How to speculate in residential property
For most individuals, investing in housing will be the most important financial decision they will ever make. What is fascinating is that most of us make property investment decisions randomly, without thinking much about timing and expected return.
This post is aimed at providing a framework on how to speculate in property in a more intelligent way. The aim is to improve on the buy-and-hold model that most households employ. Instead of buying a house automatically when we turn 30 or 35, wait a bit or buy one earlier. Alternatively, buy a property elsewhere and use the rental yield to finance the payments for the apartment you rent at home.
One of the main benefits of property investments as opposed to stocks or bonds is the ease by which we can lever up the returns. 80% leverage is possible to attain in many markets, especially in the developed world. If maintained properly and demographics are stable, the price of the property tends to rise with wages in the overall economy. Using 80% leverage, even a 3% annual growth rate can give a safe 15% return on the equity portion of your investment – all else equal. What makes you certain that the economy will grow 3% per year? Nothing is certain, but with fiat currency and democratic elections politicians face pressure to grow wages and reduce unemployment. With such a backdrop, any politicians would prefer a low interest rate to a high one. Most savers would not notice the difference while unemployment would be kept to a minimum.
So which factors should we take into consideration before buying?
Credit and property
In history, property prices have typically moved in 10-20 year cycles. The main driver on both the upside and downside has been credit growth. Take any property market in the world and you will see a strong correlation between credit/GDP ratios and the average selling price per square metre.
It then follows that a perfect timing to invest in property is when overall leverage in the economy is low and the banking system has potential to gear up. We can quantify this potential with the following metrics:
- (Low) household debt/GDP ratio
- (Low) loan-to-deposit ratios for domestic banks
- (High) equity/assets ratio for domestic banks
- (Low) loan-to-value ratios in existing stock of mortgages
Once these conditions have been met, the potential for higher household leverage exists. Once credit growth has picked up, a reflexive process of higher property and collateral values, higher creditworthiness in the eyes of lenders and further credit growth can go on for decades.
But the potential for higher leverage is not enough. Borrowers also need to feel enticed to borrow and purchase a property. For borrowers it is important that:
- Mortgage rates are low in absolute terms
- Incomes are growing fast
- Everyone else seems to be making money on their property (causing envy, fear of missing out and hope for a quick road to riches)
The first two points should be considered together. Imagine that interest rates suddenly drops five percentage points due to pro-growth policies by the central bank. Would you be enticed to borrow and invest? Of course you will. The pick-up of economic growth on the other hand, will lead to accumulation of savings that households will need to invest somewhere. We can summarise these two factors by deducting the mortgage rate from the country’s income growth (nominal GDP). Some economists call this the “Wicksellian spread” – simply a fancy word for “carry”. Given positive carry, we can borrow at a low rate and invest in an asset whose cash flows grows at a much higher rate.
We should be careful simply extrapolating income growth however. If income growth is driven by increases in leverage, then growth will inevitably slow down.
In some cases, a high Wicksellian spread is driven by sudden increases in productivity. Or a sudden increase in money supply may put downward pressure on interest rates enough to spark a property boom.
Another factor is what is known as an S-curve, or acceleration effect. When poor people reach a certain income level, their propensity to invest in goods such as housing tends to increase multiple-fold. The reason is the high minimum cost of a motor vehicle or commoditized housing. Any household needs to make sure it can satisfy basic needs for food, clothes and hygiene before committing to buy a car or an apartment.
If the opportunity cost of investing in property is low, speculative demand tends to be high. That is a key reason why Chinese have put their money in property rather than in banks with their very low regulated deposit rates. The metric to watch here is the real rate on bank deposits, particularly if the currency is non-convertible.
Lastly, a low mortgage rate in absolute terms will make it easier for buyers to afford the monthly payment on their mortgage. Substantially lower mortgage rates therefore tends to boost property markets. But you cannot wait until interest rates are low. By then property prices will already have moved much higher.
Other demand drivers
Household formation provides steady demand for housing. In most countries, people want to own their homes. It is common to buy property when you get married and start a family. If household formation is well in excess of property sales, it is a solid anchor for future increases in property prices.
Demographics is a big part of the equation. The age group 20-40 years are the most important buyers. When this segment of the population grows in size, demand for property also tends to grow.
The supply of housing tends to be pro-cyclical and cause prices to be mean-reverting. Higher supply depresses prices and ultimately sparks a deleveraging cycle. Supply goes up when juicy gross margins lure developers to increase their pace of construction. As lead times in construction are 1-3 years, construction may overshoot when demand has started to weaken, leading to multi-year down cycles.
On the flipside, the perfect time to invest is when gross margins are so low that no developer wants to build. At that time, the replacement cost of housing will be higher than the cost of buying existing homes. The lower the existing inventory of housing, the better.
