plonkee money an english-er's thoughts on personal finance

October 14, 2008

house prices, bubbles, and investment returns

Filed under: house — Tags: , , , , , — plonkee @ 11:18 am

I was tidying up my desk the other day and found some old work-related magazines. In the April 2007 edition of Mathematics Today (I know, I’m a geek – I swear it’s going to end up on Have I Got News for You one day) there was an article about investing. It was mostly about the Markowitz model, but covers a bunch of other interesting stuff.

One of the things is something that’s quite well known. Average house prices in the UK oscillate, regularly going through boom and bust cycles and are mean reverting to between 3 and 3.5 times average earnings. This makes excellent sense, because most houses are still bought by home owners and mortgage companies have historically offered mortgages of about 3 times salaries, and then most people have a deposit as well.

According to this article, which had figures up to 2005, house prices are at a 55 year high compared to earnings, with the average house price in 2005 being more than 6 times average earnings.

It’s possible that this is a genuine shift in the underlying housing market caused by many more people using two incomes rather than one to get a mortgage. And of course, if you use twice the average earnings, and multiply that by 3, then you get 6 times the average earnings. Maybe the price/earnings ratio has fundamentally shifted.

On the other hand, the general rule in investments is that when someone suggests that the underlying rules of business have changed they’re usually wrong and we’ve reached the peak of a bubble. And maybe in 2007 (when I bought a house :( ) we did.

But, the house that I bought was valued at just under 3.6 times my earnings. Does that mean that I am in a better position? Maybe when it comes to keeping my house, but not otherwise.

I normally assume that the long term average is about right, so this means that house prices will revert to 3 to 3.5 times average salaries, but this means that my house is *really* worth only about 1.7 times average salaries. That’s the value that I should expect it to hold in the long term – my house is not as nice as average.

If we assume that inflation will average 3% and earnings 5%, then over the next 30 years – the length of my mortgage – then the actual expected return on my house is about 2.5%.

I can really only expect to do better if:

  1. there really has been an underlying shift
  2. or

  3. I can sell at the top of another peak, and not need to buy

Neither of these is looking exceptionally likely to me. All in all, it’s a good job that I like my house :) .

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