Property Investment Articles

Economics in Property Investment

The article below was written by Dominic Farrell and published in "Property investment news" February 2005, published by Farscape Ltd.

What has economics got to do with property investment? 

Thomas Carlyle, writing in the 19th Century, referred to Economics as “the Dismal Science.”  But he was wrong.  Economics is dynamic, exciting and lies at the heart of everything we do. Every day we make economic decisions because, in a world where most people have unlimited wants and limited resources, we have to decide how best to allocate those scarce resources to satisfy our needs. 

This is certainly true in the property market, where making the right choice between investment alternatives is the difference between an investor making a profit or a loss.  Although you may make a profit on an investment in practical terms, in terms of opportunity cost, that profit may be a loss in real terms.  As an example, Saver A’s bank account pays 5% interest while Saver B’s pays 2%.  Both accrue interest but Saver A receives more than double that of Saver B.  In terms of opportunity cost Saver B has lost 3% by not making the right investment choice.  This concept is the cornerstone of all investing, not just in property, but in equities, commodities, bonds, antiques, stamps, wine…..indeed all investment options.

Understanding a few economic principles, defining a strategy based on an individual’s tolerance to risk and having a stringent set of financial tools allows an investor to take a “top down” approach to property investing, looking at the country, region, county, city then postcode as investment options.  This rigorous approach to finding where to invest leads to greater success than the “bottom up” approach of choosing a street in a town because it’s just around the corner or “my mate Joe has invested there so it must be good”.  A top down approach allows a more thorough analysis of the alternatives (and opportunity cost), a more informed choice, better targeting of your investments and greater success in all market conditions. 

How does economics affect property prices?

The economy and property markets are inextricably linked.  Every one of the property market crashes in the 20th Century was accompanied by a severe recession in the economy: the early 1930s depression, the Yom Kippur war and oil crises of 1973-1976, the late 1970s and early 80s and most recently the early 1990s.  The latter crash followed a doubling of interest rates from 7.5% to 15% and a near doubling of unemployment, from 1.6m to 3m.  Interest rates, employment, oil prices and geo-political events all have a major effect on property markets. Let’s take a look at why. 

Prices in any free market are determined by the forces of supply and demand.  When demand outstrips supply, prices rise.  When supply outstrips demand, prices fall until a new price is achieved where supply and demand are equal.  We are seeing this now in the UK market where the supply of residential property for sale exceeds the number of people wishing to buy.  Prices have fallen and sales prices are, on average, 7% below asking prices (Hometrack: January 2005)

When seeking where to invest, the astute investor is looking for countries and regions where demand is increasing in excess of supply.  This may be due to macro economic factors such as falling interest rates, growth in real incomes, European Union accession, Euro entry, high foreign direct investment, or high employment.  At a local level, Government policy, such as the relocation of jobs and EU funding are significant, as well as new hospitals, airports, no-frills airline routes and special events such as the Olympics, Commonwealth Games or European Capital of Culture.

An investor should look for areas where there is an “inelastic” supply of property.  This means areas where there are legal, economic, political or purely space reasons why more properties cannot be built quickly.  An increase in demand cannot then be met by an increase in supply so as the demand rises, so prices also rise up to the point where demand ceases. Good examples of this concept are National Parks such as the Lake District, small islands such as Manhattan in New York and overseas properties on a beach which always attract a higher price as supply is limited.

Interest rates

Interest repayments represent the largest item on most landlords’ operating cost statements.  Many new investors have been caught out by the rapid rise in the Bank of England base rate from a low of 3.5% between July and early November 2003 to 4.75% in early February 2005.  This represents a 36% increase in the cost base of a landlord with variable rate products.  An understanding of the mechanics of the economy would have signalled the impending rise back in late summer 2003 when many astute investors took the opportunity to fix rates at historic lows.

An investor is wise to keep an eye on the decisions of the Monetary Policy Committee of the Bank of England, which sets the UK Base Rate.  The Committee announces interest rate decisions at 12 noon on the first Thursday of the month and the minutes of the meeting provide an insight into the future direction of interest rates. Inflation is a key component of their policy decisions, driven either by demand, such as the UK property market in the last four years, or pushed up by rising costs, such as wages, oil costs or rents.  The low inflation figure of 1.6% in December 2004 (Consumer Prices Index), is a positive sign for an investor in terms of interest rates and cost control, but not at all helpful in eroding the value of any loans and other debts.

Investors in overseas markets must consider interest rates carefully when deciding in which currency to hold debt, with base rates as varied as 4.75% in the UK, 2% in the Euro zone and 2.5% in the US. Understanding why and when currencies fluctuate in value, how to spot future movements and whether to forward-buy local currency in anticipation of a revaluation are critical points for the profitability of any overseas investment.

Employment

Strong employment underpins property markets whilst high unemployment, such as in Germany, has a negative effect (the Berlin property market has been in decline since 1997). Employment in the UK is at 20-year highs, real (inflation adjusted) incomes are growing at about 5%p.a and GDP growth is strong at +2.8% - providing little evidence to suggest that a massive crash is imminent.

Keynesian multiplier effects

For long-term investments, whether in the UK or overseas, investors should search for areas experiencing a “multiplier effect”. The term was coined by John Maynard Keynes, the English economist, and in essence describes how an initial injection of investment or government expenditure multiplies itself many times over.  The opposite is also true, where job losses after the closure of a major regional employer have repercussions and cause job losses in the supply chain.

Liverpool is a good example of the multiplier effect.  From the 1950s, with the UK economic focus shifting to Europe and the development of containerisation within the shipping industry, many Dockers found themselves unemployed.  As a result, the local shops and cafes closed because their customer base disappeared.  Local companies which supplied goods and services to the docks or shops also closed or laid off workers.  As a result, this negative multiplier effect caused a downward spiral in terms of jobs and wealth.

However, in 1994 Liverpool received European Union Objective 1 status (local GDP below 75% of the EU average) and an injection of government cash. This positive multiplier effect provided a massive boost to the local economy, increasing employment and disposable income and generating greater spending, which in turn created more jobs. Liverpool’s remarkable and ongoing transformation has been nothing short of spectacular, culminating in the award of the European Capital of Culture 2008. And property prices in the city have mirrored the relentless rise in fortunes.  

Property investors should seek to concentrate investments in areas which are about to be, or already are, in the early stages of a positive multiplier effect and avoid at all costs areas which are in decline.

The Keynesian multiplier effect goes a long way to explaining the significant increase in investors looking at overseas markets, particularly the ten new European Union members which acceded on 1st May 2004.  All 10 new members (Cyprus, Malta, Latvia, Lithuania, Estonia, Slovakia, Slovenia, Czech Republic, Hungary and Poland) are experiencing positive multiplier effects due to their new-found EU status and the inflow of Foreign Direct Investment.  Further, their property markets are not as mature as in the UK, Spain and Portugal, attracting what Keynes called a substitution effect.  Investors and homebuyers are substituting more expensive and mature markets for those which are emerging and are in a strong growth phase, hence are cheaper and offering better returns.

Economics determine the profitability of your investment and opportunity cost, multiplier effects, interest rates and supply and demand factors should be central considerations in your investment decision. Economics is a dynamic, living science and a little understanding of key concepts will reap significant rewards for the serious property investor. 

Dominic Farrell
Bewarethesharks.com