact on wealth should be minimal.  We will lose something we did not know for certain that we had.

Looking back to the early Nineties, which is the most often quoted property slump, values dropped in nominal terms by 10%, although more in real terms.  Now, if you are sitting in a house worth, say, £300,000 and over the next two years its value drops to £270,000, so what?  It does not impact on the property’s primary purpose which is to keep you warm, dry and secure.  In another ten years, it may be worth £500,000, hardly a blow from which most cannot recover.  So why are we worried? 

In truth, it is because we are not rational creatures, particularly when it comes to investment, and we are least rational about property.  Changes in the value of our home, or flat on the Costa del Sol, affect our mood to a large extent.  If our home rises in value, we feel rich, even though it means that the next property on the ladder has risen by more money, making it harder to buy.

Also, marginal buyers suffer disproportionately.  Those who put down a small deposit may lose it all or worse, may owe more than the property is worth.  People’s mobility is affected.  People spend less when they move less frequently which impacts upon real businesses and jobs.

So, it is a worry but asset values cannot increase continuously without distortions affecting the market.  Periodic shakeouts are a necessity, however unwelcome, to introduce a degree of sanity and remove anomalies.  All property rose in value for no reason than we were rushing to invest in property.  It was, in part, down to speculation as amateur property developers spurred on by TV programmes tried to get rich quick.  Some did and now we will endure a coupleof years of discomfort.  History tells us not to be too pessimistic, though, as those who hold tight will tend to see it come right in the end.

An American friend commented to me at the weekend that it is now possible to buy a property in Detroit for $50, not in the smartest parts, of course, but somewhere familiar to those who have seen the film 8 Mile.  This prompted me to have a quick look myself and to ponder whether something similar could happen here.

Having spent two minutes on Google, it is certainly easy to find properties for sale for under $10,000 but I did not see anything quite as cheap as $50, although it would help to be familiar with the geography of Detroit.  For those calling for property to be cheaper here, be careful what you wish for.  Property being too cheap brings problems of its own.

The question we are asking is; could it happen here?  Certainly, the UK seems to have avoided the greatest excesses of sub-prime lending.  In the United States, it seems that some loans were structured in a way almost guaranteed to ensure default, for example, interest rates jumped to ruinously high levels after the introductory sweetener.  In many things, too, we lag behind developments across the Pond and it could be that we shall be spared the worst simply because the party stopped before we had dug ourselves in too deep.

The last property crash was worsened by the fact that many poorer families had bought their own homes under Right to Buy and it was questionable whether many of these people, who were subsequently repossessed, should have been buying in the first place.  The benefit system is much kinder in the UK to those who fall upon hard times whilst renting and there are people who need this kind of protection.  Only time will tell whether we manage to avoid a significant enough rise in repossessions to avoid a large fall in prices but policy makers would do well to note that borrowing to buy a property is not the right solution for everyone.

One of the disappointing things about, mainly, the stock market is that private investors are truly terrible at deriving benefits.  Not so the residential property market.  When it comes to their own homes, people tend not to sell when the market drops; partly because they need a roof over their heads, partly because property is illiquid and most difficult to sell just when you need to do so most quickly, but mainly because homeowners do not want to realise any apparent loss on their home.

The good news for homeowners has been that they spend their 100% of the time invested in the market and, even though they experience slumps in value from time to time, they are always ideally placed to benefit from any upturn.  If you expect the trend to be upwards over the long term, this is a rational way to behave, even if the reasoning is less than analytical.

If we contrast this behaviour with that of the same people in the stock market, it tells a very different story.  Investors seem to head for the market at outset with no particular plan in mind and no thought to timescales or their own expectations.  Perhaps, they have responded to lurid headlines of fantastic returns being made somewhere and worry about missing out.  This may be why so much retail money floods into the fashionable sectors and funds.

If the market drops in value, these same investors sell quickly and move into, for example, cash, worried that losses would become even greater.  Worse still, many simply look at the best performing fund over the last three years, say, and decide to pile into that.

This is why the latest research from Lipper Feri is so depressingly familiar.  Outflows from some very sensible sectors are huge and funds like the Merrill Lynch Blackrock Gold & General Fund have benefited enormously, in its case to the tune of more than £300m.  Now, I am not suggesting that this is the bottom of the market, nor am I saying the Gold & General Fund, which has ridden the good news in commodities, is the wrong place to put money.  All I say is that it is pretty depressing to see all these investors chasing their tails, most simply guaranteeing that they will lose money.

