What parents tell the children about property
Parents have instilled in their children the desire to get onto the property ladder, not just as a lifestyle choice but as a way to avoid permanent loss of possible wealth. But the expected economic rewards of home ownership are misunderstood by most parents, biased by the experience of their generation. Tell most people what the long term trend of house prices has been ‘in real terms’, after stripping away the illusion of general inflation, and they will stare at you in disbelief. But unless you believe the real trend of growth will be above the real cost of mortgage debt, there will be a high financial price and loss of flexibility on that ladder. Lifestyle benefits may make it worth a high price but, like work/play or pay/satisfaction choices, that’s for kids to decide.
You do not need to be a financial adviser to see how parents hand down to their children their own views about property as a store of value and source of growing real wealth. Unlike many financial goals, however, this one comes with an urgency based on a popular belief that house prices rise much faster than other financial assets, including the return on cash-based savings, so that the property ladder may permanently be just out of reach. This is almost the exact opposite of most consumer items young people want in a hurry, whose future price is quite likely to be lower in real terms. So the house price psychology works against all sound general advice to defer purchases till they can be afforded, even in households where that is the advice given on student loans or credit card debt.
Thinking through the logic, the psychology I am describing needs the assumption that property will tend to outperform other forms of capital, otherwise savings (or perhaps equity investment) would be expected to provide the capital equivalent to whatever ‘rung’ on the ‘property ladder’ a young person is aiming to get onto. It is only the assumption that property is unbeatable that raises the spectre of never getting onto the ladder. Where does the assumption that other risky investments will not typically keep pace with property come from? Not from any economic theory – in fact it is deeply flawed as an explanation of sustainable economics. But it is does reflect the outcomes for a particular generation, or at least it reflects the way the outcomes were experienced.
How asset prices behave
Rather than rely on received opinions, it must be useful (whether kids or parents) to base our biggest investment decisions on an informed and objective view of long historical evidence of the behaviour of asset classes (like cash, houses or equities) in real terms (after adjusting for general price inflation in the economy). This is all basic No Monkey Business stuff. Real prices and real investment returns generate real wealth outcomes – just like compound interest.
For property, the information about real wealth generated might be taken from a longer history than the received view, based on particular shared experience. But it might also be defined differently. Unless we are very financially aware, our experience of the ‘wealth creation’ from property will not typically account at all accurately for
the cumulative extent of the illusionary gain due to general price inflation
the opportunity cost of the investment (the next best use of the money)
the impact of high levels of mortgage debt on which an unsustainably low or negative real rate of rate of interest was paid for much of the time (and partly tax-deductible for some of the time)
the investment of additional capital in the maintenance and improvement of the properties we owned
Even if we are so financially aware as not to have been fooled by these effects, it would be foolish to assume that the real cost of debt will again stay so low for so long; that property prices will always rise in real terms by more than the real cost of debt; that the real cost of debt will exceed the cost of renting (in a market more friendly to property owners than the one we grew up in); that the investment in improvements an owner needs to make also carry no ‘opportunity cost’.
House prices and equities
Comparing house prices with equities makes sense for a number of reasons. The stockmarket is clearly an alternative risky investment to property; in terms of a sustainable economics, it makes sense that they should not behave quite differently; we have much more developed and evidence-based thinking about equity investing than we do for houses, even though home ownership is wider than direct equity ownership.
House prices do in fact fit into the same long historical perspective that No Monkey Business adopted for equities. When expressed in real terms, equities show a long term trend but also fluctuations around the trend that (for all but very long horizons) swamp it, so that actual experience over periods as long as 10 years is usually more explained by the cyclical movements than it is by the long term trend itself. This makes market conditions, or timing, very important to your expectations. So it is for property. Even if you subscribe to the view that over the long term property will exceed the returns from other risky assets, the cyclical deviations from your expected path might make it appear, after the experience of a particular interval as long as a decade, to be very disappointing or even a source of regret.
