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Macro-economics and the risks to property investors - Interest rates - House prices


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I’d like to start a conversation about macro-economics and the effects that it might have on property investing. In particular, I’m going to challenge the notion that house prices always go up and highlight that the price rises which have been enjoyed by property investors for the past generation have been largely due to the steady decline in interest rates. Ultimately I’d like to find clarity on the question of whether property investment is still a good idea today and if so then is the same formula that worked previously still the best approach. I’ve tried to research this topic thoroughly but please do disagree with me and offer alternative ideas. What I say relates mostly to buy-to-let (BTL) investments that involve a mortgage.

 

A)     Let’s start with some fundamentals: property investors generate profit from two sources: rental income and capital growth. With rental yields where they are today (around 4-6% gross) it typically works out that the rental income is similar to the running cost of the property, and so the investor relies on capital growth to actually make profit. If you knew house prices were going to stay still for the next 30 years, would you still be interesting in BTL?

 

B )    Having established that capital growth is important, let’s examine what causes it. For people to pay more for houses they have to be able to afford to pay more and this generally means one of two things: either they are earning more (wage growth) or they can access cheaper mortgages (interest rates falling). Rob & Rob have often talked about affordability on their podcast and explain how it’s this combination of wage and interest rate that determines what people can pay, not just how much they earn.

Interest rates have been falling reasonably steadily now for several decades, meaning that year on year buyers have been able to afford bigger mortgages, pushing up house prices. This is demonstrated by the fact that, over this time, the house price-to-income ratio has increased substantially but the mortgage payment-to-income ratio has been relatively unchanged.

A research paper by Victoria Monro of the Bank of England [1] estimated that over the past three decades about half of the housing price growth was due to wage growth and the rest due to falling interest rates. Therefore, if interest rates had not fallen, we would have seen half the price growth over the past three decades.

 

C)     So what happens next? Assuming interest rates will not go negative, two things can happen: either rates stay low or rates go up, and surely they will eventually go up. This means that investors will be relying on wage growth alone to push property prices higher and when rates do rise this will have an opposing effect as buyers are faced with higher mortgage payments. If rates slowly rise over the three decades back to the point they were 30 years ago, might we expect the roughly equal contributions of interest rate changes and wage growth to cancel out and house prices stay flat.

 

D)     Does this present risk to property investors? I’d really like to hear some opinions from you all. In my eyes there are some significant risks: If I were to purchase a BTL today and house prices stay flat, I might make a small or zero profit on the rental income. But this scenario is likely to occur as a result of interest rate rises, in which case my costs are going to go up and I could find myself in a scenario where I’m making a loss each year on running the property and there are no price rises to bail me out.

If rates rise especially fast then house prices could even go down, but I’d be surprised if central banks would allow this to a significant extent. Any thoughts?

 

E)      Is there a particular strategy that could be safer? Please do make some suggestions. I for one have been wondering whether the era of capital growth is coming to and end and instead investors should be seeking to maximise rental income rather than capital growth. This would sustain a larger proportion of returns when the growth stops and give a stronger cushion as interest rates rise and increase the mortgage payments.

 

Conclusion

I’m proposing that rising interest rates over the coming years are likely to counter the effects of inflation and leave house prices standing still. This means that property investors no longer be able to rely on capital growth as part of their strategy. Furthermore, investors face a risk that their portfolios will no longer be viable with higher mortgage payments. Contrary to popular recommendation, higher income (lower capital growth potential) investments might be a safer bet for the next generation of investors. Ultimately, the central banks have control of the interest rate lever, will their decisions be likely to help or hinder investors?

But what about the 18 Year Property Cycle?!? Aren’t we entering the boom phase?? Well I’ll be honest, I’m not sure I believe in the 18 year property cycle... it’s often easy to pick out a pattern when you go looking for one, that doesn’t mean it means anything. Perhaps the 18 year cycle has some validity resulting from human psychology and it certainly seems like people are expecting house prices to go up right now. But I believe there are larger forces at play – these people need to be able to afford it at the end of the day. We might see some more growth still, I’m not predicting a crash; new 95% mortgages could push the market a bit higher still as could wage growth. But otherwise the economic levers that inflate house prices don’t go any further, and eventually will start going back the other way. This won’t necessarily result in prices going down, if central banks decide to avoid that. But it could mean prices staying flat and costs going up, potentially rendering traditional BTL strategies unviable.

 

Please feel free to agree, disagree and generally offer your thoughts on these fundamental issues.

 

[1] Read abstract and see Table 3 from https://www.economic-policy.org/wp-content/uploads/2020/10/9100_UK-House-Prices-and-Decline-in-Risk-Free-Real-Interest.pdf 

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  • 1 month later...

Interesting thoughts Tuk. If the government's stated long term inflation target is containing around 2pct, and they rarely achieve that target except in recession (I believe) then surely prices will grow at 2pct-ish all other things being equal. 

Low interest rates could be here for the long term. Most investors should be (and the BoE PRA build in to lending rules) stress testing that the borrower can cover 125pct at 5.5pct.

So I would expect investors generally to be pricing rents at the level that makes that a viable business, taking risks with lower rents as they see fit for themselves (price competition) . If the market is generally pricing rents lower then maybe there is a bubble. 

I would also expect house price growth to shift around. This year its Liverpool and Manchester, but that can only sustain so long, and then it has to cool off and somewhere else is next. Meanwhile, somewhere else will be no growth or maybe going backwards... 

Cycles aside, the long term averages are for 5pct-ish growth aren't they, for longer than the low interest rate period of the last 12 years... 

So, judicious selection of location and property are key. You can't go in with a machine gun, got to be a sniper to select places where demand will continue and ideally grow ahead of supply. 

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Hi, thanks for reading my post and sharing your thoughts!

I think what the report I linked to made me realise is that at the point of rates being changed there is then a one off of response in house prices (which may in reality take months or years to be visible). Once the transition to different prices is complete, real prices will in theory then be stable at the new level until rates are moved again.

For example, a base rate of 0% might support house prices at 8x average income, whereas base rate of 6% might support house prices at 4x average income. Each time the BoE changes interest rates, house prices will start moving towards their new sustainable level as an income multiple. But once reached, prices will remain at that income multiple until interest rates are changed again.

ON TOP of this effect, we have wage growth, a part of which is inflation which, as you point out, is targeted at 2%. So in the very long run, we would expect prices to increase with  wage growth and interest rate changes would probably balance out. Over the last 30 years though, there has been the effect that interest rates have been continually stepped down, meaning there has been a continual increase to the price to wage ratio.

What might happen now as rates start rising, is that the house price to wage ratio is going to have to come down to a point that's sustainable at higher interest rates. This might be called "real" prices falling. The question I'm wondering is will inflation and wage growth be sufficiently high to stop nominal prices falling. As long as nominal prices don't fall, insolvency due to mortgage debt should not be a problem.

 

You make an interesting point that, cycles aside, long term house price growth averages around 5%. For my understanding (presented above and in original post) to be consistent with this, it would mean that wage growth (including inflation) would have to have been about 5% as well over the long run. This doesn't sound unreasonable to me. Whether growth continues to be that strong going forward is another (not irrelevant) topic.

 

I also agree with what you're saying on selection of location and property. For stock market investments, I'm of the opinion that it's foolish for retail investors to try to pick the best stocks, but for property investment I think the rules are a different, you can make a better or worse choice. You might be wrong, but you can give yourself a better than average chance of being right by choosing well.

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