Targeted for its perceived defensive qualities, does residential really deliver what investors expect? Dirk Brounen and Tak Lam investigate
After decades of double-digit investment returns, real estate investors today face a new outlook in which success can no longer be taken for granted. Now the economic crisis has highlighted the amplitude of the business cycle, investors have started to seek investment markets that are less prone to the turns of the economy. Residential rent payments are considered to be less volatile and house price dynamics relatively stable.
We have empirically analysed the investment profile of residential price returns, using 40 years of house price history. We focused on the investment appeal and outlook of the Dutch housing market and benchmarked this to the corresponding time series of France, Germany, Italy, Japan, Sweden, UK and US.
What does the Dutch residential investment market have to offer? Real estate generally provides four investment virtues: strong returns; low risks; good diversification potential; and protection against inflation. We put these virtues to the test.
Key in the investment appeal of any investment market is the evolution of prices. House price trends have been rocky in recent years. The credit crisis has weakened house prices almost universally but we have documented positive price return over the long term in all eight markets in our sample. Over the full 40 years of price history since 1970, the Italian housing market has provided investors with returns of 10.3% on average. The German housing market offered the lowest returns when considering the full sample, and Japan has performed remarkably weakly since 1990. The Dutch housing market offered investors and homeowners a steady yield of 6.5% since 1970. But to better assess the stability of this return, we need to turn to the standard deviations of these price series.
Generating high returns in exchange for greater levels of risk is not appealing to liability-driven investors. Managing investment risk has become key ever since the volatility of stock markets erupted in 2008. To measure the price risk levels of the seven housing markets in our sample, we computed the standard deviations for both the full and sub-sample periods. In line with the return analysis, we found that Italy comes first again. The high Italian returns come at the price of double-digit risk measures. German housing, meanwhile, only becomes a low price-risk market during the second half of the sample period. Perhaps a bit surprisingly, we find that the US price series are the most stable, when considering the longer term.
Obviously the tremors of the credit crisis have changed this over the past five years, and there has been a vast disparity in price performance across the eight markets. Japan and the US especially have been hit hard by the effects of the credit crisis. In markets like Sweden and Italy, house prices continued to climb as if the economic downturn had not taken place. The Dutch housing markets used to be one of the more volatile in our sample. Especially during the late 1970s, when Dutch house prices fell by 25% due to a sudden spike in mortgage rates, the Dutch market was one of the riskier ones in Europe. But since the early 1980s the Dutch risk profiles flattened to lower levels.
A third important investment virtue of real estate is the diversification potential. In line with the modern portfolio theory, we assume that prudent investors like to spread their portfolio to reduce the overall risk. To achieve this risk reduction, low correlations are key. In table 3 we state these correlation coefficients for the different housing markets with European stock, bond and cash returns. We assume that European investors typically construct portfolios along these three standard investment categories, and the correlation coefficients offer us a good indication of the diversification potential that each housing market has to offer.
Overall, the correlations underline the fact that adding housing into a mixed-asset portfolio can effectively decrease the risk exposure. Almost all coefficients are close to zero, or even negative, indicating that portfolio risk is likely to drop once housing allocations increase. The Italian housing market has the lowest correlations to offer, with negative correlations for all three asset categories. The Dutch housing market also fits the profile of portfolio diversificator. The highest correlation is with European stock returns, which is only 0.07.
Besides mastering the balancing act between return and risk in their portfolios, most investors also need to contend with the eroding effects of inflation. The large liability-driven investors, like insurance companies and pension funds, especially need to be able to generate portfolio returns that continuously exceed the inflation level. Academic research has demonstrated that both stock and bond investments fail to deliver any protection against the swings of inflation and even lose value when inflation rates run up.
We have put our housing figures to the test and assessed the ability of house price returns to hedge against the European CPI dynamics. In table 4, the correlation between house prices and inflation levels are stated for short (one year), medium (five years) and long-term (10 years) investment horizons. High correlations here indicate a strong ability to hedge against the hazards of inflation risk. Except for Sweden, we found evidence for inflation hedge capacities for each housing market, especially when considering the medium and long-term investment horizons. Buying and holding for 10 years means the correlation between the European inflation and Dutch house prices rises to 0.77. In other words, in the event of an increase inflation pressure on the liability side of the balance sheet, the odds are strong that Dutch house prices have increased at the asset side.
The price performance of housing markets is to a certain extent a function of local market microstructure.
To reap the fruits of residential returns, investors need to implement an investment strategy that provides investment access to the local housing market. A first and prime condition for this access is the market structure of ownership. Figure 1 plots the 2010 homeownership levels, which range between 33% in Japan to a staggering 77% for Italy. Considering the statistics of the first part of our study, one might want to include the Italian housing market in the investment portfolio, since it offered the highest returns and the biggest diversification potential. But in a market where 77% of the assets are owned by the users, investment access is restricted.
At the other end of this spectrum, we find that two-thirds of the Japanese housing market is rental, and therefore appealing for investors to get involved. Unfortunately, the Japanese price dynamics have so far proved to be the weakest. The Dutch housing market offers a balance between both. The investment profile of the Dutch housing market offers the performance virtues, and at an ownership level over 56% the market is not dominated by homeowners.
