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by Neil Lewis, of
Property Secrets
The key argument put forward by the
Economist to justify an expected property price fall of 25% in the UK
(over 4 years) was the application of a p/e (price to earnings) ratio
to property.
We believe this is wrong-headed - but
creates buying opportunities for the property investor if vendors take
the dramatic advice of the Economist.
--------- quick explanation of
p/e------------------
p/e ratio: by dividing the price of a stock by its earnings, you get
the p/e ratio. Slow growth stocks typically have a p/e ratio of about
10. Faster growing stocks (that expect future earnings to increase)
have higher p/e ratios.
During the Dot Com boom, some telecom
and technology stocks had p/e ratios in the order of 100, and many had
a ratio of above 50.
With hindsight, we were are all a bit
stupid to think this was sustainable. Vodaphone's p/e ratio is
currently around 25.
--------- end of quick explanation of p/e------------------
The p/e ratio is normally used to
value stocks. And if, despite the exuberance of the tech boom, we'd
reviewed our stocks according to the long term sustainable p/e ratio
back in 2001, we'd have sold everything and made a fortune!
So, having failed to the predict the
stock market collapse of the past few years, the Economist seems
overly keen to avoid the same mistakes with property. Wrongly, I
believe.
Here's what the Economist says;
"The p/e ratio. The price of any
asset should reflect its future income stream. Just as the price of a
share should equal the discounted present value of future dividends or
profits, so the price of a house should reflect the future benefits of
ownership - either the rental income earned by a landlord or the
implicit rent saved by an owner - occupier.
"During the dotcom bubble, investors
behaved as if profits no longer mattered. Likewise, people today are
ignoring the link between house prices and rents
"The p/e ratio helps to expose the fallacy that house prices are
rising because of growing populations and fixed supply, because these
factors should affect the rental as well as the owner-occupier
markets.
"The fact that prices are rising much
faster than rents suggests that homes are being bought in the
expectation of capital appreciation rather than underlying
fundamentals. That is the definition of a bubble.
** What's wrong with the Economist's
conclusion?
The relationship between a property's
income (earnings) and price (capital value) directly affect each
other.
If one falls, the other rises and
vice versa (see section 2.2 of
www.PropertyDeveloperSecrets.co.uk for a detailed explanation) and
how this knowledge can help reduce the risk of your investment.
For instance, if more people choose
to buy first time properties than to rent, then rental demand will be
weak in this sector and so rents will grow more slowly than house
prices.
On the other hand, if house prices
rise more slowly then the demand will shift the other way. Thereby
driving up rents faster than house prices. This is already beginning
to happen in the first time buyer market.
Hence, the use of the p/e ratio as
applied to property, does not 'expose the fallacy that house prices
are rising because of growing populations and fixed supply'.
In fact, every time there is strong
capital appreciation in house prices, rents will rise more slowly.
Likewise, in a period of slow capital
appreciation (which keeps the first time buyer in rental
accommodation), rents will rise faster.
Hence, The Economist's analysis does
not disprove the argument that says that capital values are justified
on the basis of fixed supply and rising demand. It simply demonstrates
that rents are currently low and therefore are set to rise.
It is important for economists to
recognise that property moves in cycles (between rising rents and
rising capital values). This cycle does not apply to stocks and their
valuations, and so this method for valuing stocks does not imply a 25%
crash in property values over the next four years, as The Economist
suggests.
The circumstances which cause a
property crash (and not just a slower growth) are different. See below
for an explanation.
** An alternative conclusion - rents
to rise 25%?
Let's say that you agreed with the
logic of the Economist's argument that capital values are 25% above
the long term rental income.
In this case, you might just as
easily conclude that rents will have to rise by 25% (rather than
capital values needing to fall). This change in rental values would
bring back the balance to the p/e ratio.
In a scenario of slowly increasing
capital values (which we are now entering) this is a much more likely
indication of the future direction of the property market.
This alternative conclusion would
have a dramatic effect on the Economist's suggestion that you should
sell your house and rent instead. You shouldn't!
** So then, what makes a property
market crash?.
Okay, so what happened in 1989 / 90
/91 when house prices really did fall?
If you ask the CML (Council of
Mortgage Lenders) they will tell you that the key reason that people
defaulted on their mortgages was because they lost their jobs (not
because property was over valued or because interest rates went sky
high).
That is why the CML has been pushing
the concept of 'income insurance' for a mortgage ever since.
Losing your job is the number one
reason for a forced property sale. And a large number of forced
property sales can create a loss of confidence and a market crash.
So, if the level of UK unemployment
suddenly races up (from the current level of 5.1% to over 10%), then I
grant that the Economist's scenario of falling house prices will come
true.
However, there is no evidence of a
big jump in unemployment. In fact, average annual earnings growth has
recovered from 2.9% (this time last year) to 3.4% and even the UK
manufacturing sector is beginning to sound positive.
This does not look like 1989!
** Central London is the exception
Having said this, I believe that the
Central London market is different.
The Central London property market is
largely the preserve of City workers and Americans plus other
corporate relocators.
Since the dotcom bubble burst in
2001, the number of corporate execs, financiers, or tech gurus,
relocating to London for 1 to 3 years has crumbled.
Even the ever present American
tourist has stayed away from the short let apartments in central
London.
In this particular market sector, the
demand for property rentals is far more fluid and likely to expand or
contract much faster than supply. Hence, this market is much more
likely to overshoot in terms of prices up (and also, prices down).
** The rest of the UK is looking good
But Greater London and the rest of UK
is different. It is based on a domestic market whose population is
expected to grow by 12% between 1991 and 2021.
This population growth is a result of
people living longer as well as inward migration (as demonstrated by
the NHS's recruitment of overseas nurses and medical staff).
Another long term trend is the
reduction in the size of households from 2.51 to 2.36 (between 1991
and 2001).
These two effects mean that more
people are chasing fewer houses. (Note: this is not a dynamic effect -
happening over the next 6 months - it is a long term (30 year)
demographic change. Think of it like an enormous slow moving tanker,
it might be possible to turn it around, but it ain't going to happen
any time soon).
All in all, the property market looks
set to reward investors who patiently build portfolios based on good
rental income and long term capital growth potential.
More information about Property Secrets
is available from:
www.PropertySecrets.net
Copyright Property Secrets 2003
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