Using valuation ratios to sense-check the attractiveness of a property market
Valuation metrics for property are somewhat flawed as they don’t always mean-revert. From my experience, valuation ratios are good as sense checks, but growth and credit conditions may be just as important. The key ratios to check for any market are:
- Affordability ratios (price/household income)
- Rental yield, a.k.a. cap rates (rental income/price)
- Price/construction cost
- Real (inflation-adjusted) price
We can compare the ratios over time and between countries. Taxes, environmental regulation, transaction costs or demographic changes may cause historical averages to lose their significance. The elasticity of land supply and population density also differs between markets, so cross-sectional comparisons may not be meaningful either. One should be aware that in bull markets, buyers may rely on capital gains to finance down payments, which contributes to property prices overshooting on the upside. When property markets turn south, down payments will have to be paid from income rather than capital gains or debt. This will provide a floor for the property price. But as mentioned earlier, cycles may last as long as 20 years so one should not expect mean-reversion within a decade just because the ratio is somewhat higher than in history.
Best property markets in 2016
To conclude, this is the checklist we will need to tick off:
- Valuation metrics well below historical or cross-country averages
- Fast population growth in the 20-40 year old cohort
- Underleveraged households
- Banks have capacity and willingness to lend
- High Wicksellian spread (NGDP% – mortgage rate)
- Household formation above the rate of construction
- Low inventory in the existing housing stock
To start with Europe, valuation metrics in Northern Europe are off the charts. Wicksellian spreads are still positive as leverage is growing fast. It is hard to say how much longer the bubbles will last, but it is my belief that we are nearing the later stages. In Sweden, housing construction is turning upwards. In Norway, the economy is highly dependent on continued weakness in oil prices. Demographics in Northern Europe are acceptable. At these cap rates housing may have a bit further to go, but the banking systems are overextended with low capital ratios, high loan-to-deposit ratios and overleveraged households. Southern Europe has different problems: growth is anaemic due to their use of the (for them) overvalued Euro. Their banks are not healthy enough for a sustained property boom. I would guess real estate investments in these regions are dead money until the Euro finally breaks down. If I had to choose one European country to invest in, it would be Germany. Wages are kept low in relation to productivity and interest rates are very low in comparison to underlying growth rates. A D-mark is likely to be stronger than the current Euro.
The US property market is in a better position. Valuation metrics are close to historical averages. Thanks to immigration, the population growth is still positive. US households have deleveraged since the global financial crisis and now look healthier than they did in 2007. Banks are well capitalized, more profitable than in Europe and not terribly reliant on wholesale funding. Housing construction is not excessive compared to historical averages. American companies are strong and dominating in important innovation-intensive sectors such as software and pharmaceuticals. The country is overdue for a recession in the near term, but in the longer-term mortgage rates can fall further and productivity and credit growth can provide positive carry.
The Chinese-speaking parts of the world, and countries dependent on Chinese trade and investments seem to be in the late stages of property booms. This includes Canada, Australia, Hong Kong, Singapore and to a lesser extent resource-dependent countries in Africa and South America. Canada and Australia have very extended households. Loan-to-deposit ratios are among the highest in the world. China may have low household debt, but it is a poor underdeveloped country. Few of its citizens can afford commoditised housing. The primary reason for high property prices in these regions (including Vancouver, Sydney, Singapore or Hong Kong) is credit creation in China. We have now reached a situation where both domestic and foreign investors (mainland Chinese) are overextended. Valuation ratios in Hong Kong, Australia and large Chinese cities have reached levels only seen during major property bubbles in history.
Japan’s property market is similar to Europe in that weak demographics and growth has not been able to spark a lasting boom in property prices. Leverage has come down since the late 1980s when property prices peaked in absolute terms. Within major cities, you will find cap rates of 4% or so, while rural regions offer cap rates that are much higher. There is a large stock of empty housing outside of urban areas while urbanization and demographics outside of major urban centres are terrible. Given fixed 30 year mortgage rates of less than 2%, if you are Japanese you can borrow cheaply and collect a decent yield. As the world’s most overleveraged major nation, there is optionality in the government’s resolve to produce growth and inflate away its debt. If I were a Japanese saver, I would hedge against an inflationary scenario, either by owning high quality foreign currency or alternatively Yen-denominated fixed rate debt used to buy property.
So are there any regions in the world where property is genuinely cheap? My vote goes to mid-grade properties in Vietnam, and Iran. Vietnam’s economy is in the early stages of a new credit cycle since the 2009-2012 bust. Productivity growth in Indochina may be higher than almost anywhere in the world. Interest rates are high but have the potential of falling once restrictions on foreign investments are reduced. You can get cap rates of 6-10% without looking very hard, particularly in lower-grade property that foreign investors would not be interested in buying. With regards to Iran, its population is also highly educated and hard working. The country has been cut off from the world due to American sanctions, which will most likely be removed at some point. The housing market is in a deep slump with little interest from buyers. Exports of oil are shooting through the roof. Iranians abroad are turning home in droves to participate in the revival of the economy and take advantage of low labour costs. The Vietnamese Dong and Iranian Rial have black market rates close to the official exchange rates, which means major depreciations are unlikely. Most importantly, their banking systems are undeveloped and the gearing of the economy is higher than many other developing markets.