The deteriorating long-term returns from residential property

The chart has been divided into three distinct periods, defined by inflection points at price peaks and subsequent slumps in prices. Why these inflection points, which really only represent cyclical movements, should also represent secular changes is the subject of a further note. Nevertheless, the differences are stark, with the most recent period offering a very poor rate of capital growth from the last peak in 2007 to the present day. The sharp-eyed amongst the readers will see a second dashed line on the chart for the current period. The lower one represents a modest fall from the pricing peak and reflects a general expectation as a result of the 2020 recession. This is there primarily to suggest that the upper dashed line represents a peak-to-peak measurement, comparable to the other measured periods.

Beneficiaries and losers

For sociologists and aspiring owner-occupiers, lower house price growth might be good news. Owning residential assets – the main assets of the population – is no longer producing the growth in wealth for the most affluent. Over time, this will tend to make housing more affordable and to equalise asset wealth across the population. This is being reinforced by the current vogue of a continuing process of property improvement through replacement of parts of the property that are only partially depreciated (eg new kitchen units) for the purposes of style or change for the sake of change. Such activity effectively reduces depreciation of the housing stock but benefits the buyers. For pure investors (non-owner-occupiers) and those owner-occupiers whose main objective is capital appreciation, this might represent a reason to generally avoid the market and to invest their capital elsewhere, such as in equities. Although there are other factors, such as changes in taxation, which have deterred private investors, the lack of capital appreciation is driving a number of private investors from the market as the total returns can often fail to even match the cost of capital. More constructively, it suggests a need to be much more tactical than being a long-term investor. Again, this will be the subject of a further note. For house-builders, a lack of growth in house prices, given that their input costs (labour and building materials) will grow with inflation, places their profits margins under pressure. For them, and contrary to general perceptions, low growth in house prices signifies a lack of demand. One safety valve is the cost of raw land, the price of which will vary depending on demand, as the supply is largely fixed. However, house builders will largely be competing with the existing land uses or alternative uses for the land, and this can limit the responsiveness of land prices to housing demand. Finally, for existing owner-occupiers, most of whom – according to the research – could not afford to buy the house that they occupy, this suggests that they may need to re-think their predilection to own a property greater than their needs and to continuously modernise their homes. The latter activity accelerates the rate of depreciation and produces a poor return on the marginal capital employed which, unless an immediate sale is being contemplated, may be negative. Of course, this is also true of most purchases of chattels, particularly those involving technology, but chattels are not typically purchased to effect a financial improvement in the well-being of the owner. All of the above assumes that the low growth in house prices over the latest period will continue or fall further. I will deal with this in a separate article.

While UK commercial property ownership is dominated by investors, the residential market is dominated by owner-occupiers. That indicates the need for a different basis for comparing the markets: nvestors see total returns whereas owner-occupiers see the market in terms of capital pricing (and compare, as a separate calculation, the difference in mortgage repayments – which normally includes capital repayment – and the alternative of rent). In the UK, the concept of implied rent as an economic characteristic of owner- occupation has been almost completely removed from the population’s consciousness with the withering and eventual abolition of UK Schedule A taxation. Certainly, there are other players in the residential market – investors who rent out housing and providers of social housing are the two other main owning groups – but these are substantially price-takers, with prices of both land and buildings being determined by the owner-occupiers (or their agents, such as the mainstream house-builders) who would tend to out-bid the other groups in a competitive environment. This raises the prices and lowers the returns to pure financially-driven investors and is the main reason why institutions, in particular, have found it very difficult to participate in this sector of the property asset class as opposed to commercial property where they are the dominant holders. For owner occupiers, owning is not just about utility – or having somewhere to live – but also about status and security. Investors seek to maximise net returns, whereas occupiers seek to maximise social and other benefits, while also seeking to at least keep pace with market prices so that they can relocate without losing ‘value’. The desire for more and better housing, as well as competition from other land uses and the restrictions on supply imposed by planning controls, has meant that house prices have tended to rise over the long-term. There is no law of economics that says that this has to happen, but the tendency reflects the increasing affluency of the population, in particularly – in a circular argument – the increasing affluency of the wealthier parts of the population. As people become more affluent, they tend to spend more of their discretionary spending on housing and services. For owner-occupier buyers, as opposed to owner-occupiers generally, the limiting factor on their buying power is the availability of finance: the equity (or, colloquially, the deposit) and debt (or mortgage). Both are largely dependent on household earnings and growth in earnings, although the provision of mortgages is, in part, dependent on lending policies of banks/building societies and the control by regulators (now mainly the Bank of England). The Bank of England has been particularly active in recent years in attempting to avoid the risk of market ‘over-heating’ by matching the availability of mortgage offers with the long-term ability to service the loans. Even so, it has probably only been partially responsible for the slowing rate of house prices growth in the last 50 years, which is shown in the chart below.

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