Why the next generation may struggle to repeat the property windfalls of the past.
We all think we understand the property market – particularly residential property. For many of us, our family home is our largest financial asset. Those of us with grey hair (or no hair) have often enjoyed very strong returns from home ownership, especially across Europe and the US. But looking ahead, it’s hard to see our children or grandchildren experiencing the same gains unless something fundamental shifts.
The chart below shows the real return – after inflation – of the UK residential property index since 1970. Over that period, real prices doubled several times: from 1970 to 1980 (index 20 to 40), and again from 1987 to 2002 (40 to 80). There were notable dips along the way, masked by the simplicity of the index. If you were lucky enough to buy in the early to mid-1990s, you may have enjoyed nearly a threefold gain without ever truly experiencing a meaningful downturn. That sort of experience shapes the widespread belief that “you can’t go wrong” with residential property.
UK Real Residential Property Prices Indexed to 100 in 2010
The gains of course were often magnified by mortgage leverage. Debt amplifies returns on the equity you put in. If you only put in 5% cash and borrowed the rest, a simple 2x increase in the property price becomes a 20x return on your stake – ignoring interest costs.
From an investment standpoint, the average real annual return to UK residential property has been about 3.1% over the past 55 years. This compares with roughly 5.3% for the UK equity market over the same period. Both have proven to be great long-term investments, but equities have outperformed residential property across most time-frames and in most markets. They’re also liquid and inexpensive to trade, unlike property – especially high-end or secondary homes.
The positive experience we have in the UK contrasts with countries such as Ireland, Spain, the US and Japan, all of which have endured sharper and more volatile property cycles. While markets usually recover, not all do. Ireland, Spain and the US have delivered similar long-run real returns to the UK, but Japan is a different story: Japanese residential property has produced a real return of just 0.04% a year over 55 years. Japan’s demographic challenges are well known, but it still demonstrates that residential property isn’t a guaranteed winner, even in a country with very limited land supply.
Real Residential Property Prices, Index to 100 in 2010: top left to bottom right, Ireland, Spain, USA and Japan.
A major driver of rising residential prices globally has been falling interest rates. Conversely, many of the falls in property have been generally caused by interest rates shocks such as the one the UK received in the late 1970s when the Bank of England base rates touched 17% and again in the late 1980s when rates touched 15.4%. There are a variety of reasons for the sensitivity to interest rates, but perhaps the most intuitive one is rising interest rates increases the mortgage payments paid by the first-time buyer, impacting affordability.
It is difficult to generalise, but figures from academia, the Bank of England, and the European Central Bank, suggest a 1% change in interest rates typically results in a 3% move in property prices, although the range is wide. Properties tend to be most sensitive when rates are low, and high-value properties are particularly exposed to changing financial conditions.
Another contributor to long-run real house price growth has been rising wealth. As we have got richer, we have been able to pay more for the land our properties sit on. Limited supply – whether due to geography or regulation – adds upward pressure. But supply isn’t always constrained. Oversupply played a major role in the housing downturns in Japan in 1990 and in Ireland and the US in 2008.
In the UK real residential property prices have been broadly flat since around 2008 when the global financial crisis, tighter mortgage regulation, and stretched affordability effectively ended the long boom (see chart below). Premium London property has fared a lot worse. According to estate agent Savills, high-end London prices have fallen 21% since their 2014 peak – factor in inflation and this is comparable to the major busts in the past experienced by Ireland, Spain, the US or Japan. It reflects a more hostile environment for the international buyer base that previously supported prime London – Russians, Chinese, EU nationals – and changes to UK tax treatment for non-doms.
All this comes just as other countries – many with better weather – such as Italy or Dubai, are working hard to attract high-end buyers. However, despite the fall since 2014, London remains one of the world’s top 10 cities, with prices comparable to Tokyo, Sydney, Paris, and Shanghai, though still below Hong Kong, New York and Geneva.
Source: the Financial Times
Despite softer prices and lower interest rates, UK housing affordability remains stuck around its long-term average, suggesting limited upside from here. Without a sustained recovery in real income growth, property simply won’t deliver the kind of long-term gains previous generations enjoyed.
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