Which way to Invest?

UK Property Report

The UK is a nation obsessed with property. Property has a pervasive influence on our culture, economy and politics. It also divides the nation.

There are those who believe that “you can’t go wrong with good ol’ bricks and mortar.” It offers the combination of a solid income stream and long-term capital gains.

It’s hard to argue with that. History shows property has been a good long-term bet.

Even the financial crisis of ’08 only seemed to create a pause in the relentless rise of UK property prices. Prices fell for a few years, but it wasn’t the Armageddon scenario many expected. Instead, the market has bounced back and in many parts of the UK, house prices are near or even at record levels.

And unlike other ‘asset classes’, property will always have an intrinsic value because people need a roof over their heads.

A crowded island

Another key feature is its limited supply. In the UK, we live on a ‘crowded island’ with around 64 million people. That’s a lot of people in a small land. The supply of land faces serious constraints and with a growing population, demand inevitably rises.

For home buyers, you can understand their sense of urgency to get on the ladder, particularly in a rising market. It’s not a nice feeling to be ‘left behind’. And today, whether you have a 10% deposit or a 30% deposit, you can get a low interest rate – fixed or variable. So if you can afford the mortgage repayments, why wouldn’t you buy?

For investors, there is also a logical case for buying property. Cash at bank is earning next to nothing, yields on bonds aren’t much better and stocks can be volatile.

Whereas, renting out a property isn’t difficult and the yields are greater than the mortgage payments, giving an investor ‘positive gearing’. You get the capital gains, a bit of income and someone else pays off the mortgage. Sounds like a good deal.

Having said that, there are those who believe the property market is in the midst of an unsustainable bubble, propped up by dirt-cheap credit. The higher prices go, the more unaffordable property becomes, enslaving many to a lifetime of debt.

In the UK, the Bank of England has certainly played a big role in supporting the property market, slashing the base rate to all-time lows of 0.5%.

You’ve got a friend in me…

table-graph

In the middle of the financial crisis, this drastic cut was deemed an “emergency”. Yet over six years later, this so-called emergency rate is still in place.

Bear in mind, this venerable institution has been around for over 300 years. In that time, Britain has faced two World Wars, the Napoleonic Wars and the Great Depression. And yet the Bank of England never saw the need to cut the base rate below 2% during these calamitous events.

The new normal

The passage of time has made this extreme rate cut feel normal. In fact, it is normal relative to what’s happening in the rest of the world. The US has its base rate at 0.25%, the EU at 0.15% and Japan at 0.10%. Near-zero is the new normal…for now.

The purpose of this policy was to prevent the collapse of the global financial system. Banks were overleveraged and undercapitalised all over the world. Near zero rates would buy them time, allowing their balance sheets to deleverage in a more gradual fashion. We were meant to emerge with a smaller and safer financial system. But in economics, there is often the law of unintended consequences.

There is now more debt than ever before. According to the McKinsey Global Institute, the global economy has surpassed the (pre-crisis) debt levels of 2007. In aggregate, households, governments and companies have all taken on record levels of debt.

The point is today’s ultra-low interest rates have provided a major market distortion. Property owners (and governments) can ‘afford’ to borrow more while rates are this low. What’s more, the longer rates stay this low, the more borrowers believe they will stay down forever.

Yet it wasn’t so long ago that 5% was considered a very low rate. In the 1970s, the Bank of England base rate moved in a range between 5% and 17%. In the 1980s, the range was 5% to 16% and in the 1990s it was 5% to 14.8%.

Can you imagine how borrowers would cope today with rates in that sort of range?

This isn’t ancient history. It’s three decades in the lifetimes of most British adults. It illustrates how quickly we forget the past and base our expectations of the future on only the most recent events. But fear not…

Turning Japanese?

It is possible for rates to stay low for decades. Japan has proven that.

After a major asset bubble during the 1980s, the Bank of Japan raised rates in the early 1990s to quell speculation. The bubble burst and the value of house prices collapsed, along with everything else.

By the mid ‘90s, Japanese rates had been cut to near-zero, in an attempt to revive the economy. They’ve stay there ever since, but it hasn’t worked. Japan has undergone two ‘lost decades’ (and are in the middle of a third) characterised by chronic deflation, low interest rates and low growth.

Land prices today are sitting at less than half their peak value some 25 years later. In the six biggest cities, the percentage falls are even greater. This is despite the fact that Japan is an even more ‘crowded island’ than the UK.

Central banks, including the Bank of England, are obviously keen to avoid a similar deflationary cycle. And yet they have followed in Japan’s footsteps – embracing both quantitative easing (QE) and zero interest rate policy (ZIRP).

In 2015, the UK looks set for deflation for the first time in 55 years. The Bank of England has publicly played down the risks saying it was “unlikely to endure for very long”. Time will tell.

That’s the thing with macro risks. Many a storm passes by without serious damage. And every now and then, one comes along that wreaks havoc.

Right now, there are few signs of an imminent property crash in the UK.

Mortgage lending is fairly stable and the government is very supportive of the property market (Stamp Duty reforms, Help to Buy scheme).

The economy is delivering growth on the back of falling unemployment, low inflation and low interest rates. That’s a recipe for house price gains.

Having said that, it would be hard to imagine another boom is around the corner. Interest rates are already at rock bottom levels, the government has already done what it can to stimulate the market and affordability is stretched (the ratio of average house prices to earnings is well above its long term average).

Summary

It is my view that the Bank of England is likely to raise rates later this year, along with the US Federal Reserve. Given the lack of inflationary pressure (prices are actually falling), I don’t envisage big rate rises, but locking in a fixed rate now looks prudent. That will at least remove interest rate risk.

I can see the merits of buying property as a homeowner or investor. As stated previously, property has an intrinsic value and a history of long-term capital appreciation.

However, the dark side of property is debt. As the Chinese proverb goes “man see’s the bait but not the hook”.

Asset prices can go and up and down, but the debt doesn’t move unless you pay it off.

There’s no magic formula for managing your money. Buying what you can afford and not overleveraging yourself are two timeless principles of property ownership.

About Which Way to Invest

As it suggests, Which Way to Invest helps private investors decide where to invest their money.

Importantly, the research is completely independent and has not received payment (directly or indirectly) from any of the companies mentioned in this report.

Between us, I have more than 29 years’ experience working in the financial services industry. So whatever your interest, I’m here to help.