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House prices as bonds

It’s often said that cheap money has driven up asset prices. What’s not so appreciated is that this raises a big puzzle about the housing market.

Few economists doubt that low rates have inflated house prices. In fact, say Bank of England economists, “the rise in real house prices since 2000 can be explained almost entirely by lower interest rates.” My chart shows their point. It shows that as index-linked gilt yields have fallen since the 1990s so the ratio of house prices to the earnings of first-time buyers has risen. There’s a simple reason for this. As interest rates fall we discount future cash flows less heavily: these cash flows might be rent, or the rent we save by owning our own home. And if future cash flows become more valuable so too will the asset that generates them. Lower interest rates therefore mean higher asset prices. Simple. 




No. Here’s the puzzle. Although house prices have steadily risen relative to wages during the era of falling interest rates, equity valuations have not. Share prices are actually lower now relative to earnings or dividends than they were in 1998 even though 10-year index-linked gilt yields have fallen by six percentage points since then. To put this another way, the correlation between those yields and the house price/earnings (PE) ratio has been 0.83 since 1986. But the correlation with the share-price/dividend ratio has been only 0.16.

Which poses the question: why have house prices been so sensitive to falling interest rates when equities have not? In theory, the impact should be similar: a lower discount rate on future cash flows should raise all asset prices, houses and equities alike.

So why isn’t it? It’s not because the supply of housing is inelastic and doesn’t increase as prices rise (it is, but the same is true of equities). Nor is it because housing is bought by borrowing whereas equities are generally not. The link between asset prices and interest rates, via a higher present value of future cash flows, applies to equities as much as housing in theory.

In truth, half of our puzzle is easy to solve. There are good reasons why equities haven’t benefited much from falling bond yields. One reason for those lower yields is that economic growth has slowed down across the western world: this is what former US Treasury Secretary Larry Summers means by secular stagnation. Also, since the 1990s listed companies have become older and so less likely to offer long-term growth even for the same rate of gross domestic product (GDP) growth. On both counts, long-term dividend growth has fallen. That offsets the benefit of a lower discount rate being applied to future dividends.

What’s more, when interest rates are near-zero, conventional monetary policy is less able to protect the economy from downturns: central bankers have to use less reliable methods such as quantitative easing. This increases the risk of deep recessions, which should increase the equity risk premium. That too offsets the benefit of a lower risk-free discount rate.

One contributor to low bond yields is that global investors have become more risk-averse: they want safe assets even at negative returns. But this very same risk aversion reduces demand for equities.

It’s easy, then, to explain why equities haven’t much benefited from lower bond yields. But this just returns us to our puzzle: why haven’t house prices suffered these effects too? Lower future growth should mean lower growth in rents as well as dividends and so lower house prices. And the same risk of recessions that makes it dangerous to hold equities should also make it dangerous to hold housing.

What, then, is so different about housing that it has escaped the downside of lower bond yields? One possibility is that, for many of us, housing is not wealth. If it doesn’t matter to us whether our house price falls then it is in effect a safe asset. To put this another way, my house gives me risk-free future housing services just as a bond gives me a risk-free income.

If we regard housing as we do bonds, then it should behave like bonds. Which it does.

Two big facts, however, speak against this theory. One is that house prices fall in recessions. That makes them like equities and unlike bonds. The other is that even before interest rates began their long downtrend, house prices had risen in real terms. That’s consistent with them offering higher returns to compensate for their riskiness, which also suggests they are like equities.

On both counts, house prices should have behaved like equities during the long downtrend in interest rates and not risen as much as they in fact have.

There is, perhaps, a justification for this. If investors expected a shift in aggregate incomes from profits towards wages then we should see house prices rise relative to share prices: house prices are in effect a claim on future wages.

But there’s another possibility. Perhaps houses are overpriced because the market is pricing in the good news of lower interest rates (a lower discount rate applied to future rents) but not the bad – that they are a sign of lower future growth in rents and greater riskiness.

Honestly, I’m not sure which of these explanations is right. Personally, I’d attach a non-zero probability to houses being overpriced. I appreciate that you might disagree. But if you do, you have to believe something quite counter-instinctive about the housing market.