An investigation into why London real estate has been such a brilliant investment
Over the past 40 years we have seen real estate prices go through the roof. Back in the day, a house was just where you lived. Now it is the middle class’ primary financial asset.
In 1975, you could buy a house in my now trendy then slummy West London neighbourhood for £5,000. Today, you would struggle to find one for under £1.5 million. It isn’t just London. A friend’s parents bought a vast Park Avenue apartment in the 1970s for $36,000. It must be worth $7 to $10 million today. We mock real estate chatter as the tedious obsession of middle aged dinner parties but it is not a trivial topic and serious students of economics can profit from examining the causes behind this spectacular 30,000% price hike.
The first and most obvious explanation is inflation. £5,000 was worth more in 1975 than it is today. Using a generous GDP deflator, our West London house should be worth six times as much, or £30,000. The Park Avenue apartment would have rocketed up to $216,000 if its present price were to be equivalent in 1975 purchasing power. Obviously we still have to go a lot further to explain why this investment has been so successful.
The next place to look is availability of credit. Ever since Nixon closed the gold window in 1971, the world money supply has skyrocketed. Despite monetarists’ predictions, all that cash sloshing around hasn’t driven up the cost of goods and wages but it has forced up asset prices. Central banks can create money at will. Land only God can create. If the supply of money rises and the supply of London property does not match it, obviously the price of the latter goes up.
And a thirty-year bond bull market has pushed interest rates to a fraction of what they were in the inflation ridden 1970s. Lower interest rates should make houses more affordable by reducing mortgage costs. But since we decide how much house we can afford by considering our monthly nut, instead of lowering our housing costs, declining interest rates merely goose asset prices. We probably all end up in the same house we would have bought anyway, but merely pay the previous owner a huge premium.
We can quantify how much easy money has raised house prices. According to all the finance textbooks, the proper price for an asset is the discounted present value of all its future cash flows. For a house, that is the rent it will earn in perpetuity, discounted by the current risk free interest rate. In 1981 the yield on the 30-year treasury hit 15%. Today it is barely over 3%, almost 12% lower. If we discount future rents by 3% rather than by 15%, the value of an asset rises around 600%.
Adding the effect of interest cuts to the inflation rate, real estate prices should have risen 3,600% and this seems about right for most places. My in-laws bought their place in Cardiff almost 50 years ago for £5,400 and inflation and the drop in interest rates together pretty much explain the value of their home today. But these are not nearly enough to account for the 30,000% London price hike. Inflation and discounted present value alone should make our London house worth £180,000 and the Park Avenue apartment $1.3 million. We have several multiples more to explain.
Part of the answer must be economic geography. In the 1970s, New York and London were in decline. Port and manufacturing jobs were disappearing and the white middle class absconded to the suburbs. Inner city became an epithet. Nobody with money or options wanted to live where I live today.
In the 1980s both London and New York began their transformation to world-class hubs for finance and media. These days, if you want a job as a derivatives trader or fashion photographer, you had better come here. Since clients and suppliers are centred in these cities the price of admission for a career in most glamorous industries is a London or New York address.
Of course, London and New York have been hip for some time. The empty storefronts and drug gangs that plagued my neighbourhood disappeared more than fifteen years ago. The economic geography bounce explains the 70s, 80s, and 90s. What explains the continued rise of London and New York real estate since 2008?
Brad Delong (and John Stuart Mill) tell us the flip side of lack of demand for consumption goods is a lack of supply of safe assets. The bubble created assets that seemed safe that weren’t. Just because a mortgage-backed security was rated AAA didn’t mean it held its value. Looking for investment opportunities today is a daunting task. Bonds yield 2%, shares still have stratospheric P/E ratios, governments can finance their bloated debts at yields lower than the inflation rate. In this environment, London real estate looks like a good deal. If you are an Uzbek millionaire who has made his fortune through connections with the local ruling clan, London property is the ultimate safe asset. Even if it does not continue to appreciate, at least you have a bolthole should things go wrong at home. Our respect for the rule of law means your property will be safe here no matter what happens to your factory in Samarkand.
Perhaps the best reason to remain sanguine about real estate as an investment is political. A crash would be good for the young and for first time buyers but it would be disastrous for banks and for the middle aged and middle class. Governments here and in America seem committed to not let house prices fall. Britain as a whole would probably be better off if we put our money into productive investments rather than into bricks and mortar but the economic health of much of the middle class is dependant on houses holding their value. A government that let them crash would probably be soon voted out of office. A rise in interest rates would devastate house prices and so our fragile recovery. Perhaps that is the most convincing reason to expect the Bank of England and the Federal Reserve will keep rates miniscule for quite some time. As long as banks keep lending, house prices can continue to rise.