Property Follies

March 11, 2011

There has been a great deal of discussion about the causes of the most recent financial crisis, and the ensuing recession, with many conflicting suggestions about how to prevent a recurrence.  Last week’s issue of The Economist has a special report on one of the more mundane potential culprits: property (or real estate).  It argues that, although property is widely regarded as a relatively safe investment, it is in some ways one of the most dangerous of assets.

There were many reasons for the housing bubble that has now burst, from huge amounts of global liquidity seeking high returns to the rise of private-label securitisation. But it is striking how often property causes financial trouble. “We do not want to fight the last war,” says one European banking regulator, referring to property busts, “but the fact is that we keep fighting the same war over and over.”

There are a number of reasons to think that property investments are riskier than the common perception.  The first is the sheer size of the property market.  The article estimates that, even after the recent decline in prices, the total value of property in the rich world is something like $ 80 trillion (of which about 3/4 is residential), compared to about $ 20 trillion in all equities.  To make another comparison, the value of property investments is close to 200 % of the combined countries’ GDP in 2010.

Property, especially residential property, is also an inconvenient asset in many ways.  If you have a portfolio of stocks or bonds, you can sell a portion of it to raise funds.  It is hard to sell off a bathroom and a couple of closets from your house.  The property market also tends to be illiquid; quoted values are based, typically, on a small number of recent transactions; one odd deal can significantly affect the results.  And just wanting to sell a house does not guarantee that you will find anyone who is interested in buying.

Property is also the one asset where ordinary investors can achieve very high leverage, perhaps putting down only a few percent of the purchase price in equity.  Together with tax subsidies for mortgage interest, this leads, at least in the US market, to artificially high house prices.  Since the notional owners have so little equity, things can turn sour quickly when prices fall.  The article estimates that about 25% of mortgages in the US are currently “under water”: the outstanding balance on the loan is more than the property is worth.   The recent popularity of low-quality “liar loans” (with no income verification) and “innovative” securitization has hardly helped matters.

Commercial property is slightly less crazy, but even there, otherwise sensible investors can do silly things.  Quite a few years ago, when I was working as a pension fund consultant, one of our clients made a sizable investment in a commercial property fund.  The fund manager had shown them graphs of the steadily increasing value of the fund over the previous several years.  I pointed out that, if their equity managers were allowed to value their portfolios based on what they thought the stocks should be worth, the volatility of their returns would very likely be lower.  The client went ahead with the investment anyway.  Then there was an economic downturn, and they wanted to shift some money from property to another asset class.  Unfortunately, they had not read the clause in their contract, standard for real estate funds, that said that the manager could not be forced to sell property in order to meet a redemption request.  I don’t know if they ever got their money out.

Buying a house also is not a straightforward financial transaction:

…  if housing were simply a financial investment, buyers might be clearer-eyed in their decision-making. People generally do not fall in love with government bonds, and Treasuries have no other use to compensate for a fall in value. Housing is different. Greg Davies, a behavioural-finance expert at Barclays Wealth, says the experience of buying a home is a largely emotional one, similar to that of buying art. That makes it likelier that people will pay over the odds.

Perhaps some of this will finally sink in.

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