A property crash always unfolds in similar ways: credit runs dry, a priced-out majority stymies demand, confidence falters. Sound familiar? Then prepare for the bear, says Jonathan Compton.
A year ago, a small group of investors, including myself, approached investment banks with a substantial sum. We wanted to buy a short on any leading UK residential house-price index – in other words, we wanted to bet on house prices falling. We were prepared to accept adverse terms, as long as the option was for five years. As buy-to-let landlords, we reckoned that even losing the bet (ie, if prices rose rather than fell over five years) would be cheaper than the cost of selling (after adding up the tax on gains, stamp duty and other costs involved in buying back later). In practice, we were trying to buy insurance. Yet although the banks had many put options available on foreign-property indices, none would touch our offer in the UK market.
When investment banks turn away seemingly easy money, investors should panic before the rush.
I have worked in many overseas markets, and have witnessed more than a dozen major property bear markets. They always unfold in similar ways. Each market abounds with unreliable “experts”, whose livelihoods depend on perennial optimism, while property owners remain mired in self-delusion, unable to countenance that the value of their primary asset is deeply cyclical. Hence I have met many otherwise intelligent people who refuse even to believe the data in front of them now. Both the 1988-1992 and 1973-1975 UK property crashes saw average house prices fall by well over 25%; in the past 20 years the UK property market has risen higher than before either of these market “corrections”. When a rocket runs out of fuel it continues to rise before plunging earthwards. This is where we seem to be now.
How credit drives house prices
There are two key propellants for house values: the availability and price (ie, interest rates) of credit. In every developed country there is a close correlation between the rate of growth in credit and property prices. After the financial crash, many countries embarked on quantitative easing (QE) to save their banking systems. This flooded the system with money and forced interest rates down to record lows. Credit became available on the easiest terms and at the lowest rates in history. Small wonder that house prices in almost every developed country have surged since 2008 (London is now the second-most expensive city in which to buy property in the world).
Now, however, in the UK, the US and Europe, quantitative easing is slowing or being wound down. We can’t know when or by how much rates will rise, but the next moves will be up, and even a small rise will have a significant impact on borrowers’ cash flow. The Bank of England rate is 0.25%. If it were to rise eighteenfold to 4.5% – which is where it was when RBS and Lloyds all but collapsed in 2008 – the impact would be dire. Many household budgets are already stretched: at the end of last year, UK household savings fell to their lowest levels since records began in 1963. Meanwhile, consumer borrowing, credit cards, bank and other loans have risen above the previous all-time high, which came just before the banking crash.
Clearly, the credit tank is almost empty. Underlying all this borrowing is another problem – stagnant incomes. Real disposable income has been flat since 2007 and remains below that level. Gross incomes have seen headline growth (such as the rise in minimum wages) but net income continues to flatline. This has less to do with the recent rise in inflation than with the slightly faster increase in taxation. Meanwhile, the banks are being prudent with their loan books. Borrowers and politicians grumble about their “greed’” in demanding larger deposits, and offering loans at much lower income multiples than pre-2008, but unlike in previous cycles banks are controlling their risks and exposure better. Also, legally they now have to stress-test new borrowers. This is good practice, and mortgage repossessions in London fell to an all-time low of less than 400 at the end of 2015. But this prudence also means growth in mortgage loans – a key driver of house prices – has stopped and may be reversing.
Economic migrants and empty houses
Credit is always the key fuel for house-price rises. But there are other factors. For over 30 years, London has been the UK-wide driver behind higher property prices for an unexpected reason: its population stopped shrinking. In 1939, London’s population was 8.6 million. By 1986, it had fallen to 6.4 million. Then various factors, such as globalisation and immigration, resulted in a prolonged rise. By 2015 the population had surpassed its previous high. Creating housing for an extra 2.3 million people was bound to affect prices. Even as late as 1995, the number of properties that sold for more than £1m was tiny, at less than 200 nationwide (84% were in London). In 2015, the number was 70 times greater, at more than 14,000.
While globalisation and London’s recovery as a major financial centre drew in many foreigners, the overall immigrant “flood” story is more nuanced. Initially it was small: according to a 2017 report by the Mayor of London, in 1994 about 5,000 people net (ie, after emigration from London), rising to an average of about 35,000 net between 2005 and 2015, with a surge to 68,000 in 2016. Of these migrants, about half came from elsewhere in the UK. This has been hugely effective economically. London attracts young people who contribute significantly to state coffers, and then spread into the regions when they start families. The data shows this in action. In 2015, about 35,000 people in their twenties (UK-born and foreigners) moved to London. But 20,000 people in their thirties left – UK citizens with dependants seeking greater, cheaper space further away and some foreign-born migrants going home.
So that’s demand. What about supply? The UK has about 28 million properties for a population of 65 million. For all that politicians and some disingenuous think-tanks and charities squeal about empty properties owned by evil (ie, “foreign”) speculators, only about 600,000 homes – 2.2% of the total (1.7% in London) – are empty. About two thirds of these are due to people changing their homes every ten years or so, or houses standing empty after the owner has died, waiting for probate to be granted. Most of the remainder are houses in areas suffering net emigration, which includes most cities north of a line between Chester and Norwich. So at first glance, the market is very tight.
