How should you think about real estate?
Alexander Joshi, London UK, Head of Behavioural Finance
- All investors are subject to behavioural biases, and it’s no different when it comes to buying and selling real estate
- Last year took the wind out of the US and UK housing markets, although the prime central London market – which attracts wealthy investors from across the globe looking for coveted real estate – is proving more resilient
- And while your house is your home, it’s not uncommon for some investors to over-invest in real estate. This can bring its downsides, although real estate has historically considered a hedge against inflation over longer periods
- A portfolio diversified beyond real estate across asset classes, sectors and regions provides solid foundations for protecting and growing wealth
As a boom in many US and UK property markets peters out, and interest rates hit post-financial crisis highs, what is the outlook for investors?
Residential real estate interests many investors. Most own a home, or homes, but several also invest in property. There’s a tangible benefit and practical factor at play with owning property; you’ve also got a place to live or a regular monthly cash flow. There may also be an emotional connection involved too, even to the most hard-nosed investor, that can’t be measured.
So, as central banks started to lift interest rates aggressively last year, what has been the effect on the US and UK housing markets, and how might it affect investor behaviour? (European markets were discussed in Swiss ski properties scale new summits and Middle Eastern buyers refocus on Europe’s most valuable real estate).
US property prices on the slide
Investors tend to watch the US economy very closely. As the old saying goes — if America sneezes, other economies typically catch a cold. The level of interest rates is an important factor in sentiment in housing markets. Consequently, the US Federal Reserve’s aggressive hiking of the policy rate last year, from 0.25% to 4.5%1, took the wind out of the domestic property market.
As the base rate rose, so US mortgage rates climbed from 3% to 7% in 2022 and both new and existing home sales dropped, falling 40% from the January 2022 high.
Housing is the among the most cyclically sensitive sectors of the American economy, and property prices have started to fall; US house prices are down 2.5% so far from the 2022 peak, according to the S&P CoreLogic Case-Shiller index2. Building permits and housing starts are also down 25-30%, though construction employment has held up well.
UK property: a tale of two markets
Investors around the world tend to have a lot of interest in UK property. It can be regarded as a tale of two markets – London and the rest of the UK, both discussed in detail by Stephen Moroukian, Head of Product and Proposition for Real Estate Financing at Barclays Private Bank, in our Markets Weekly podcast – 13 February 2023.
Across the broader UK property sector, prices have slipped by just shy of 4.5% in the past six months3, after years of rapid growth. The average house price in the UK was £281,000 in December having peaked at around £294,000 in August last year. These are similar to levels recorded around March last year, and that’s still up 10% to 15% over five years.
This broad UK market is inextricably linked to the health of the mortgage market, and as in the US, mortgage approvals fell significantly in the latter half of last year. Approvals of 35,600 in December4, compares to a three-year average of 70,000.
Mortgage rates in flux
Fixed-rate mortgages peaked at 6% to 7% at the height of the UK ‘mini’ budget in September 2022. They are now comfortably falling and widely reported at just under 4% for a five-year period. This is still around double the lows in fixed-rate deals seen two years ago, and mortgage borrowers have shown increased interest in tracker mortgages.
The squeeze on household incomes from the rising cost of living and higher borrowing costs is, however, likely to continue to weigh on demand.
London: still a prime location
London, and particularly the prime central London (PCL) market, is behaving very differently from the rest of the UK.
As recently covered in London prime real estate shows its resilience, luxury sales are outperforming the wider London housing market. Among the drivers of this discrepancy is a weaker property buyers being less dependent on debt. 5
There also remains a continued shortage of stock for ‘best-in-class’ property. Lastly, the reopening of London, both to the UK and international buyers, as the COVID-19 pandemic recedes has occurred when the sterling/dollar exchange is favourable for foreign buyers. Indeed, this group of buyers are thought to account for almost half of all real estate purchases in PCL.
