New research from the Bank of England corroborates what many of us have suspected – that house prices are high because interest rates are low. “The rise in real house prices since 2000 can be explained almost entirely by lower interest rates,” conclude two Bank economists.
Common sense says this must be right. Like it or not, housing is an asset just like shares or bonds. And the price of an asset should be equal to the discounted value of future benefits from it – rent if you are a landlord, the rent you’ll save if you are an owner-occupier. Lower interest rates mean by definition a lower discount rate applied to future rents, so they must raise the price of housing.
Simple.
Well, not quite. Exactly the same reasoning should apply to shares; lower interest rates raise the current value of future earnings and so should raise current share prices. But this hasn’t happened. Since the mid-1990s the All-Share index has risen only around as much as dividends: the dividend yield is much the same as it was in 1995. But house prices have risen much faster than rents: the rental yield has halved since the mid-1990s.
Which poses the question: why have falling interest rates benefited house prices so much more than equities?
It’s partly because houses were unusually cheap in the mid-1990s. But this doesn’t explain why rental yields have fallen relative to share prices since the early 2000s.
Instead, there are three other reasons for the difference.
One is that housing, but not equities, has benefited from the same safe-haven demand that has helped reduce bond yields. Cristian Badarinza and Tarun Ramadorai at Oxford University’s Said Business School have shown that house prices have been driven up in part by overseas investors seeking a safe haven from political risk in their own countries. Yes, the direct effect of this has been confined to London, but high prices there trickle down to the rest of the country (as people like your correspondent sell up and move out).
A second factor is credit availability. You can borrow four times your income to buy a house but not to buy a tracker fund. Leveraged investments are naturally more sensitive to falling interest rates than less leveraged ones.
I fear, though, that something else is going on. Just ask: why have interest rates fallen so much since the 1990s? One cause is secular stagnation: investors expect weaker long-term economic growth now than they did then. This explains why equities haven’t responded much to lower rates: the good news of a lower discount rate is offset by the bad news of lower future dividend growth.
House prices, however, seem to be pricing in the good news of lower rates (a lower discount rate) but not the bad.
My chart shows some evidence for this. It shows that since the early 2000s – that is, after much of the underpricing of the mid-1990s was eliminated – there has been a tight link between house prices and labour productivity growth. Prices have risen well when productivity grew nicely, but not when it didn’t. The correlation between productivity growth and share prices has been weaker in this period. This suggests that house prices do not discount productivity growth in advance, so weak growth comes as a nasty shock.
There is a precedent for markets to misinterpret interest rate changes. Back in the 1970s interest rates soared as inflation rose, and share prices slumped. In 1979 Franco Modigliani, a Nobel laureate, said this had led to shares becoming underpriced because they had taken on the bad news of high rates but not the good – that inflation meant higher nominal earnings and the erosion of corporate debt. The fact that prices soared in the 1980s suggests he was right.
It could be that the housing market is now doing the same partial discounting but in reverse. It is taking on the good news of lower rates but not the bad. If so, it is committing the error of which George Mason University’s Scott Sumner has warned us for years; it is reasoning from a price change, without asking why the price has changed.
All this leads to a simple inference. It is very possible that equities are cheap relative to housing. Which points to them outperforming them over the longer term.
