Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 9 October 2012

Money Illusion in London Housing Market


It is a truth universally acknowledged that London property is a sure bet. The fact that property prices are at back at the peak is testament to the inherent strength of the market. Unfortunately neither of the two “facts” is correct. I've talked about why it isn't a sure bet earlier. Let’s deconstruct the myth of prices reverting to peak.

The London House Price index (Graph 1) certainly seems to indicate that the pre-crash peak has been surpassed.

Graph 1: London House Price Index











Source: www.landregistry.com, Author


However, the index is based on nominal prices. What matters to both house buyers and investors is real return. After all if you wish to fund your child’s education or your old age care costs through selling/mortgaging what is usually the biggest asset on your household balance-sheet then you need house prices to at least keep up with inflation. No point celebrating a doubling of house price if a cup of coffee triples in price. The London housing picture is no longer so ebullient if you look at the real house price index (deflated using UK RPI – Graph 2).

Graph 2: London House Price Index – Nominal vs Real













Real house prices are 8% higher than the post-crisis low but still 11% below the peak. Worse, they seem to have hardly budged over the last decade.

For non-UK based investors or those for whom London property is only a small portion of their global portfolio holdings, UK-inflation does not matter as much as the exchange rate. A large part of foreign buying of London property is based on the ‘flight to safety’ thesis. Whether capital flees economic turmoil (Europe) or possible expropriation (oligarchs/politicians from across the world), the assumption is that money in London property is safe and can be taken out whenever the need arises. This assumption is falsified if property prices increase but the Sterling plummets. Therefore one way to look at how global investors have done is to translate the HPI into dollar terms (Graph 3). Foreign investors are still 21% away from the peak even as European turmoil and Chinese capital flight have strengthened the Sterling and raised prices 36% above the post-crisis trough. In addition, real returns (based on an inflation rate appropriate to the foreign investor) are going to be lower.

Graph 3: London House Price Index – Nominal, Real, US$-denominated











Source: www.landregistry.com, http://www.ons.gsi.gov.uk, www.oanda.com, Author


It is not just money illusion which is responsible for the prevalence of the belief that London property is back at the peak. Selection bias is also responsible for influencing the post-crisis recovery story. The data presented to the general public is designed to capture attention rather than to aid analysis. The nominal HPI for London is often quoted. However, the aggregate house price index hides the radically different performance of various London areas. Newspaper stories of pricy mansions and foreign investors stampeding to London also sway perception towards the view that London property has made back all losses and more. Data show that house prices are at a peak in only 12 out of 32 London boroughs. And these are nominal peaks. Only 2 boroughs are at real HPI peaks and only 1 from the perspective of Dollar investors (Figure 1). The numbers would be marginally higher at 3 and 2 respectively were it not for a small decline in the HPI for Chelsea and Kensington in August.

Figure 1: London Boroughs at Peak HPI













Source: www.landregistry.com, Author


Effectively three boroughs - City of Westminster, Hammersmith and Fulham and Royal Borough of Chelsea and Kensington - are skewing the London housing market. This is apparent from tables 1&2 below which show how the best, worst and median boroughs performed over the last decade and since the crisis.

Table 1: Return over the last decade – Jan 2003 – August 2012
Return (annual)
Nominal
Real
In US$ (nominal)
Borough
Best
8.5%
5.1%
8.4%
Royal Borough of Chelsea and Kensington
Worst
2.0%
-1.1%
1.9%
Croydon
Median
3.8%
0.5%
3.7%

Top-3 average
7.5%
4.1%
7.4%
City of Westminster, Hammersmith and Fulham, Royal Borough of Chelsea and Kensington
Bottom-3 average
2.2%
-1.0%
2.1%
Barking and Dagenham, Croydon, Sutton
Source: Author, www.landregistry.com

Table 2: Post-crisis return – Jan 2009 – August 2012
Return (annual)
Nominal
Real
In US$ (nominal)
Borough
Best
10.5%
6.6%
12.1%
Royal Borough of Chelsea and Kensington
Worst
-1.5%
-4.9%
-0.1%
Barking and Dagenham
Median
3.1%
-0.5%
4.6%

Top-3 average
9.0%
5.2%
10.6%
City of Westminster, Hammersmith and Fulham, Royal Borough of Chelsea and Kensington
Bottom-3 average
-0.4%
-3.9%
1.0%
Barking and Dagenham, Bexley, Croydon
Source: Author, www.landregistry.com

Foreign buyers focusing on a narrow-end of the market (Figure 2) have caused a widespread misperception that London property is back at the peak.

Figure 2: Demand for London Property

















The theory of peak price is not true even on a nominal basis in most boroughs. On a real basis, only Camden apart from the three cited above are anywhere near the peak. Excluding these four, on average real prices are 15% below the peak (13% below including the four).

So the next time someone says that London property is back at the peak, do disabuse them of their money illusion.

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