One of the drawbacks of living in London is that talk during social encounters inevitably turns to house prices. If I had £100 for every time someone asked me with a mixture of incredulity and pity that “you haven’t bought a house?" I might have just enough money to buy a room in Chelsea. Such bubbling confidence about real estate is not confined to London where average price rises are now higher than average annual post-tax income. The primal desire to own a house probably continues from the time our hunter-gatherer ancestors scoped out the best cave within walking distance of the neighbourhood hunting grounds. Civilization only refined the cave to a penthouse with finance enabling an easy takeover on affordable EMIs. This deep-seated bias makes it incredibly hard to have a rational conversation about residential real estate as an asset class. Apart from the emotional attachment, judgement is further clouded if house prices are racing up (as they are in London and other markets). “I bought last year and I’ve made 15% already" is a fairly typical response of people marvelling at their own investment acumen.

A cold, calculated look at housing as an asset class is justified in the year that Robert J. Shiller won the Nobel Prize in economics. My scepticism with residential real estate “assets" is because houses are not an asset per se. They are not productive assets that generate wealth such as factories. Moreover, owner-occupied houses generate no rent. This lack of income/rent production coupled with transactional illiquidity, a lack of mobility and replicability (new houses are always being made) stretch the traditional definition of an “asset".

However, houses certainly are a necessity of life. Moreover, we spend an inordinate amount of money throughout our life on housing from rent or mortgage to maintenance and tax. Viewed in this context, a fully paid-down house is a hedge while you work your way to wealth. Freedom from paying rent or mortgage not only takes substantial financial pressure off you, but also enables you to pursue callings from which you may have been dissuaded by the realities of life. For example, a 4% per annum rental/mortgage cost is equivalent to nearly one-third of after-tax income as current prices in most cities imply that people on average pay seven-eight times income. Coupled with the emotional value attached to a house, the investment thesis almost starts to make sense.

However, don’t make the mistake of assuming that by investing in a house, you will achieve millionaire status. It pays to take a long view on housing by looking at a 10-year period. After all, that is at least the length of time you’d live in it or seek to hold it. Although long-term data on house prices is not easy to come by, especially for markets such as India, there is a series available for the US compiled by Shiller. Graph 1 shows the distribution of real returns. As the distribution shows, unless you timed the pre-financial crisis period perfectly, you had a 58% chance of making money over a 10-year period in the last 150 odd years. Even then, average real returns were a paltry 1.4% per annum. To double purchasing power, these rates had to be sustained over approximately 50 years (which they weren’t). The odds against house flippers were even worse, with the probability of a positive return being less than half.

The hoopla surrounding housing is purely a money illusion where we have been so transfixed by the recent nominal increases that we fail to notice the levelling effect of inflation (Graph 2). Barring the Alan Greenspan-created credit binge, real house prices have been remarkably stable post-World War II. Other long-term time series of house prices such as the Herengracht Index for Amsterdam show a similar divergence between nominal and real prices.

A look at Graph 3 shows that this has indeed been the case in the US. It shows the real house price expressed in terms of the real price of equity (productive assets). The two periods of large relative appreciation of house prices were 1915-1920 (World War I and its aftermath) and 1929-47 (the Great Depression and World War II). The third period was in the 1970s’ stagflationary era. Because of the ensuing economic growth and despite its impact on house prices, the credit bubble barely increased the relative ratio between house and equity prices. Adding the fact that this ignores dividends, the return from equity would have been much higher. Therefore, it might make sense to have a long-term investment plan to buy a house (on the lines of what we talked about last year). Even though cold logic plays little part in the decision to purchase a house, it can still be put to use on the associated financial decisions.

Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy through writing and trading.

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