House prices & biases

Polly Toynbee wants us to come off the house price drug. She says:

Property speculation is hardwired in the British brain after decades of a one-way bet - with only a few small blips.

This statement is both true and false. It’s true in the sense that the Brits have traditionally seen housing as an investment. But it’s false, in the sense that this investment has not yielded spectacular long-run gains. My chart shows this. It shows the ratio of real house prices (from the Nationwide) to real GDP. You can see that over some long periods this ratio has barely risen at all. Since the end of 1955, house prices have risen 2.7% a year in real terms, whilst GDP has grown 2.4%.
Over the long-run, house prices rise more or less in line with GDP.
Granted, this is better than shares, which have risen 1.2% a year (ex dividends). But it’s not a fantastic gain. Which raises the question. Why, then, have people thought that house prices are a good investment?
One reason, stressed by Akerlof and Shiller in Animal Spirits (which I’ll be reviewing soon), is money illusion. If you’d bought an average £20,000 house in late 1974, you’d now have an asset priced at just over £300,000. A great gain? Not really. Prices have fallen relative to money GDP. Most of the gain is just inflation.
A second reason is the availability heuristic. My chart shows that prices have soared since the mid-90s. It’s natural to weight this evidence more heavily than evidence from the 70s showing that prices can fall relative to national income. But it’s wrong to do so.
Thirdly, house price gains come for free. I don’t mean they are free of tax - so are stock market gains within pension funds. I mean they come on top of the consumption benefits of housing.  I can invite laydeez round to my house, but not to my Scottish Widows tracker fund.
Fourthly, there’s a self-serving bias. If we hear news of a neighbour’s house selling for a given sum, we assume our house is worth more because we have such good taste that  our home improvements are so much better than theirs.
Finally, there’s an “out-of-sight” bias towards risk. Every night, Robert Peston tells us how much share prices have fallen. But he doesn’t say every night: “you’ve lost another £300 today on your house” - even though this is the average daily loss someone would have suffered on a £400,000 abode over the last six months. The result is that we regard shares as much riskier than our own home; remember - individual house prices are much riskier than house price indices.
There are, therefore, a number of biases leading people to overweight the gains from property speculation.
But should policy-makers do anything to combat this, as Polly asks?
Maybe not. I suspect that house prices will fall further, and for some time. Perhaps, then, the passage of time alone might wean people off the property drug - for a while.

Comments

[jdc]

Also you can borrow to speculate on housing much more easily than on shares. If you got a 90% mortgage on your £20,000 house, then you haven't turned £20,000 into £300,000 - you've turned £2000 into £272,000.

[Luis Enrique]

Point 3 is often overlooked - buying the house you live in can be seen as investment relative to renting your house, and the return on investment judged by comparing flow costs and capital gains in the two scenarios.

I think housing you don't live in (buy to let) got a reputation as a sure fire investment just because rises in house prices make for huge returns when you are leveraged. If you put £20,000 down on a £200,000 house, stuck some tenants in it to cover maintenance and mortgage interest payments, and sold it for £240,000 a few years later, you get a 200% return. Hard to do that on the stock market! The ease of finding tenants made this look like a low risk very high return investment strategy.

[Luis Enrique]

ah - beaten to it by jdc

[William]

It's also because the alternative to a house is a flat. If you get the right mortgage, the total interest paid is less than the total cost of rent, so you're ahead.

[Curly]

Just what, exactly, is the woman arguing for?

[dearieme]

"Most of the gain is just inflation." Fair enough, but how many investments are available to Joe Bloggs that give him decent, albeit erratic, protection from inflation? Lots of people have vague memories of hearing about the great Weimar inflation.

[Ted]

I'd be interested on your thoughts as to why the cost of housing should track GDP anyway.
Virtually everything else we consume expressed as a ratio of GDP is much more affordable now than it was in the 1950s. Why not houses? It must be due to planning restrictions, cos it surely requires less labour to build a house nowadays with JCBs, advanced industrial construction materials etc. etc. than in the 1950s. Is it all down to rises in land values? What is the "economic libertarian's" view on the property ponzi scheme we are running where, when it comes to housing, all the cumulative technological and economic growth we've gone through in the last 50 years does not translate into any improvement in standard of living in terms of being able to buy a nice place to live in (ignoring the added value of a few improvements to homes like central heating that happened over this time). Or am I missing something, like the effect of inherited wealth?

In the US, apparently, house prices (per square foot) have apparently been rising roughly with CPI over the long term. Houses over there are more expensive in real terms than 30 years ago but they are generally much bigger nowadays. This makes a lot more sense to me.

Ta!