Far better, surely, to have some sort of plan at outset and to use knowledge of the past to manage expectations of the future.  As people have discovered in property, buying into the market and sitting tight forever is not a bad strategy. 

For the last ten years, residential property in the UK and much of the rest of the World has been a one way bet; the ones who missed out were those who did not borrow as much as they possible could.  Those who felt uncomfortable with being in debt or who kept betting on a drop in price missed out.  The question for many is whether this is likely to be the story of the next ten years.

If the doomsayers are right and we find ourselves replaying the ‘crash’ of the early nineties, what will this mean to the average home owner?  Officially, prices fell then by about ten per cent, stalled for a couple of years and rocketed off in about 1996.  Of course, the pain of a fall in values will not be evenly distributed.  Those who have to sell will find themselves disadvantaged, although we are much more accustomed to the idea of letting our property now than we were back then.

For anyone who bought, say, a couple of years ago or who does not need or want to sell, will they really notice?  So long as they can afford their mortgage and, with rates looking more likely to fall than rise, affordability is hardly an issue compared with ten years ago, owners can sit tight and let things blow over.  The real losers back in the early nineties were those who sold even though they expected to be homeowners in future.  They found themselves buying into a rising market having lost ground.

Homes also provide shelter, it is not as if we can do without one.  People will not all sell out to hold cash and this provides some underpinning for the market.  As with most assets, it is not market timing but time in the market that delivers the return.  For every ‘clever’ investor who sells out at the top and picks up a bargain, there may be many tales of heartbreak. 

From here in Perth, capital of Western Australia, where I am visiting, the residential property boom looks somewhat different from the one we have experienced over the last ten years in most of the UK.  In the UK, we have become accustomed to explaining away the furious rise in the prices of homes in terms of supply and demand, i.e., there is insufficient supply to satisfy the demand, which is rising.  There is plenty of land, it is just that we will not let anyone build on the bits of it which are sited where people want to live.  We have surrounded our cities with greenbelt, and very nice it is too, but it does nothing to alleviate the lack of supply.  That lack of supply when coupled with a seemingly limitless supply of easy credit, secured against ever rising prices, has fuelled a tremendous boom.  Now that one of those elements may have been removed as the credit crunch takes hold, it may be that the market will grind to a halt.  The fact that supply is inflexible makes the residential property market inefficient, amplifying the boom and bust cycle.

In WA, some things are similar; the economy is booming creating a surge in demand and mortgages are relatively easy to obtain.  The residential property market in WA, and probably most of Australia, is dominated by new homes.  Not for Aussies the problems and expense of living in a home built for the needs of a different century.  Also, WA is hardly short of land; an area the size of Western Europe accommodates just two million people, mainly around Perth, which is growing at a frightening pace.  Of course, some suburbs trade at a premium as the rich prefer to congregate together but bulldozers carve out new land for building every year.  Want a home?  There is a plot ready and waiting for you to build upon.  This ever increasing urban sprawl brings with it other problems but short of land they are not.  Those hoping for a home in WA may have to wait up to two years for a builder to get around to them, though.

So why have house prices in WA and the rest of Australia been booming much like the UK (and the US, amongst others)?  I put it down to confidence in the economy and easy credit.  It does not really matter what you pay for your home so long as you believe that someone will buy it off you for more (the greater fool syndrome) and the borrowing is cheap and expected to remain so.  No one cares that they are paying twice as much for their home as they would have done ten years ago so long as it doubles in value over the next ten years.  Thus do asset prices lose any connection with the fundamentals.  What’s more, the more they go up, the happier we feel.  Warren Buffett has spoken rather disparagingly of those buyers who wish up the price of investments and it does seem a little irrational to draw comfort from the fact that you will have to pay a great deal more for your next purchase.

Whilst we were in the throes of the boom, here, as in the UK, those who should know better explain things away as being different this time.  If, as seems increasingly likely, this boom derails next year, the same commentators and economists will be telling us how it was all so blindingly obvious that it was going to end in tears.  We wait with bated breath.

They said it would be different this time.  Property developers assured us that they were not creating an oversupply and offices were being put up on the basis of being pre-let to a blue chip tenant.  So why is the press full of doom?

