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Residential property as an investment

17 May 2016

A long term lesson in residential property as an investment...

In Amsterdam, just on the outskirts of the medieval city lies a canal. On the edge of that canal sits Herengracht, one of the most prestigious neighbourhoods in the city, built in the 1600s at the start of the golden age of Holland. Over time it has housed wealthy financiers, slave traders, diamond cutters and the like. It has always been considered a premium area, in one of Europe’s most prosperous cities.

Dr Piet Eichholtz, a professor at Holland’s Maastricht University, had a novel idea. As the Dutch are such meticulous record keepers, he should be able to construct a time series going back 350 years which showed the change in the value of housing, adjusted for inflation, using the neighbourhood of Herengracht as the basis.

We’ve all heard the refrain, adopted as fact, that property is a great investment. With that in mind, what do you think the 350 year investment return on housing in Herengracht has been? Over the complete 350 year period, housing in Herengracht has achieved a total return of (drum roll please) 250%! That’s a mere 0.2% real return per annum.

In an interview with the New York Times Dr Eichholtz said, "There is a myth which says that real estate values go up significantly over time, and that this is especially true for central city locations.

Perhaps this is simply a Dutch problem. Maybe in other, newer economies, we would find a different result. Actually, no.

Dr Robert Shiller won the Nobel Prize in Economic Sciences in 2013, in part for his work on a long run housing index for the United States going back to 1890. Apparently, Americans aren’t as meticulous record keepers as the Dutch so he couldn’t go back further. However, that still provides us with 125 years of data.

What did Shiller find? In the 100 years from 1890 to 1990, property prices in the United States were virtually unchanged on an inflation adjusted basis.

From around 1995 through to the mid 2000s prices went up sharply, and then dropped back to the inflation adjusted point.

In real dollar terms, the price of housing declined from 1900 until roughly the end of World War II. Economists at the time felt that was perfectly normal. Shiller explains in an article in USA Today ,

"Well, I think you have to reflect on the fact that it's done it before. Home prices declined for the first half of the 20th century [adjusted for inflation]. Economists discussed that back then. Why are they going down? The conclusion was...of course home prices go down. There's technical progress. They are a manufactured good. Back in 1900, homes were handmade, you know, [by] craftsmen. But now, in 1950, we can get all kinds of power tools and prefab."

Reflecting on the 100 plus years of data his housing price index represents, Nobel Laureate Robert Shiller concludes, “To me, the idea that buying a home is such a great idea is just wrong. They may very well decline for the next 30 years in real terms."

Could that possibly be true? Here are a few of Shiller’s reasons for thinking so:

  1. It’s happened before. Anytime, anywhere we have enough data, we’ve seen it happen.
  2. Homes go out of style. In USA Today he comments, “What kind of houses will they be building in 20 years? They may have lots of new amenities. They will be computerized or something in some way that we can't anticipate now. So people won't want these old homes."
  3. By just owning a home, you are not adding real value. What adds value is building a new home or improving a home; leaving a home simply sitting on a section isn’t adding new economic value. If that worked, why would any business bother to innovate, engineer and improve their products and services? Instead, they would just buy old stuff and hold on to it.

Of course, Shiller’s index tries to take account of the two key points that confuse most of us when thinking about the value of housing. The first is the improving nature of the housing stock. The average home in New Zealand just keeps getting bigger. According to the New Zealand Treasury , new dwelling floor area has increased from about 110m² in 1974 to just under 200m² now. You have to pay more for a much larger living space, but we shouldn’t confuse that with an investment return.

The other factor Shiller accounts for is inflation. Sure, Grandma may have bought her two bedroom home for £3,000 in 1955. £1 in 1955 would have bought what $50 buys today , so, all things being equal, that home should be worth $150,000 today just accounting for inflation alone. Of course, this doesn’t account for the significant money Grandma poured in over the years, into new roofing, flooring, paint, carpet, etc. It also assumes she didn’t have to address any major structural issues.

Nevertheless, what Shiller’s data does show is that over short periods of time there can be very large increases in the value of property. That’s what has been experienced recently in New Zealand, as well as around the world (see chart below from The New Zealand Initiative ). The problem is that it just doesn’t last long term.

House Prices Deflated By The CPI

The chart shows that New Zealand property has boomed recently, just like in the rest of the developed world. However, it also shows that, for 18 years from 1976 to 1994, housing in New Zealand showed very little (or no) price appreciation after accounting for inflation. That’s a long time for an investment not to perform.

Since the early 2000s housing has performed spectacularly. Unfortunately, the long term data tells us that this is an aberration, and not the rule.

This is essentially the warning that economists such as Reserve Bank Governor Graeme Wheeler have been highlighting. In a presentation to members of parliament recently, Wheeler said ,

"The house price to income ratio for Auckland is at nine. It's twice that for the rest of the country. A ratio of nine puts you, according to Demographia figures, in the top ten most expensive cities in the world. This is just dangerous territory."

Is residential property a great investment? It is if you don’t count the costs or factor in inflation. Perhaps it is if it turns into a forced savings scheme. It certainly is you are fortunate enough to live in a golden era of sharply climbing real property prices. But if you are on the other side of that climb, it will likely be an unhappy experience.

Recently, a 30-something living near Auckland remarked angrily that overseas buyers were pumping up prices. If this is the case, then it represents a huge transfer of wealth to New Zealand. Overseas buyers are purchasing property at top market prices, bringing a lot of money into the economy as a result. When prices go down these buyers are likely to have the least amount of stickability. As they sell back to New Zealanders, the difference between what they paid and what they sell at is nothing more than New Zealanders (legally) ‘picking the pocket’ of these speculators.

Does any of this contradict the experience of the many New Zealanders who have built wealth by borrowing, buying a house, gaining some capital appreciation, borrowing more and buying another house, etc? No. Those investors took big risk, and it paid off. The purpose of this paper is simply to provide some historical context to the true long term nature of the game they are playing, and to caution investors that there is really no long term precedent for housing to deliver more than a 0.5% to 1.0% real return. Given the recent boom in property prices, both here and abroad, investors should consider very carefully before doubling down on property investments in the coming years. For, as the Spanish philosopher Santayana said, “Those who cannot remember the past are condemned to repeat it.”