A New Theory for the Residential Property Asset Class

Globalization has deepened complexity and allowed seamless investment across the world. This has enabled investors to diversify into ever more asset classes. Our focus here is on the residential property asset sub-class. Typical avenues of investment into property are:

·         Direct investment into commercial property;

·         Direct investment into residential property;

·         Investment in property ETF or listed property company via purchasing shares;

·         Investment in a real estate investment trust.

Property as an entire asset class has historically delivered risks and rewards halfway between equities and bonds. Its benefits include its ability to keep pace with inflation and its usefulness in a portfolio of investments as global property returns have demonstrated a moderately low correlation to North-American and European equities. Its drawbacks are that the asset class is susceptible to bubbles and property can be illiquid.

It is the residential property asset sub-class which we are focused on as it has historically been the most lucrative of the sub-classes. It is not only the largest property asset sub-class, but also the largest out of all investment asset classes, with residential property just in the UK worth over GBP4 trillion. Its benefits include:

·         On a risk-adjusted basis, residential property has outperformed all other assets over the long-term, with a 10-year average weighted return of 10.6%;

·         More liquid than commercial property;

·         Good to be used in diversification strategy as it has low correlation with commercial property (0.70), bonds (0.04) and equities (0.09), as measured by the Pearson product-moment correlation coefficient over the past 40 years;

·         Residential property has the lowest volatility of all asset classes over the long-term;

·         It can be used as a hedge against inflation, partly due to the ability of landlords to adjust rent upwards and partly due to the uptrend of property valuations over time;

·         Depending on the area and type of property, there are chronic supply/demand imbalances;

·         Residential property has intrinsic value through being a tangible investment;

·         Favourable tax treatment of residential property and debt finance has also made it attractive.

However there are some drawbacks to investment in the residential property sub-class:

·         Low liquidity if compared with bond or equities markets trading;

·         High transaction costs and cumbersome settlement and clearing process compared to stocks or bonds as residential property transactions generally require exchanges of physical documents prepared by lawyers;

·         Lack of pricing transparency as most price information comes from prior transactions that may be weeks or months old by the time they are published;

·         Asymmetric price movements as historically residential property prices tend to move up more readily than down (pricing stickiness). This is due to the tendency for sellers who don’t receive offers in their desired price range to resist selling;

·         Significant holding costs of residential property including maintenance expenses and property taxes;

·         Rents are outstripping average incomes, which is sustainable short-term but will be a constraint in the long-run.

More recently within the residential property sub-class, I believe we can discern more distinctions between certain types. This is supported by the difference in price increases between the various market segments – for example prime London property prices have increased 53% since Q1 2009 and 10% just since Q1 2012, whereas comfortable property prices have increased 15% since Q1 2009 and 7% just since Q1 2012. There are several factors propelling this divergence of residential property:

·         The market is now global;

·         Investors hunting for yield have turned to residential property as an inflation-matching income;

·         The wealthy have increased their share of the world’s wealth whilst the middle-class (associated with comfortable and affordable property) have suffered a decrease in their share over the past five years;

·         The advent of larger knowledge economies have continued to consolidate and create more global financial and business hubs.

This divergence can be extrapolated onto the below matrix:

Residential Property Demand Elasticity Matrix

	Super-Prime	Prime	Comfortable	Affordable	Low-Cost
Global City	Perfectly Inelastic demand	Perfectly Inelastic demand	Inelastic demand	Inelastic demand	Elastic demand
Transnational City	Perfectly Inelastic demand	Inelastic demand	Inelastic demand	Elastic demand	Elastic demand
Developing Global City	Inelastic demand	Inelastic demand	Elastic demand	Elastic demand	Elastic demand
Developing Transnational City	Inelastic demand	Elastic demand	Elastic demand	Elastic demand	Elastic demand
National City	Elastic demand	Elastic demand	Elastic demand	Elastic demand	Elastic demand

Looking vertically, city allocation is based on the total capital flows through a city, as the assumption used is that the more international the city the larger amounts of capital that will pass through. However there are many exceptions, such as the Channel Islands, Cayman Islands, Luxembourg, and many more which would feature as global cities if solely based on total capital flows. Therefore, city allocation is a function of total capital flows + population size. The rise of the knowledge economy renders population size for cities an important factor as a greater population can (hopefully) provide a greater number of highly skilled knowledge workers. So for instance:

·         Global City – London, Hong Kong, New York, Tokyo, Zurich, Amsterdam

·         Transnational City – Beijing, Frankfurt, Mexico City, Chicago, Boston

·         Developing Global City – Paris, Shanghai, Moscow, Mumbai, Sao Paolo, Dubai

·         Developing Transnational City – Lagos, Istanbul, Buenos Aires, Jakarta

·         National City – Chongqing, Calcutta, Bogota, Dhaka

Meanwhile looking horizontally, Super-Prime property is property valued at or over US$10 million, Prime property is property valued at US$2 million to US$10 million, Comfortable property is property valued between US$1 million to US$2 million, Affordable property is property valued between US$250,000 to US$1 million, and Low-cost property is property valued up to US$250,000. Low-cost property is that often associated, globally, with the lower-middle class and working classes. Conversely, the middle-classes are associated with affordable and comfortable property, whilst the upper middle-class and global 1% would be associated with prime and super-prime property.

There has been a trend over the past 50 years as a result of a growing world population against a finite supply of land. Super-prime property has increased by 2,690% since 1975 and prime property has increased by 2,580% in the same period. This trend and rising prices will continue, as demonstrated by the demand elasticity matrix.

More specifically, there are several desirable locations to invest in residential property. Using a net of gilt yields measure which compares government bond interest rates to rental growth to demonstrate a comparison of where investors may put their money, suggests there is potential for 30% growth in average New York residential capital values and 40% in Tokyo property by 2016. Moreover, it is suggested that the average price of prime London property will increase to GBP 6million by 2045, up from GBP 1.5 million currently. Rising prices will be most keenly exhibited in the global cities with their favourable legal protection, quality of life, attractive tax regimes, lifestyle, and world-class schools. Research also forecasts London’s average per capita income to grow by more than any other world city between now and 2025, from US$66,000 currently to US$95,000 by 2025, mainly due to booming financial services and increased tourism. By 2025, London will have the fourth-largest city economy in the world (US$821 billion), despite the fact that its population size will remain stagnant. Tokyo will have the largest economy of any urban city (US$1.98 billion), followed by New York and Los Angeles. The other developed city to demonstrate meaningful growth during this period would be Hong Kong, which would also benefit from its world-class financial services industry. These factors will continue to facilitate rising prices for residential property in these global cities.

Ultimately, residential property is a composite good providing many different functions to a buyer – it is an investment asset, a utility as people live in these properties, and as a Veblen good where lifestyle and luxury play a role in the decision. Perhaps the residential property demand elasticity matrix can help illuminate market movements and facilitate investment decision-making in this asset class.