If you own a house, and your mortgage payments are eating up so much of your monthly income that you can’t find 5-10% of your money to invest then sell the house and downsize.  I appreciate this may seem like a fairly dramatic course of action but it is the one course of action which can get you results in a reasonably short period of time and will help set you up for life.

One of the primary causes of the financial crises in the US and Britain has been our unhealthy obsession with home ownership and a widespread failure by many people to understand how to value property over time as against the other main assets you might put money into:  Shares, bonds and commodities.

We have lived through twenty years or more of most people believing that “you can’t go wrong with bricks and mortar” or that “rent is throwing money away paying someone else’s mortgage.”

These are simplistic beliefs that are often entirely incorrect.  Like all assets, sometimes property is good value and worthy of investment, at other times it is dangerously expensive.  Many rich people understand this and always have.[2]  Given the above, it is worth taking a closer look at property and how to value it.  The decisions you make about it will have a huge impact on your wealth over a lifetime.

Many people in the English-speaking world feel familiar with property as an asset class.  There is a long tradition of owner-occupancy in countries like the UK, America and Australia which is less the case in many other countries in the world, including wealthy European nations such as Germany and France.

House prices are a national obsession in the UK and US and regularly discussed in the press.  Houses tend to be an individual’s biggest asset and there is also an inevitable emotional attachment to one’s primary property over and above the attachment one might have to a share or any other type of investment for obvious reasons.  You can’t live in a share or a bar of gold, clearly.  The problem with this is that many people feel they are “experts” when it comes to property and never more so than in the last twenty years.  There is nothing like a rampant bull market in an asset class to make everyone feel like a genius.

In reality, it is intriguing how many folk prognosticate on the housing market without understanding any of the key long-term measures of value or issues such as the impact of inflation and interest rates on the market.  This is a very similar point to the one I have made elsewhere on the blog about how many people investing in shares don’t understand how they are valued.  Property is likely to be your biggest investment.  It would make sense, therefore, to really understand how it is valued.

Nearly all of the estate agents I have ever dealt with in London who confidently hold forth about the state of the property market demonstrably fail to grasp much, if any of what follows.  This is entirely analogous to just how many financial advisers only have knowledge about only a limited sub-set of financial markets.

So how do we value property?

The first thing to say is that over the long run and I am talking about over three hundred years of data here, property is absolutely not the “sure thing” which most people have come to believe it is in the last twenty years or so.  “You can’t go wrong with bricks and mortar…” can be a very dangerous and entirely incorrect statement.

Anchoring

A facet of human behaviour long highlighted by psychologists, especially in the realm of finance is that we tend to have relatively short memories and this leads to a phenomenon known as anchoring.  Basically what this means is that, if something has been true in your personal experience (eg, ever-rising house prices) you will tend to assume this is the normal state of affairs.[3]  We tend to assume something that has been true in our lifetime or an even shorter period will continue to be true.  Our current obsession with property is a good example and understandable given we have witnessed a relatively long and very strong bull market.

A more extreme and potentially more illustrative example of anchoring and the trouble it can get us into would be the dot.com boom of the late 90s.  Amazingly, it took only about two to three years before a very large proportion of people and even the supposedly professional investment community had become dangerously anchored, thinking:  “Technology stocks always go up and are not subject to the traditional rules of stock market valuation.  It is different this time.”  We are all aware how this ended for most of the participants in that market.  Lots of people lost a great deal of money.

It is best we are aware of anchoring and other similar behavioural traits each time we consider a market.  To get a truer picture of things, smarter investors will do their best to look at a much longer time frame, difficult though this may sometimes be.  If we do this we will see that as with any asset class, over the long run property performs extremely well at certain times and extremely poorly at other times.  Given the experience of the last twenty or so years, it may come as a surprise to many readers that…

…UK property basically did not appreciate in value at all from 1900 to 1960.  That is for no less than sixty years…

In the 1965 book “The Economics of Housing”, the author, Lionel Needleman wrote:

“There are considerable risks attached to investing in housing.  The housing market is both unstable and unorganized.  House prices can fluctuate violently and yet houses are much less negotiable than most forms of investment.” [4]

How different this stance is to the conventional wisdom of today.  People living in the 1960s would have thought you were completely crazy if you had suggested you were thinking of borrowing 110% of the value of a house with a view to renting it out or planning to use a few property investments to fund your retirement.

I do not claim to have a magic formula to predict exactly when property will do well or badly but there are certain metrics and methods for giving us a fighting chance of figuring out whether we are closer to a strong period for housing or to a weak one just as there are for every other type of investment.

Given how significant an investment property is and how your choices about property will affect your monthly cash flow and your ability to invest in anything else, it would seem like a good idea to get to grips with these measures of value before we make any investment decisions.  Strangely, relatively few people do this.  It seems that most people are largely unaware of what follows, including many estate agents as I’ve already suggested.  This is one of the reasons we have experienced property bubbles on both sides of the Atlantic.

So let us look at key metrics we might use to understand real value in the property market.  These really aren’t that complicated.  The tools used by smarter professional investors are simple enough and I would argue that we should all have learned about them at school.  In my experience they tend to be poorly understood by many people.

Inflation

First off, I want to look at the relevance of inflation.  As you may have seen elsewhere on the site, inflation is extremely important when thinking about wealth generally.  This is especially the case when considering the performance of a property asset.  Economists and behavioural psychologists describe a phenomenon known as money illusion.  This basically means that the majority of people do not take inflation into account (sufficiently or at all) when thinking about changes in the value of something.  This is particularly the case with property.

