House prices: Part 2

Housing in investors’ portfolios

Last week I noted the rise in house prices in many countries over the last year and the sometimes frenzied behaviour of buyers. I argued that this would support the economic upswing over the next year or two but also likely turn the central banks hawkish sooner than they might otherwise. This week I focus on the role of housing in investors’ portfolios.

One of the reasons for the surge in house prices is greater investment in housing, both by individuals and institutional investors. Rental yields (the annual return excluding any capital gains) vary enormously but are commonly in the 2-5% range net of costs. This is attractive compared with long-term bond yields, now very low or even negative in some countries, since house prices should also be expected to hold their own against inflation over time.

Gross yields (before costs) are higher but investors often under-estimate annual running costs (repairs, voids, depreciation etc) and there are also substantial ‘in-and-out’ costs (when buying and selling) which makes investing in housing unattractive without either a large capital gain or an extended holding period. Further, only the very large investor will be able to diversify by area sufficiently. While the holder of a small number of properties may successfully pick localities coming up, they cannot adequately diversify away location risk. In the UK there are very few collective investment vehicles for residential property, though more are available on the US market. Housebuilder stocks are another option though this is not the same as holding actual property.

There are also policy risks for property investors such as the risk of the imposition of rent controls or changes to tax regimes. Rent control is a hot issue in Germany, is common in many US cities and is supported by the London mayor. Always a foolish policy measure because it deters the supply of new housing and often leaves tenants in decaying housing, it is nevertheless politically popular.

Prices don’t always go up

But with prices now high on measures such as house price/income and house price/rent, investors face another risk – a period of flat or declining prices in coming years. US purchasers in 2006 are only now seeing prices back to the same level in real terms.

But if you want to frighten yourself with a worst-case scenario look at the chart for Japan. After the peak in 1991, Japanese house prices fell almost in half and are still about 33% below their level 30 years ago. Whew! Of course that disaster reflects a very inflated starting point, followed by a long period of disappointing economic growth and general price deflation together with a declining population. Prices are now rising, albeit slowly. From the low in 2009 they are up about 20%, not bad with the general price level about flat.

Still, even without falling into ‘Japanification’, house price gains in the US and Europe could be much more modest in coming years, simply because of the high starting point. The big plus though, from the investor point of view, is that if inflation and wage growth do pick up in coming years house prices will reflect that and provide important protection.

As always, diversification is key. We regard owning your own home as very important – otherwise you are ‘short’ property since you need somewhere to live. Investment property may also be a useful asset for many investors, though don’t underestimate the costs and hassle. But for most investors it is wise to diversify across as many areas as possible, including stocks, fixed income and commercial property. Alternative such as private equity or structured products may be appropriate for some investors too.