Well, the most comforting thought is that the press is always full of doom or over excitement, that sells papers and pulls in the viewers.  It is, however, possible that things are getting a bit sticky in the world of commercial property.  Perhaps some of those blue chip tenants will default in the face of falling profits.  Perhaps some of the retail tenants in shopping centres will go bust.

It is certainly the case that property has been performing perhaps a little too well over the last couple of years.  It is also worrying that it has been by far the most popular choice of fund for retail investors over recent years, driven, in part, by fear of equities and hype in the Sunday papers.

For investors with a long term outlook, there may be no more than a period of depressed values to worry about.  Many of those running for the exits will, no doubt, fall headlong into another, worse, problem.  Such is the history of market timing.

Will our house prices go the way of those in the US, i.e., downward?  Well,  our American friends were until recently busy building houses at the rate of 2million a year, which is a pretty astonishing rate of activity compared to us in the UK, where we build about 200,000.  Given that their population is about five times ours, that means they are building twice as many new homes per head of population than we are.  It would seem, therefore, that their supply of property is better than ours.  Here, it is difficult for young professionals with good jobs to buy a home, let alone the much discussed sub-prime sector.  In the parts of the UK were people most want to live, the South East, mainly, there just are not the numbers of homes being built.  Other places, such as Liverpool and Manchester may find the market in a slightly weaker state over the coming couple of years but there seems to be no reason for too much gloom amongst those who have a home.

Here, there seems to have been much less of the sub-prime lending that is causing so many ructions in the markets at the moment, so, perhaps we shall avoid most of the dislocating problems associated with widespread repossessions.

Of course, if you do not have a home, a crash is exactly what you may need to be able to afford a place.  The trouble with property is that people do not flood the market with cheaper places when prices are under pressure, for the mos part, they stay put until they can sell it at a price with which they are happy.  Developers, also, may just sit tight and wait for better times, except for those who have over built.   

Things may get sluggish here but a crash in the places were some need it most seems highly unlikely.  Even in the early nineties, prices did not fall except were there was a distressed borrower and back then we had a recession and very much higher interest rates to spice things up.

Certainly, parts of the States are seeing some more 'realistic' pricing and some borrowers will struggle with affording their mortgage but interest rates have come down a fair bit over there and this may ward off the worst that could have happened.

Still, expect to see many more headlines of the scary sort in months to come even if there is no good news for would be first time buyers.

Is the stock market, as a whole, an inherently riskier place to invest money than the residential property market?  Now, I am not for one second suggesting that either is an appropriate place to put your money, although one or both may be, I am just opening up the discussion.  I am also considering the property market in investment terms rather than housing terms, no share portfolio will keep you dry through the winter or give you somewhere to show off your latest plasma TV.  These thoughts are probably, therefore most applicable to excess property investment, by which I mean a second property, a buy-to-let property or a house larger than your requirements, which you hope to sell to fund your retirement.

Firstly, what do we mean by risk?  It is, I suggest, unlikely that the stock market or the property market will drop in value to zero.  It is, of course, possible to make a bad choice of investment.  Some companies will go bust and some properties may become worthless, perhaps because of flooding or encroachment by the sea.  Now, you would be daft to buy a property without insuring it against these risks but most people will buy a share in a company without any corresponding insurance against loss (i may cover how another time).  This, then, starts to colour our view of the relative merits of the investments; we take more risk with our stocks, for some reason, than we do with our real estate.

The world of professional investors usually expresses risk in terms of the volatility of returns.  An investment which can deliver high returns with periodic big drops in values is considered to be riskier than an investment which is more steady in its delivery, even if they end up at the same spot.

So, how does volatility compare?  My main concern here is one of information delivery.  If you valued your share portfolio every year, it may not look particularly volatile and, indeed, in most years it would have gone up in value, probably even in 1987.  This is where the stock portfolio is at something of a disadvantage when compared against property.  You see, property is not valued by anyone, let alone the market (as distinctly opposed to an estate agent or even a surveyor) in anything like real time.  Depending on how often we move, a property may only be market valued, i.e. bought, once every seven years.  We may read in the press about the general sentiment but no one is able to rub our noses in its value in real time, minute by minute.  If you own a stock portfolio, you can watch it go up and down every minute of the working day, responding instantaneously to investor sentiment, and it can be frightening for some.

Also, I have referred to a stock portfolio as opposed to one stock, mostly, as it would not be rational to hold only a couple of different shares.  Diversification is easy with shares, not so with property as it is expensive and slow to sell, amongst other things.  