Because of inflation, the value of the £ and the $ have fallen in real terms by more than 90% since the early 1970s.  This is why prices from the early 1970s seem so incredibly “cheap”.  In 1973 for example, you could buy a decent sized house in London for £10,000.  That same house would in all probability cost £500,000, possibly even more today.

Does this mean that the “lucky” person who purchased a house in 1973 has increased their wealth by a factor of fifty?  If you do not take account of inflation then you might conclude that they have.  The price in 2011 is exactly 50x what it was in 1973.  Surely they have made 50x their money?

The difference between Wealth and Money

But here we look at one of the most important concepts in investment:  The difference between wealth and money (particularly paper money).  In the example above, if the individual concerned sold their house they would take away fifty times the amount of paper money that they started with (£s in this example).  They have grown their money by a factor of fifty.

But what has happened to their wealth?  The key thing here is to look at how much the price of everything else has gone up by.  The first and most obvious thing to look at is how much the price of other houses has increased.  What I am about to say might seem blindingly obvious to the point of being ridiculous but please bear with me as it is crucial to illustrating a key point:  Let us say the “lucky” owner of this house wanted to sell it, cash in his “gains” and buy another house in the same area.  Has he or she increased his wealth in terms of houses in the area?

The answer should obviously be “no”.  If you sell and then buy in the same market then, all other things being equal, the prices in that market will have gone up just as much as the price of your property.  This is the most extreme example but the point stands that even though this person has 50x the amount of pounds sterling they had before, they can still only buy one relatively nice house in this part of London.  Another similar house in the same area will cost exactly the same as the one they are selling:  Their wealth in terms of number of houses in this area of London has not actually increased at all.

Now, it is quite possible that this person has always wanted to move to rural Scotland when they retire and prices there have only gone up by 25x since 1973.  This being the case, our lucky seller has increased their wealth in terms of houses in rural Scotland by a factor of 2x.  Thanks to the appreciation in value of their London house being double the appreciation of a house in rural Scotland, they can now buy twice as much house in rural Scotland than they could have done originally.  Their wealth in terms of Scottish houses has in fact doubled.  This is obviously good news and shows that we should always be thinking about relative wealth when working out if we are doing the right thing with our money.

To continue the analogy, let us say the price of a posh meal out for two in London was £10 in 1973 and today it is £100, which is probably about fair.  Then we can see that the owner of the house is better off in terms of meals out given these have gone up by a factor of 10x in £ terms vs. their house which has gone up by 50x.

Similarly, a flight to New York in 1973 cost about £85.[5]  To keep the arithmetic simple let us say that the price today is £850 (you can get cheaper flights but this is probably about right for a large number of economy fares to New York) then the homeowner is five times richer in terms of flights to New York and meals out than they were in 1973.  Again, there has been far greater inflation in house prices than in flights to New York (for lots of structural reasons).

The point here is that if you want to build wealth you must always be thinking about comparative value and purchasing power.  A simple number of £s actually tells you relatively little about whether you are truly getting richer or not.  Perhaps the above examples seem a little esoteric.  A more recent example over a shorter time frame might help solidify the point:

Is a £1 million pound house still a £ 1million pound house when it’s worth £1 million?

I happen to know a number of people who purchased a house in central London for around £1,000,000 in around 2006 and 2007.  They consider their house to be as valuable today as it was then.  Even despite the “terrible” economic news we have heard almost every day since late 2008, they can at least content themselves that their property has not fallen in value.  Is this correct?

Again, what follows may be a little hard to grasp but it is important we do grasp it.  Let us say that someone purchased a house in London in 2007 for £1,000,000.  Here is a very important consideration that the large majority of people don’t make:  At that time £1 was worth about $2 so they had purchased a house worth $2,000,000.  Hopefully this much is easy to follow.

Today, a nice estate agent reassures our property owner that due to all the same good solid reasons trotted out for the last twenty years (constrained supply, foreign buyers galore), their house is still worth £1,000,000.  Fantastic.  The only problem is that the £ is now only worth $1.55 (at the time of writing).   Over the last five years, the pound has been the worst performing currency against the US dollar of the 16 biggest trading currencies in the world.  This means that our friend’s London property is now worth $1,550,000.  It has fallen in value by no less a sum than $450,000.

You may well ask: “Who cares?  This person lives in London, shops in London, sends their kids to school in London.  Why is this relevant?”

The answer is that this assessment of value is actually extremely relevant to this person’s true wealth, the main reason being is that the vast majority of things in the world that this person may want to buy are priced in dollars:  Oil, gas, rice, wheat, cotton, copper, timber, paper – the list goes on and on.

Not many people really, truly notice what is going on but when the pound weakens against other currencies, very many of the things we need to spend money on become more expensive, usually with a small time lag.  This is perhaps most obvious at the petrol pump but you can see it in your utility bills and, if you’re really paying attention, your grocery bills too.  As a result, the fact is that the pound sterling price of your property is a poor indicator of what is happening to your real wealth.

If your property is “worth” the same in pounds today as it was five years ago but nearly everything you need to buy in your life (petrol, bread, eggs, milk, cars, electricity, train fares) has gone up in price by 20-30% then in real terms you are actually 20-30% poorer than you were five years ago.

In this blog post we have looked at how important inflation is when considering the true value of property.  There are two other key valuation metrics that we must be aware of to give us the best chance of working out where we are in a property cycle:  Rental yield and the ratio of property prices to salaries.  We will look at them in the next installments…

 Click here to see the next blog entry about property and creating surplus…