Where to Invest – Why Not to Listen to Gurus – Price Increases in 2020 – Buying New Builds and What’s Next for Tenants – 14/03/2021

Mar 14, 2021

This week the supplement is going to look at regional shifts as so many people ask “Where to invest?” as one of their big questions, particularly if they live overseas or in a low yielding area. We also take a journey into the macro and get specific about rent increases, and a really important but little understood economic concept which is actually quite simple to understand (I hope!) when explained properly (that’s set me up to fail already!)

The headlines won’t have escaped property investors I’m sure, and their reach is far beyond that. Every time we recruit for a property-related position in one of our businesses, I always ask “Are you interested in property?” Of course, no-one turns up and says “nope, it’s rubbish” (although I have had a few lukewarm answers in my time!) The most common response, instead, is “well, I do look on rightmove quite a bit……every day in fact!” (tip – this is not the best answer!) So the majority take a significant interest – even people who haven’t moved for 30 years + and have no intention of moving tend to know what’s up for sale on the road, at what price, with what agent, and why Mr and Mrs X are moving.

What we’ve seen last year is the biggest move upwards in capital growth nationwide for a little over 6 years. It might feel like more than that, but in October 2014 the UK HPI was up 9.39% (comparing to the 8.5% reported in December 2020). I’ve discussed some reasons why that might have been somewhat false (the 2020 figure) because of a 2019 election and a strange old year – but we will see as this year develops just how much of an outlier that is. (In December 2019, the figure was 0.9% and 2018-19 was overall a VERY limp year for capital growth indeed – and also a great time to buy – yes, the two things are definitely related!)

What we’ve also seen is a relative rarity although it has become more normal in the past 5 years after an incredible bull run between 2010-2016. The best performing region has been the North West (+11.2%) and the weakest performing region has been London (+3.5%). The East Midlands has charged on and has long been a favourite of mine (+10.6%) – the danger of course is that these sorts of rises are a long way from sustainable and getting on the gravy train late on can be a concern (although only if there are fundamental reasons why prices have been overbid, and also if you overpay/become a motivated buyer). Whilst I’m not a fan of timing the market – I shared an example this week in one of our live Mastermind sessions in our PIP Members only Group that is worth sharing again here.

I had lunch with an old school friend a few years ago. To put this into context, this guy was the shining star at our school. Incredible work ethic. Fantastic brain. A real thinker. Great chess player. Spectacular mathematician. He opened the conversation with “I’ve been getting these emails about property from a guy called “Robin Hood” (Name changed to protect the not-very-innocent). Are they telling the truth?”. Just shows that intelligence doesn’t equal street smarts. After a guffaw that alerted the entire restaurant, I took a quick 53 minutes to tell him why those emails were largely nonsense although they do occasionally contain a few nuggets.

He then countered with “But in Solihull, prices have only doubled in the past 30 years or so. In London it is up many times more than that!” I dropped my knife and fork (so you know this must be important!). Looking at Jan-1995 versus Dec-2020 the capital growth in London as a whole is 566.4%. In Solihull it is 335.7% (figures for Solihull don’t go back before Jan 1995 unfortunately!). And no, sadly I didn’t know those figures at the time…..but that’s a pretty significant difference (and yields are not necessarily hugely different either). Plenty more than 100% which is what my friend was suggesting.

Digging a little further, he was basing this solely on his parents house. Agreed in early 1987, they paid a whopping £325,000 for a fantastic new build property by a top local builder on a desirable new estate. They still live there and when this conversation happened they had in their head that it was worth about £650k (in reality, it was about £750k and today is more like £800k). I explained to him that my parents house (which they had bought in 1984, in the secondary market) for c. £50k was worth more like £350k (although it had been extended in the interim too). This was obviously a very different multiple (7 times rather than double!)

So what does that property parable teach us?

1) don’t gauge an entire area on one transaction!

2) be careful when buying at the top or what might be the top of a hot market

3) new builds perform woefully compared to secondary market stock

There will be lots to be made over the next few years with sensible property investments, but they must remain sensible. I’ve definitely learned this lesson before I had that conversation – sadly – but it isn’t one I will ever need to learn again.

So back to the regions. Two more regions had performance in excess of 10% – Yorkshire and the Humber (a lot of rooftops there) and also the South West. My Alma Mater in the West midlands also put in a very strong 9.4%.

Two events happened last year as well that are relevant. 1) Base rate was crushed down to 0.1% and 2) Supply was short. These two factors are the primary reasons in my view that conspired to send the market up in what was a false year for so many reasons, but primarily because of the amount of government stimulus money around (And the enforced savings due to normal spending outlets being closed for half of the time). So, I would be describing the last 12 months performance, whilst very welcomed by me and my existing portfolio, as an aberration.

However, going forwards, the recipe is set as I’ve been outlaying over the last couple of weeks, for a “melt up”. This will be more fundamental and the growth experienced last year is unlikely to correct in any major fashion (although I still expect wobbles this year, and we’ve already had one if you look back at the headlines over January and February). The budget has given investors clarity and fresh confidence I think – we will have to watch the auction results carefully to tell but initial enquiries this month look like the market is still short on stock and thus very warm, with a new wave of buyers.

So, if past performance is no guarantee of future returns, and there are notes of caution in chasing areas upwards – what are you supposed to do? Here’s a few suggestions.

Take a look at the new build premium in the area. How many units are going up? How much is the population growing or forecast to grow in that area? Councils often have this data and there is a census going on right now which is the best data collection exercise for a decade. What percentage of planning permission is accepted? Are the local authority meeting their targets in their 5-year plans? What jobs are coming to the area, versus employment at risk? Are there any freeports that have been announced which may benefit the area, and what’s the best way to get upside exposure to these opportunities?