What of the returns?  Well, ignoring income form dividends or rent, which I gauge to be similar after costs, I think property and equities have probably delivered similar capital growth.  If you take into account transaction costs and the difficulties of diversifying across a number of properties, it may well be that a property portfolio has lost ground to a share portfolio.  What, though, will the next twenty bring?

After years of stalling, the Government finally caved in to pressure from the property sector and allowed the conversion to and establishment of Real Estate Investment Trusts from January this year (REITs are an established investment in many other countries).  Unfortunately, the year has not been kind to the sector with a loss in share price of almost 25% so far.  They have also been hit by the Governments proposal to introduce a flat rate for Capital Gains Tax of 18%.  Capital Gains realised within the REIT most be largely distributed to shareholders as income, with correspondingly higher rates of tax.

In fairness, most REIT investors would not be buying investment property directly and appreciate the high liquidity of REITs, even if they bring with them higher volatility and slightly higher tax.  it does, though, look as if the hype has proved to be without substance and REITs in the UK may be confined to the fringes for a while.

I remember buying a property in early 1999 against the backdrop of warnings that the housing market may be about to drop in value.  At that point we were two years into the current run.  The latest report to cast doubt on the sustainability has been published by no less than the International Monetary Fund who, by the way, do admit to lacking full data.  For the last eight years, or so, we have had innumerable reports warning of overheating and predicting dire consequences.

So far, anyone who has accepted the efficacy of these warnings and sat on their hands has simply fallen further behind the game, whilst the majority who ignored them chattered gleefully about their gains.  There seems to be a concensus that the market will not rise indefinitely but none about how it will come to a halt.  It makes some sense to look at the experience of the last 'crash' in the early nineties to see whether it casts any light on how things may pan out this time and whether any lessons can be learnt.

Firstly, the Chancellor of the Exchequer, Nigel Lawson, removed the doubling or tripling of tax relief on interest payments for people buying together.  Coming after a period of sustained price rises, this had the effect of panicking couples (whether in a relationship or not) into buying together so that they did not miss out on getting a foot on the ladder with all of the attendant riches to come.  This amplified the rising prices into a surge.  Once the relief was removed for new mortgages, those people could then reflect on whether they should have bought together or even bought at all.

Secondly, the early nineties brought with them a recession, the last one, in fact.  This meant that those losing their jobs had to make distressed sales or where repossessed.  Markets being marginal, nothing affects prices more than forced sales and illiquid markets like property are affected even more.

Thirdly, there were some severe interest rate hikes as the Government tried to keep Sterling in the European Exchange Rate Mechanism.

So, a Government induced bubble, followed by recession and extremely high interest rates.  What actually happened to those owning property?  Well, for those needing, or wanting to sell, they may have made a paper or actual loss.  If they were buying again, this would be reflected in the price they were paying.  For those who did not sell, they may not even have known what was happening to the value of their property.  If you are not looking to sell, why would you need to know its worth?  

My experience is probably typical.  I bought at the end of 1987 and lived there for the next ten years.  Re-mortgaging was less common then so its value whilst it was a home was rather academic.  Nonetheless, by 1997 it was probably 'only' worth 20% more than ten years earlier, if anything.  Of course we all know what happened to its value over the next ten years.  For those who had to sell, values dropped by about 10% at the trough of the 'crash'.  Some people did a bit better, some a bit worse, but hardly cataclysmic.  I know that these benign looking figures do mask some genuine misery but, on the whole, people came out of it unscathed.

So, what of today, will prices crash, fizzle or storm ever upwards?  Well, nobody really knows.  It is very difficult to imagine prices continuing their ascent uninterrupted, in fact, London did stutter in 02/03, but they would only crash if many owners decided they had to sell at any price.  In the absence of a recession, that, surely, seems unlikely.  I expect we will just have to live in our homes and reacquaint ourselves with the notion of earning more in a year than we gain in property appreciation.  Prices could stagnate for ten years but, so what?  Homeowners will not lose out unless, that is, they are planning to sell up and live in a Winnebago for the rest of their days.  Journalists and, even, the IMF, will have to fret about something else, perhaps poverty, and life will go on.  Then, further down the road, it will all start again.

The subject of Property Investments has been exercising the press recently, by this, they mean the Property Unit Trusts.  To recap, briefly, these are pooled investment vehicles purchasing and owning commercial property on behalf of their investors.  The investors receive the rental income and any appreciation of the property value and those running the fund receive management charges and other fees.

