19 Novembr 2015
Property is not a pension
by Frank O’Nomics
After a pre-fab shed in Peckham sold for just under £1mn last week it may not be surprising that an ONS survey of 10,000 households (released this week) showed that 44% of people think that property is the best way of making money for their retirement, with their pension from employment coming a distant second at 25%. Regular readers of celebrity interviews in the Sunday Times Money section, which asks the same question, will know that there it gets an even more emphatic response favouring property. Similarly, it will be no surprise that, following the adoption of new Pension Freedom legislation in April, £4.7bn has been taken from funds that would previously have gone towards buying an annuity and that the lack of commensurate flows into other funds suggests that a fair proportion of this has gone towards buy-to-let property, so that property effectively becomes a pension, at least for some.
Further support for preferring property over pensions appears to have come from the latest survey from the Royal Institution of Chartered Surveyors. A net 12% of their members report a rise in inquiries in October, and the RICS now forecasts 5% per annum growth for the next 5 years due to a chronic lack of housing supply. The latest house price index data shows that the average jumped by £2,500 in October alone, with the annual growth rate running at 5.2%. So, is this a one-way bet? Are we mugs not to get involved?
The view is certainly not all one way. Only last week, UBS pointed to the potential for a substantial turn downwards in the UK property market. Either way, most conventional investment logic would argue that over exposure to one asset class for a long period of time just doesn’t make sense – pension funds need to generate a pool of assets that can provide a steady income for 30-35 years, not just 5. A balanced portfolio is much more likely to protect your carefully accumulated retirement pot than a row of terraced houses in Hackney.
Interest rates will not stay low forever and, depending on the percentage of equity invested, buy-to-let properties could become uneconomic once they start to normalize. Indeed, without the continued escalation of house prices one could argue that buy-to let is already uneconomic. With mortgage rates currently around 3.5%, there is very little margin to be made from rents given that, after costs, rental yields struggle to beat this (in London at least). Further, the recent budget has undermined the tax incentives of a buy-to let mortgage by reducing the higher-rate relief by a quarter each year from 2017-2020, so that relief will then be restricted to just 20% on all mortgage interest.
The Council of Mortgage Lenders reports that the rise in household incomes, helped by higher real wage increases, has meant that the median mortgage payment from home owners has fallen to 18.1% of income from 18.9% over the last year. However, the rise in house prices has meant that the average loan-to-income ratio has had to rise from 3.06 to 3.16 for buyers to be able to afford to buy a new home. This has to be close to a ceiling on loan-to-income ratios. Not only will many lenders be reticent to offer mortgages at such multiples (unless they have very short memories) but many younger people will choose to rent rather than lumber themselves with such a heavy debt burden. As this undermines demand, a lack of new buyers will inhibit price growth.
Rental yields may be very similar to those of equities (the FTSE 100 index yields 3.14% currently) but, while equity valuations are also quite demanding on a historic basis, these assets are much more liquid. If you decide that you want to be more conservative you can sell your equities today, while selling a house takes several weeks in a buoyant market and an indeterminate time in a property downturn.
Will property price rises in the next few years be sufficient to outweigh a lack of rental income and protect pensioners from a future downturn? One can argue that the pick-up in real wages means that housing has become more affordable, and the shortage arguments are for the present compelling. However, the recent UBS study shows that, of the 15 cities it covers, London was the second most expensive, just behind Hong Kong. They argue that “price-to-income and price-to-rent values have surged to all-time highs” and that it would take a skilled service sector worker 14 years of average earnings to buy a 2 bedroom flat, compared to just 5 years in Boston and Chicago. London has been the prime driver of the rise in prices over the last year, but the average £24,636 increase represents 75% of the average Londoner’s salary.
The website www.housepricecrash.co.uk carries an interesting chart of national real house prices (ie after adjusting for inflation) since 1975. The trend level of 2.9% per annum may look attractive, but not against other asset classes, and the alarming downturns seen in the early 1990’s and after 2008 should be sufficient to worry the conservative investor. Over the last 10 years house prices are up 24%, which looks a poor return when compared to equities which have returned 60%. Clearly, one can be selective about the period of time used to assess asset price performance, and hence illustrate the benefits of one over the other. Further, periods of property price falls often coincide with an equity market sell-off so you are often choosing between two well-correlated assets. For this reason, it makes much more sense to have your pension in a properly balanced portfolio that has exposure to domestic and international equities, fixed income securities and, yes, some property. However, it will be commercial property that a typical pension will choose to invest in – largely for the income benefits. Any exposure to residential property will be little more than the house building subset of the equity market, or an investment in mortgage-backed securities (again purely for the income benefits). It is just not easy for large pooled pension vehicles to invest directly in residential property, and the fact that they will be deterred by the management costs and illiquidity should be more than sufficient to deter anyone managing their own fund.
These views will not be sufficient to undermine the UK housing market any time in the near future, and further price rises look quite likely. However, this does not mean that property represents a rational alternative to a properly balanced pension portfolio, one that is not over-correlated to one asset class and is managed to weather a full economic cycle. You have been warned.