Don’t be scared of markets that have taken off a bit in the last 12 months, but remember why the false dawn has happened. Rents are up a mere 1.3% over the same period, with 2.2% upwards movement in the South West and the East Midlands – so yields are commensurately lower. If a £100k house rented at £600pcm before, yielding 7.2% gross – the same house would on the above figures now be £110,600 with a rent of £613.20pcm or a yield of 6.65% gross (A drop of 7.6% in relative terms). If you have been working to long-held margins or metrics you may need to revise them. We’ve only just started to see some inroads in lower mortgage rates (down from maybe a 3.6% best price for a ltd co 5-yr fix to 3.3% best price, broadly speaking) which won’t make up for a margin squeeze. But at these sorts of capital growth figures, flips have worked well, releasing stock to crystallise some gains has also worked well (although you may regret releasing stock at 2020 prices when we get to 2025!)

So what would I do if I was starting today? I’d assess all the freeports and look at strong yield, how soft or tough the market is, visit a few areas, speak to lots and lots of agents, try and build some relationships, and get busy. There’s no substitute for breathing the air and getting boots on the ground. Other large infrastructure projects are available – and one plus of Boris looks to be that there will be more of these on the horizon – good for prices, and good for long term economic growth and productivity.

And if you thought that was heavy…..onto the real economics sermon of the day! I want to talk about price elasticity of demand. I have a faint hope that one day the sort of common sense that I try to write on a Sunday reaches a wider audience and gets to policy makers, because this is a genuine attempt to put some factual argument forward and discuss how the rental market WILL be influenced over the next 5-10 years.

The desire to write about this was stirred when I read an article shared about Lloyds bank and their entry into the PRS. Not just in the build-to-rent market – there would be no real news here, they are a massive name but so are Aviva for example who announced their entry into that market as far back as 2009 (!). They seemed well ahead of the game now and have made a couple of long-term plays in social housing in mid-2020 without attracting many headlines – so read into that what you will, there is already breakneck growth going on in that sector and this looks like they might just be ahead of the game again on that one.

So firstly – what is it? Price elasticity of demand (PED) simply formalizes the relationship between the change in quantity demanded based on the change in the price. The typical concept of course is that as something becomes more expensive then less of it is demanded. This is true apart from certain types of luxury goods where the price is seen as a badge of honour – there might be more high end watches sold at £25k than £15k for example, for the same watch.

The key sub-concept to understand here is inelastic goods. This means that when the price changes, there is not much of a change in demand. Usually, you find, these are goods that are really quite critical. Petrol or diesel is a typical example. Price shoots up, people still need it. Even though petrol prices can be quite volatile, it rarely changes behaviour and sees people substitute the car for another form of transport. Of course, sometimes/oftentimes they just have no choice.

This inelastic concept is of course massively relevant to property. Last year we all had a lesson in risk and reward. Hotels, short stay accommodation and to a lesser extent HMO take more risk in order to make greater returns. That risk was crystallised last year in a big way. The young HMO tenant could often “substitute” their HMO room for going back home to Mum and Dad’s. Short stays were substituted by furlough, working from home, projects being put on hold, vacations and trips cancelled, etc. etc. The family in the 3-bed semi don’t have that luxury of a substitute good – during a pandemic, as a rule, they live where they live and they need to carry on living there!

The more “vanilla” your property, the more inelastic the demand is likely to be. SA operators will tell you that the market is brutally price sensitive as a rule, and lots of clever algorithms are working on AirBnB, booking.com, etc in order to maximise revenue (but in reality driving prices down a lot of the time). The market is too competitive to make excellent margin/supernormal profit. This isn’t to say SA isn’t profitable, but that one destination is relatively easily substituted by another.

So when price goes up for rental stock – how does demand react? There have been a number of studies, and data isn’t fantastic on this stuff, but the figure that comes out of a few reports is -0.6. What does this mean? It means that for every 10% increase in the price of rents, the demand will fall by only 6%. When occupancy is a lot tighter (caused by people not moving, people needing more space, fewer people per household – all of which occurred last year) this will shrink and has been shown to be as low as -0.2. (10% price rise, 2% fall in demand).

This is overall bad news for renters. I would put the point across that realistically, for an increase in costs of 10% over 5 years (could be caused by taxation, compliance costs, licensing schemes, a whole number of things) that in a tight market up to 80% of these costs will be borne by the tenants. 80%! So making changes that increase costs really need to be well thought out. I’m all in favour of solid and clear compliance (such as the electrical certification bloodbath! – NOT). It makes sense at a high level but implemented hurriedly and woefully, during a pandemic. Very poor indeed.

Take this out to EPCs and the want for landlords to contribute up to £10,000. Superb – so expect them to recover up to £8,000 of this from the tenants over the next 10 years or whatever is deemed an acceptable payback period – and expect the market to stand it! The only way to loosen the market is to build more stock or to encourage more landlords into the market – I wouldn’t think Lloyds will be interested in terraced houses that are 120 years old or 1960s ex-LHA semis, which make up a lot of the rental stock in areas. I also don’t see them being interested in leasehold flats! That will leave urban areas and/or purchase of existing BTR schemes (which won’t help supply of course). Perhaps I am wrong and time will tell.

But before government at all levels continues to load costings onto the landlords, there should be a real conversation about the likely incidence of the consequences. Rather than just blaming the landlords when the price of rent shoots up. Wonder what Lloyds’ policy will be for rent increases – RPI + 2% anyone? 4th January sounds about right to me.

As always, please like, comment, share, disagree or engage with this post – genuinely grateful for the feedback every week!