For a long time property funds have been unfashionable, were mainly run by insurance companies and being sited firmly in the unloved end of their fund ranges.  In fact, the Investment Managers Association did not even have a Property Fund category, placing them in Alternative Investments.  This, however, is under review.

All this changed with the bear market of 2000-2003.  Fund management groups badly needed something to peddle as an alternative funds which invested in stocks and shares.  Consequently, there was a rush to launch funds or reinvigorate the marketing of the ones which existed.  So successful was this at attracting money from investors that, by 2006, something like a third of all fund sales were for property funds.  Not surprisingly, this led some commentators to start to speak of a crash.

The problem for private investors is how to make sense of the flow of information.  The papers are full of boom and bust stories and the next big thing.  Also, their journalists are heavily dependent on 'expert' commentators, many with a sale to make.

As always, it is good to start with establishing a few fundamentals.  It should go without saying that property, like all investments other than cash, is a long term investment.  Property has some key differences to other investments, such as Blue Chip shares.

The property market is nowhere near as efficient as that for the major stocks.  If you need a value for a share, any investor can obtain, free of charge, an exact price which is only fifteen minutes old (assuming that you are not trading a significant number of shares).  It is easy to guage the state of the market because there are numerous indices expressing investor sentiment.

Property, by its very nature, is different.  It is harder to value accurately and expensive and time consuming to buy and sell.  A BP share, for example, can be bought or sold almost instataneously and Market Makers are required to ensure that a ready market exists. 

For fund managers, this the liquidity of an investment, i.e. How easy it is to buy or sell, is very important as they manage the flow of money in an out of the fund.  A share based fund will find no problem with mananging this process because shares can be easily bought an sold as required, for those investing in real estate, things are not so simple.

If a property fund is attracting a lot of investor money, they may find that the delay in purchasing suitable property impacts upon the performance, pain which must be shared by existing investors.  In order to manage this, restrictions may be placed upon new investors.  Given that fund managers are largely rewarded on fund size rather than performance, this goes against their interests, one of the reasons it is such a rare occurance.

On the other hand, if investor redemptions (sales) are not matched by inflows, the manager may be faced with the prospect of a forced sale of a property.  In this scenario, they may look to restrict redemptions by applying penalties such as widening the Bid to Offer Spread or imposing time limits allowed. They may be able to delay paying out for up to six months.

The benefits of investing in commercial property via a fund are that it enables diversification to be added to a portfolio and property has, traditionally, provided its returns in a less volatile manner than the stock markets.  Property values, like those of most investments, are underpinned by rental yields and one the attractions to many investors is that yields still remain higher than for most equity funds.

So what should we make of the current press focussing on apparent problems in the commercial property market?  Well, there is rarely any smoke without fire.  Property funds have been over-marketed to a risk averse investing public over the last couple of years.  The investing public has, in turn, shown that it has still maintained its appetite for the next bubble.  Real Estate Investment Trusts have performed poorly since their much hyped launch at the beginning of 2007 and the UK property market cannot forever absorb the wall of cash without someone, somewhere starting to become concerned over valuations.

The fundamental case for property is linked to yield and, like almost all assets, yields have been driven down by prices going up.  If you are investing for the short term, should you be in property, anyway.  If you believe you can time the market, good luck to you.

A recession, with corporate tenants defaulting on rents or simply cutting back on expansion plans may cause real problems for the sector.  Property has often been a boom and bust industry and may still be.  The developers would have us believe otherwise and it is true that there is probably a lower proportion of speculative building with many projects pre-let prior to commencement.

Many fund management group have launched Overseas Property funds to help investors spread their risk or find higher returns/risk.  Like some of the UK funds, these are often investing in the shares of property companies rather than real estate and may display equity-like characteristics.  It certainly pays to look under the bonnet before buying.

The problem for the investor is that everything looks overvalued from many perspectives; commodities, real estate and stock markets have all done pretty well of late.  As ever, there are many reasons for cautious investors to beware.

If you are investing for the longer term, it almost better to establish a sensible strategy with a diversified, sensibly priced portfolio and never again read the financial pages.  I always say that if you lived on a desert island and just received annual dividend/interest payments, you would not be concerned about fluctuations in the value of you capital.  Were you to return home after twenty years away, you would probably be pleasantly surprised at how wealthy you had become.  Time, with investments, is the real provider of returns and patience, a virtue.