[wonderfulforhisage]

One huge plus to buying with a mortgage is that the principle borrowed isn't subject to inflation. So if I borrowed say £100k 25 years ago I now have to repay only £100k whereas the value of my house is perhaps £700k. The interest I paid on the £100k over the years will be roughly equivaltent to rent had I not bought.

[Current]

All this talk of supposed biases misses some key points.

Firstly, tax breaks. Yes there is a tax break on a pension sure, but it also comes with a huge management fee, a house doesn't. Also, even with a pension the income is taxed when you earn it at the end. Quite likely at a much higher tax rate than those we are enjoying today. The same is not true of housing. If you make a profit you can keep it, it is not classed as income but capital gain. The tax breaks for housing are clearly much better than those for shares.

Secondly, shares have not performed so well. So, where should we naive investors put our money then? Where can we get a return equal to the economic growth rate? The answer is we can't. Economist have shown that such returns cannot be achieved, see the writings of Arnott & Bernstein.

I think the biases are irrelevant here. People are acting reasonably rationally under the constraints of the problem.

[Alex]

Regarding money illusion, remember that even if much of the gain is just inflation, you almost certainly borrowed the £20k - and there's nowt illusory about the effect of inflation on your debts!

[kinglear]

I know quite a lot of laydeez who would happily be invited to look over your Scottish Widows fund

[Luis Enrique]

Is Polly proposing taxes on capital gains realized upon the sale of a main residence? So if you want to move house you have to pay twice if you want to afford a house of equivalent price - once to the tax man and again to make-up the money for the new house. That'll do wonders for labour market flexibility.

[madjay]

No Luis. Firstly, there is no reason why
the total tax rate should increase. The gains
can be used to reduce income tax and increase
purchasing power, so that
we are not focusing the tax burden on hard work and letting
dumb luck get away tax free.

Secondly, capital gains tax will act as a
shock absorber on runaway prices. There will
be less money from those trading up or
(even more importantly) down inflating the property bubble. So
those who are not asset loaded would be better off.

A stable, damped housing market will help labour flexibility - it is wild gyrations that, as well as being outrageously unjust,
trap workers in negative equity.

[Luis Enrique]

madjay,

but if taxes from property capital gains are offset by, say, lower income taxes, that will still increase the relative price of moving house (if you don't move house, you enjoy the lower income tax but not the moving house tax)

I'm afraid I can't figure out what you mean by your second point.

On your third point, you are right that negative equity depresses labour market flexibility, I hadn't thought of that. But house prices are not typified by wild gyrations - we had long periods of rising prices, during which labour market flexibility was not inhibited.

[Nick Rowe]

2.7% real, tax free, PLUS somewhere to live? Sounds very good to me!

[Giles]

Another important point, related to dearieme's about their value as an inflation-hedge, is that a house is an asset providing reliably a service (a roof) that you need, and therefore costlessly matches a liability (the need to keep dry every day) against an asset (the house) without any risky fluctuations. If property is about 20% of our expenditure, a significant chunk of the risk of living is taken away by actually owning the house.

So I bought my house (in 2007) on the understanding that I needed to 'lock in' my South West London housing services for the next 30 years, not as a speculation. The fact that, in euro-terms, it may now be 40% cheaper, is not relevant to my needs.

[madjay]

Luis,

OK - I hold my hand up, I didn't read your
post carefully enough. In the very specific example you give of someone buying
another house of equal value, CGT might increase their moving costs. But that depends
on how the policy is implemented; you could
allow some or all of the gain to be tax-free if reinvested in your PPR.

I would disagree that this long mad boom has
had no impact on labour market flexibility. Lots of people I know have been deterred from moving from the North to the South East because, unlike in your example, an equivalent house cost far more. It seems sensible that house prices will tend to rise most where the jobs are. It is people like that who would benefit from higher post-tax income and a housing market damped by CGT.

In any case, I suspect that the impact of CGT on labour market flexibility would be outweighed by
the benefit of a level playing field between
investment in housing and other assets, before we even begin to consider the equity arguments.

[Matthew]

I'd like to add to Giles' point, which follows on in a way from Dearieme's, which is that as housing is a service you will need all of your life, then a bought house is one of the very few things that you can buy now and reliably predict you will consume when you are retired and not producing anything. So it takes a lot of uncertainty from consumption, and especially in retirement.

[Luis Enrique]

apropos of not very much, I'd have thought taxes on property capital gains would also impact the incentives to maintain and improve property. I know people who buy properties, sling in some a cheap wooden floor and ikea kitchen have a bad name, but there's more to property renovation than that, and upkeep of the housing stock strikes me as a pretty useful activity.

[removal service london sw7]

Taxes on properties can easily be avoided if purchased or sold in a Trust. This will be a good option for people writing a will.

[Property in Turkey]

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