Yet there has been a considerable supply response. The number of private-sector houses built in London in 2015 was the highest since 1978. Indeed, gross completions (ie, private and public) have been rising steadily since 1986, the year London’s population stopped shrinking. Since 2001, London’s housing stock has grown faster than in any decade since 1945 as a result of new building, fewer demolitions and a sharp rise in conversions. Indeed, the private market has been working so well that there are now large pockets of unsold new developments nationally (such as in Salford), or in London (considerable stretches of the south bank of the Thames). Some of these expensive apartments are proving unsellable at current prices. North of the Thames, in Chelsea, asking prices in the luxury end are down 25%.
The government doesn’t know what it wants
What has failed to work has been government policy, which has been bumbling along for decades. I am a big fan of the Right-to-Buy policy, which has provided many families with a huge leg-up, meaningful wealth creation and a stronger stake in the system. The flaw has been the lack of adequate new social housing for poorer people – local authorities sold council houses then took the money and ran, rather than reinvesting. Housing associations have been significant suppliers but at too slow a rate. (Also, when interest rates rise, the balance sheets of many such associations will be shredded, given their molecule-thin levels of equity).
The government has also turned hostile on buy-to-let, even though the sector has spurred much new building. The big hikes in stamp duty – especially on second homes; the removal of key tax breaks; and new levies such as Energy Performance Certificates will have two contradictory results. Most (80%) of buy-to-let landlords own one property. Assuming 50% borrowing, then in practice they are paying tenants to occupy. More and more will become forced sellers. There will be no net effect on supply, but when many investors try to sell at the same time, prices fall.
Other policies, such as on Airbnb, have been idiotic. In the year to October 2016, the number of Airbnb rentals in London alone rose by 168% to 49,350, of which 51% were whole flats or houses – a major source of often new supply. Yet governments hate private enterprise they can’t record, and thus tax, so efforts to control the sector have been cumbersome. Fortunately, the practice of using the internet to attract tenants is unstoppable. The government is also confused about what it wants. There is alarm that home ownership in England has fallen from 71% in 2003 to 63% now, and from 67% in 1991 to 35% among the under-35s. Yet this is desirable; many low-paid people can’t afford to buy. Surely we haven’t forgotten that the prime cause of the 2008 crash was selling houses to people with weak finances?
Missing the obvious
In every property cycle there is always a major element of missing the obvious. When the majority of a city or country’s population can’t afford to buy even a modest home, demand at the margin evaporates. This is where we are today: 20- and 30-somethings still at home; a reversal of the long-term decline in the number of people per dwelling; and more people travelling huge distances to work. Also at the margin is a likely Brexit effect. Net foreign immigration was slowing well before the vote; the rate of foreign inward investment is also likely to slow; and some businesses, especially in finance and services, will move some operations and people overseas. All of these factors will affect demand in a residential market that’s highly susceptible to marginal changes.
In every commodity market – and housing is as much a commodity as oil or wheat – “the cure for high prices is high prices”, ie, supply grows and demand falls. Like a vast pyramid scheme, the UK housing market has been defying the reality of low wage growth and productivity, worsening affordability and tighter credit markets for some time. Although London prices are set to fall hardest, it is inconceivable that prices elsewhere will rise as the centre slumps. And as in all markets, while the direction of supply, demand, credit and costs matter, the invisible issue of confidence can turn prices down even when these factors are positive. Do you feel cheerful about the flow of news in 2017?
Five ways to play the coming downturn
If you can find a five-year put on a UK residential index please contact me and at the very least I will buy you a decent lunch. While some house builders are well run (and the better ones are turning cautious), it would be disingenuous to suggest investing in any of these companies given my views and because the falling tide will drag them all lower.
But there is one property segment where demand is almost guaranteed to continue rising and where the supply response has been slow: warehousing and distribution centres. That’s because – as discussed in MoneyWeek just a few weeks ago – the appetite for online shopping just keeps growing. A leader in this sector is SEGRO (LSE: SGRO), which develops and runs warehouses across the UK and Europe. Demand is so strong that a recent rights issue has just closed and £365m was then spent to buy the half-share in the (Heathrow) Airport Property Partnership venture that it did not already own from Aviva. This is valued at a cool £1.1bn. On a single-digit earnings multiple and 3.4% yield, it remains cheap.
The outlook for commercial property overall is not too inspiring, but some share prices have already adjusted for this. British Land (LSE: BLND) has overreacted, falling from a high of nearly £9.00 three years ago to today’s £6.50-odds, representing a real discount of about 27% to the underlying net asset value (NAV). Management has reduced gearing prudently, and the 4.5% yield is not to be sniffed at.
Hammerson (LSE: HMSO) is a more retail-orientated real estate investment trust, both in the UK and the EU, with a tilt towards tourist expenditure which should benefit from sterling weakness. Its discount to NAV is less than British Land’s, but the 5.2% yield provides a decent cushion.
There is a semi-urban myth that weak house prices result in more being spent on home improvements, as owners look to add value via domestic refurbishment rather than moving. Although the case is unproven, the Anglo-French, long-term “dog” Kingfisher (LSE: KGF), which owns B&Q and other home improvement brands, may be a good turnaround gamble. Recent results were uninspiring but it is only in year one of five-year turnaround plan. Unusually, it is valued at just above its book value and has strong cash flow. Thus its stay in the kennels may
be ending.
If you’re unsure how the house price scenario will play out, and would like an either/or bet, then the Independent Investment Trust (LSE: IIT) may be the solution. It is run by Max Ward, costs are ultra-low, and it focuses entirely on stock picking. Its long-term track record is excellent, despite high exposure (currently 23%) to the house-building sector. This tilt hit the NAV hard in 2008/2009, but Ward rode it out well and the performance speaks for itself. The current estimated discount to NAV of 10% probably offsets the potential risks.