The comparison with equity returns can be illustrated by plotting the cumulative real growth in two representative indices: the Nationwide Index of the ‘average’ UK house price and the FT All Share Index. To make them roughly equivalent, no income is assumed from either. The Nationwide Index (unlike some others) meets the criterion set out above that it reflects additions to an original investment, so that it approximates to an ‘internal rate of return’. It does so in an indirect way because it adjusts for changes in the quality of the housing stock, so that rather than measuring the price of the same property over time it measures it for the changing ‘average’ property. The two indices are shown cumulatively from a base of 100 in 1957, the blue line being equities.
The jaw-dropping number
The trends fitted as straight lines to this data have a slope of 1.9% per annum for equities and 2.3% for houses – near enough the same considering the data history is quite short for observing economically sustainable trends.
2% a year is the jaw-dropping number. Yet it is pretty much the same as the sustainable real growth in personal incomes and in turn with real growth in economic productivity. Both assets should be expected to grow in real terms in line with the underlying growth engines of the economy. Clever people might want to make the underlying economics more complicated than this, but it’s not at all clear why they need to.
The trends look the same, so does the typical duration of cyclical deviations above or below it, but the scale of the deviations looks greater for equities than for house prices. The stockmarket is much more ‘liquid’ than the property market, with faster transaction times and lower transaction costs, so the shallower cycles of house prices may simply be a reflection of these differences in average prices.
Confusing the cycle with the trend
The graph also illustrates the point that we can easily be fooled into confusing movements related to the cycle with the real trend. It’s not only the inexperienced who do this: stockmarket professionals regularly confuse the two as well. Experience of an older generation is particularly likely to focus on the growth trend of houses from the start of the 1970s to current high levels but this rate of growth is actually nearly twice the sustainable long term rate.
The aberration in the property market as a whole is really concentrated in the last three years, rather than the nine years since the last low point of the housing cycle. Deviations of about the same magnitude have been equally quick to build up in the past. What does this imply? Perhaps it is consistent with a ‘monetary’ view of asset price cycles: when there’s too much money in the economy (interest rates too low, too much credit being created) asset prices are quick to respond. The recent house price cycle has probably also gained strength from the poor performance of equities, creating the illusion that it was a ‘better bet’ and funneling more of the liquidity in the economy into property instead of into other asset classes. This little twist has reinforced the house price psychology.
The impact of general inflation
How we think about past corrections to house price aberrations has been distorted by changes in the general price level at the time, contributing to a popular view that ‘the worse that can happen is that prices move sideways’. The three previous peak to trough falls shown in the graph were 37%, 17% and 30% but you can see they also lasted for different times. Is this how they were experienced? Well, no – not in money terms. The cumulative rise in the general price level for the duration of each bear market was almost exactly the same as the real price fall, so in money terms the real price fall barely registered as a fall let alone a crash. Hence the perception that in money terms there is little downside risk. This is less likely to happen now unless general price inflation accelerates sharply, even as house prices are falling.
From a higher real level than in either 1973 or 1990, the fall in prices in money terms is likely to be closer again to a one third fall in real terms, depending on the duration of the decline, simply because general inflation is so much lower than in past cycles. This looks like being not the first crash but the first one to feel like a crash.
What does it imply for young people?
Even if today’s house prices were at a level that could sustain real growth of 2% a year (such as with a 50% chance of growing that much), there is no reason to assume the real cost of mortgage debt will be less than this. Indeed, at the same 50% probability real interest rates will be more than 2%. This is even before figuring in the pre-tax equivalent of the borrowing costs (because they are paid out of taxed income).
With real prices well above trend today, there is only a very small probability that those last on the ladder will be able to avoid a decline in real wealth as any achieved growth falls short of the real borrowing costs.
This will be experienced as a loss of spending power or a loss of savings capacity, such as savings to pay back student loans or to prepare for child raising. This is in turn is likely to be experienced as a loss of freedom, such as about starting a family, moving to a different area or walking away from an unhappy career choice. These are dimensions of the lifestyle choices that need to be added to the more obvious ones like the freedom to stick picture hooks in the wall.