With a consistent excess of demand over supply supporting prices, PCL is expected to weather the anticipated market downturn better than most. Some predict a downturn in the area’s luxury market of 3% to 5%, while the country as a whole may see prices correct by around 10-15%.6
Real estate in the context of asset allocation
Not withstanding that for many people their house is their home, and thus much more than an investment, many investors tend to over-invest in real estate versus a sensible asset allocation for their own financial goals and circumstances.
One downside of such an approach is an over-concentration of property assets in your portfolio. Some may believe that because they are familiar with real estate this reduces the risk of holding it. However, by increasing portfolio concentration the opposite occurs.
Real estate has historically held its own against other asset classes. It is also considered to be one of the best inflation hedges over longer periods (of say at least ten years).
As the asset class return map below shows, real estate has been in the top half of annual performers three-fifths of the time since 2008. It has averaged annual returns of 6.4% compared with 6.8% for listed global equities and 3.7% for investment grade debt. However, over the same time real estate returns have been extremely variable.
When it comes to real estate returns, investors typically focus on house prices and capital gains. However, there are also costs such as insurance and servicing to take into account. As a result, the average market return is difficult to assess.
Real estate funds
Due to the capital-intensive nature of real estate investing, its requirement for active management, and the rise in global real estate opportunities, institutions seeking efficient asset management have been gradually investing in specialised real estate funds. The same is now true for retail investors, who can access a much larger selection of real estate mutual funds than before.
Many investors gain real estate exposure via listed Real Estate Investment Trusts (REITs) as well as specific illiquid funds. Equity REITs provide exposure to the income and growth return components that are comparable with those available in public equity, without suffering as much from the same expected compression in valuations.
On top of the expected return for listed real estate, illiquid funds offer an illiquidity premium and provide tax benefits and are less correlated with developed market equities.
However, many investors prefer to hold physical real estate, and the illiquidity and nature of the asset class can lead to behavioural biases.
Watch out for behavioural biases
Successful investing requires being aware of behavioural biases and knowing how to overcome them. Such biases can be particularly prevalent in real estate markets. This is due to a relatively high level of market inefficiency and intermediation relative to say equities and bonds; lower levels of information transparency; and being more emotionally attached to property versus other asset classes due to its tangible nature.
Many investors have a bias towards familiarity, and real estate is attractive because it feels real — you can touch a house whereas the stock market can seem far more uncertain and undefined.
Several investors also exhibit a bias called anchoring, or focusing on the capital gain based on the purchase price. This can lead to making selling decisions that are tied to the seller’s original purchase price, despite a very different market environment.
Comparisons to the stock market
Real estate feels real and investments less so, as such it’s important to think about what an investment portfolio is at the micro level.
Navigating market turbulence is a concern for many. Investors often think in terms of “the market” and assume that their wealth is tied to its gyrations. However, holding a well-diversified portfolio means that you’re not invested in the market but in companies.
When investing across asset classes, sectors and regions, an investor is holding shares in companies across the globe and these businesses create tangible products and services.
Whilst an investor might be less familiar with other asset classes that compose a typical investment portfolio, this does not necessarily imply more risk; quite the contrary. A diversified portfolio usually reduces risk and volatility. That said, real estate also has its idiosyncratic risks, such as those linked to its location or property type.
The importance of diversification
Real estate has provided strong long-term financial returns for investors in addition to its intangible benefits and risks. However, it would be extremely risky to hold all your eggs in a real estate basket, or any other single asset class.
In striving to protect and grow wealth over the long term for an acceptable level of risk, holding a well-diversified portfolio across asset classes, sectors and geographies is important. Within real estate this could be a mix of residential and commercial real estate, liquid and illiquid, in both public and private markets, spread across geographies.
A strong and robust investment process which leads to a well thought out strategic asset allocation to drive the core returns in a portfolio, using ‘satellite’ investments for tactical positioning to enhance returns and mitigate risks, seems a sensible approach to follow.