Figure 2 shows the breakdown of the national rental markets in our sample. The Dutch rental market is strongly dominated by public housing. More than a hundred years ago, Dutch authorities designed housing associations that supplied affordable housing for the financially challenged in society. Today, more than 2.4m homes are owned and managed by these housing associations. For these homes, rents are low compared with the market rates, partially due to the indirect financial support that these housing associations receive through government sponsored funding.
This dominance in the rental market has been widely criticised by both Dutch and European policymakers. The main concern is the distorting effects of government support on the competitive forces within the rental market. On the one hand, investors in Dutch housing will benefit from this market structure, as the social housing component functions as a natural buffer limiting the supply of homeownership and in a sense supports current price levels. On the other hand, commercial landlords need to compete with a vast supply of relatively cheap rent alternatives.
In the next 10 years this situation is very likely to change. Political pressure is catalysing the privatisation of parts of the social housing markets. Various sale programmes are currently being developed that offer tenants the opportunity to buy the rental home and thereby gradually reduce the market share of the public rental market.
The demand for homeownership is facilitated, and in some cases even stimulated, by the financial and fiscal arrangements provided to finance the acquisition of a home. The Dutch mortgage market stands out internationally, and is often misunderstood. Figure 3 shows the relative size of the total residential mortgage markets as percentage of the annual GDP in each market. The Dutch mortgage market is clearly large. In relative terms it is among the largest in the world, which has recently raised concerns after the credit crisis demonstrated the latent risks associated with sizeable debt.
This size of the mortgage market is not just a reflection of the aforementioned homeownership ratios. Italy for instance, having the highest level of homeownership, has the smallest (in relative terms to its GDP) mortgage market in our sample. This cross section in relative mortgage markets is stronger related to mortgage standards. But these Dutch numbers are somewhat inflated by the fact the mortgage related saving deposits are not incorporated. Contrary to most other markets, the Dutch mortgage market has a tradition of mortgage savings deposits that are used to eventually amortise part of the mortgage loan at the end of the term. At the moment, the sum total of these deposits equal 19% of Dutch GDP and, when accounting for these numbers, the Dutch mortgage market is comparable to the UK and Sweden.
The vast disparity in the size of mortgage markets is mainly a function of the available tax incentives. The Dutch mortgage authorities are the most generous when it comes to tax shields for homeownership. Of all the sampled markets, the Dutch is the only one in which mortgage interest expenses are fully tax deductible. The resulting tax shields stimulate homeowners to maximise their debt exposure and fully finance their homeownership. Currently, there are no direct indications that the prevailing fiscal arrangements will soon be reformed in the Dutch market. Earlier reforms in markets like the UK (1963-2000), Denmark (1987) and Norway (1992) have demonstrated that a careful and well-timed tax restructure does not need to result in sharp house price declines.
Another important factor that may drive house prices up and down in the years to come is the affordability. Obviously, this is partially related to the tax and mortgage structures available in these markets. At the same time it is important to assess whether the current house price level and disposable income in these markets correspond. Figure 4 plots the ratio of average housings costs over the disposable income as a measure of affordability. This shows that housing is rather affordable in France and Italy.
In both markets, we know that homeownership has a tradition of generational inheritance without mortgage duties. In other words, housing costs are low in these markets because financing is less of an issue. In Germany and the UK these housing costs are relatively large, partly because mortgaging is more common and not (or almost not) subsidised by governments.
The Dutch affordability rate is at a mid range, hovering around 26%. On the one hand, we know that mortgaging is very common and prominent in size. On the other hand, a large fraction of these mortgaging costs are alleviated by the tax shields in place. Affordability, measured here as the fraction of net housing costs over the disposable income, is sensitive to a large variation of factors. These include the interest rate and income level, which results from the economic business cycle. Furthermore, we know that the government factor is important as it can provide tax burdens (local taxes, transfer taxes, and so on) and tax reliefs. Moreover, the house price level itself is also important for affordability. From a Dutch perspective, we can now conclude that the current level of affordability is not a reason for concern as it is at the mid range of our sample, and there is no clear indication that any of the driving factors are about to drift away soon.
Figure 5 shows population growth across the eight sample markets. We computed the average annualised population growth number for the past 40 years. This number has been positive for nearly every market and ranges between a staggering 1.65% for the US and -0.11% for Germany. We also studied the demographic projection of the world population prospects of the demographic institute of the UN. We have listed the expected annual population growth rates for the next 20 years (2030), 40 years (2050) and 90 years (2100). This outlook varies greatly across markets. On the one hand we have growth markets like the US, France, Sweden, the Netherlands and the UK. Here population is likely to expand over the next decades. For Italy, Japan and Germany a decline in population is more likely. This implies that future demand for housing in these markets is likely to reduce also.
Population numbers are not the only factor at work. Changes in household size and demographics can influence both the quantity and quality of future housing demand. These trends, however, are more alike across these markets.
Dirk Brounen is professor of real estate economics at Tilburg University. Tak Lam is CFO at Amvest