The biggest investment most retail investors will make is in the residential property market but research into historic performance, volatility, price discovery, etc in this area is not extensive. Photo / Janna Dixon
The biggest investment most retail investors will make is in the residential property market but research into historic performance, volatility, price discovery, etc in this area is not extensive. Photo / Janna Dixon
Opinion by
Most of the investment research by academics around the world concentrates on the stock market because that asset class is the most liquid and consequently tends to be favoured by institutional investors.
However the biggest investment most retail investors will make is in the residential property market but research into historic performance, volatility, price discovery, etc in this area is not extensive.
Since the 2008 US house prices related sub prime disaster there has been more interest in the wealth effect of house prices and late in 2013 there were a flurry of academic papers focusing on the residential property market. Given that matters residential seem to be a favourite topic for Herald readers a brief summary of these research papers may be of interest.
Western world house prices
First off is a long term study of house prices in 14 major western countries since 1870 by Katharina Knoll from the University of Berlin, Moritz Schularick from the University of Bonn and Thomas Steger from the University of Leipzig. The countries in the study include the US, UK, Japan, most of Europe and Australia. Unfortunately NZ isn't included.
The key findings are that real house prices stayed constant for most of the period 1870 - 1950 then increased strongly in real terms from 1950 to 1990 and then prices accelerated even more strongly after that time. The authors decomposed house values into the actual house and the underlying land.
While construction costs have flat lined in the past four decades sharp increases in residential land prices have driven up international house prices.
Using replacement cost of the structure and land prices the authors conclude that rising land prices are the major reason for the recent strong upward trend in global house prices. They noted that "while construction costs have flat lined in the past four decades sharp increases in residential land prices have driven up international house prices. Our study suggests that up to 80 per cent of the increase in house prices between 1950 - 2012 can be attributed to land price appreciation alone."
During the first half of the 20th century residential land prices were constant despite substantial population and income growth. The authors offered two reasons for the acceleration in land prices from the 50s: Firstly the transport revolution early in the 19-20th century had the effect of greatly increasing supply of economically usable land thus suppressing price increases. Once this factor ran its course land in desirable areas rose in price in real terms.
The second factor was that zoning regulations and other restrictions on land use reduced the supply of residential land from about the 1950s. Incidentally this analysis might partly explain why the Auckland property market has outperformed the rest of NZ. Obviously population growth in Auckland has been a big factor too.
Capital market expectations
Next is a paper on capital market expectations by Rob Arnott a Californian based fund manager and index provider, Research Affiliates where Mr Arnott tells readers how to calculate total returns from various asset classes. You might think that in 2015, when the capital asset pricing model is 50 years old and the Black Scholes option pricing model can be found on a phone app, there wouldn't be too much disagreement as to how one should calculate the total return performance of an asset.
It is pretty basic - for shares and bonds you simply add the dividends/interest payments to the movement in the price of the asset to determine the total return. Not really rocket science. But surprisingly everyone isn't on the same page as regards total return methodology.
A few years back FundSource, a subsidiary of the NZX, compared the performance of the NZ stock market versus local residential property prices and decided to include the dividends from shares but exclude the rent from property. Using that methodology the conclusion was, unsurprisingly, that shares had outperformed property.
Nice one! We wrote about that faux pas back in 2011 in a story called Property v Shares: Argument Far From Over.
Mr Arnott, former editor of the Financial Analysts Journal, academic and hedge fund manager, in his paper had this to say about calculating the total return performance of residential property ...
"Consider the purchase of real estate for the purpose of either living in the house or renting it to a third party. In the case where the house is being rented the income is the rent paid by the tenant and the yield of the investment is the total rental payments for the year divided by the purchase price of the house. If, instead of renting, the purchaser decides to live in the house the property still generates income however. Because the owner is both the lessor and the lessee there is no need for physical cash to change hands. Because the value of an investment is the sum of its discounted future cash flows the house has the same economic value and must therefore generate the same future cash flows regardless of how it is used."
What Arnott is saying here is that generally an asset has value because of its future cash flows and, because prices are determined by both owner occupiers and property investors, houses which are owner occupied must generate the same cash flows in rental payments, albeit on a notional basis. Obviously commonsense but nice to have someone with a PhD in finance set matters straight.
Behavioural characteristics in Boston
The third paper looks at the behavioural characteristics of people selling their houses in Boston in the 1990s subsequent to a house price crash. The study was entitled "Loss Aversion And Seller Behaviour: Evidence From The Housing Market" by David Genesove and Christopher Mayer from the National Bureau of Economic Research and it concluded that people selling houses did not like sustaining losses on their purchase price.
It found that owners who were making losses set higher asking prices than the market and subsequently took much longer to sell their houses. Conversely people for whom the market price exceeded cost price were much more realistic in determining their selling price. This strategy works if prices bounce back but could be disastrous if prices fell for an extended period.
entitled "The Great Mortgaging: Housing Finance, Crises, and Business Cycles". This study looked at the relationship between banks and financial crises. It found that high levels of borrowing to fund residential property investment predicted a financial crisis better than increases in other forms of lending.
From a personal investing perspective one point that resonated was the fact that today 60 per cent of bank lending is related to residential property as opposed to 30 per cent forty years ago. For various reasons bankers are incentivised to prefer residential lending over other sorts of lending. Banks have previously been regarded as the intermediaries that recycled debt capital between Mum and Dad and companies.
Today the authors describe banks as being "real estate funds" and their business is writing long term mortgages funded by short term deposits. So you have a classic funding mismatch with investments concentrated in one sector. According to the Economist Magazine residential property prices in NZ and Australia are high in terms of rental yields and the ability of investors to fund mortgages. Given this scenario investors need to be careful that their deposits are diversified.
Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have an interest in the companies discussed.
