Dropping a brick
Jul 16th 2009
From The Economist print edition
Investors may be too complacent about the outlook for property
Illustration by S. Kambayashi
TWO bear markets in the past decade have made many investors reconsider their attitude towards equities. The argument that shares are the best investment for the long run no longer sounds quite so convincing. Property is not yet the subject of such disillusionment. Already, in the British residential market at least, estate agents are talking as if the crisis is over. Many people seem to assume that once the recession has finished, property prices can resume their traditional upward course.
But if equities are doomed to struggle, property will surely follow. The terrible performance of the Japanese equity market over the past 20 years is well known. It is easy to forget that property prices have suffered almost as much. Japanese land prices are still 58.5% below their 1991 peak, and indices of residential and commercial property are 44.3% and 73% below their highs respectively.
One should expect a rough link between equities, property markets and economic growth. Neil Turner of Schroders, an asset-management group, says a simple model suggests that property returns should equal the starting yield plus rental growth. In turn, rental growth is linked to income growth and thus to nominal GDP. On the same basis, equity returns should be equivalent to dividend yield plus dividend growth, with the latter linked to GDP.
Over the past decade, however, property seems to have performed much more strongly than equities. Only in 2008 did the IPD index of global commercial property show a negative return. But the 10.1% fall (in dollar terms) was a lot better than the 40.3% plunge in the MSCI world-equities index. Over the previous decade, from 1998 to 2007, an investor who put a notional $1,000 in the IPD index would have trebled his money (assuming he reinvested his income) while an equity portfolio tracking the MSCI index would have merely doubled.
Part of that outperformance may be the result of the stratospheric valuations on which equities traded in the late 1990s. Property values started from a much more reasonable base. But property’s relative stability may be an illusion caused by an illiquid market; values have simply not been marked down as much as they should have been.
The fact that British property returns were the second-worst of all countries in the IPD database in 2008 was not just down to a lousy economy. It was because British companies tend to be quicker to adjust values to reflect recent transactions. Other countries are slower to act, but the mask occasionally slips. Earlier this year the John Hancock tower, a Boston office building, was auctioned for $660m. It had been bought for $1.3 billion in 2006.
The Hancock deal was a distressed sale, of course. But other such deals will surely follow. In a recession vacancy rates rise, rental income stagnates or falls, and financing is both more expensive and harder to renew. David Skinner of Aviva Investors, a fund-management group, says that property prices since 2000 have been driven not by fundamentals but by the availability of credit.
Property was indeed a great investment at a time when financing was easy and recessions were occasional and mild. But that world has disappeared for a while. Even low interest rates may not help, as the Japanese example has illustrated over the past 20 years.
The naive belief that American house prices could not fall at the national level has been exposed by the current crisis. The belief that property prices must rise over periods of a decade or more may also prove to be false. Figures from Robert Shiller of Yale University show that real American house-prices were lower in 1945 than they were in 1900, for example. In a world of low inflation that means they could easily fall in nominal terms.
What about the argument that the result of this crisis will inevitably be inflation? Surely property would be a good hedge against such an outcome, as rents would be expected to keep pace with higher prices in the long run?
It sounds good in theory, but in practice the result of inflation would probably be a one-off rise in rental yields caused by a sharp fall in property prices. The 1974-1976 inflationary downturn in Britain saw cumulative commercial-property losses of 45%; yields rose from 5.7% to 8.7% between 1973 and 1975. Any increase in inflation would also lead to higher interest rates, causing further problems for leveraged investors. A strong economy is a far better backdrop for property than inflation ever could be.
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