FOOL'S EYE VIEW
Sell Your House And Buy Shares?

By James Carlisle
February 22, 2002

Carburton Street, London -- On the last day of the 1900's (spooky that), the FTSE All Share index peaked at 3,242. By December 2001, the market had slipped back to 2,524, a fall of 22%. There's nothing especially odd about that: the stock market's movements are notoriously bouncy. What is strange, though, is that the average price of a house in the UK has increased by 18% over the same period. To put it another way, £100,000's worth of shares from 1999 is now worth £77,583, while £100,000 worth of house from 1999 is now worth £117,837 (according to statistics from Halifax). All other things being equal, houses are being valued at 50% more, relative to shares, than they were two years ago.

It makes you wonder whether now might be a good moment to get out of the property market, rent for a few years and put the equity in your home into shares. It reeks of market timing but I must admit to entertaining a few of these thoughts myself over the last few months. But does it add up? Not really, it's too expensive to make the switch and there's no real reason to expect it to benefit you - is the short answer. For the longer answer, today I'm going to compare property and shares as investments. In Monday's Fool's Eye View, I'll finish off by thinking about the costs and the risks involved in making a switch from property to shares.

You are your own landlord

The first point to make is that when you're thinking about property as an investment, you need to do just that. If you're a homeowner, then you have two hats. With the first hat on, you are the owner of the property and, with the second, you're the person that lives there. The easiest way to think about it is that you are the landlord of the property and that you rent it out to someone else. It's just that the someone else happens to be you. So, in investment terms, you need to think with your landlord hat on and in consumer (that is, spending money) terms, you need to think of yourself as the person renting the property. Here the focus is on investment.

Property as an investment

In theory, we'd expect shares and property to move broadly in the same direction because their value is driven by the same factors over the long term: the income they can provide and the value that other investors put on that income.

Take a property that you can rent out for £6,000 per year. We can currently get about 5% per year from investing in long-dated gilts, so we might aim to get 6% per year from the property. To get that return, we'd pay £100,000 for the property. If the rent we could get for the property increased to £12,000 with long-term interest rates still the same, then we'd pay £200,000 for the property. If the yield on long-dated gilts increased to 10%, we might expect to get 12% a year from our property. So, with the rent still at £6,000 per year, we'd only pay £50,000 for it. But if the yield investors expected to get from the property doubled (to 12%) and so did the rent (to £12,000 per year), then we'd still be happy to pay £100,000.

Shares as an investment

All of this is basically the same with shares, but you just replace the word rent with dividend. With shares, though, you'd generally settle for a lower dividend yield than long-term interest rates because you'd expect it to grow more in the future. Going back to the property, we expect the rent to increase in line with two things: the desirability of the property relative to other properties in the country and the average wage. If the average wage doubles, then we'll all have twice as much to spend on where we live. Assuming the property is still just as desireable as before, then we'd have double the rent.

Dividend increases from companies will also move because of the average wage effect, because more money in our pockets means more money to spend on things that companies produce (increasing their profits) but they'll get more from the increased desirability effect. Because of technological advances, our time and effort produces increasingly more as time goes on. What an ox used to do in a week could now by achieved in an hour by a flash piece of modern farming machinery (and let's assume they cost about the same in relation to average wages).

Shares and property moving together (or not)

The good thing about all this is that with both property and shares, we're getting a stream of income that's linked to the real growth in the economy. Over history, that's tended to preserve the real value of your wealth far better than cash in the bank (with a rate of interest that does not grow alongside wages). But this gets us back to the question at the beginning. Why is property worth 50% more than shares, relatively speaking, since two years ago?

We can leave long-term interest rates out of the picture because they have the same impact on both types of asset (and besides they haven't moved much), so what the market is saying is this - companies can't produce as much income for investors as we thought they could a couple of years ago, but we're able to spend more on our houses. That doesn't seem very credible.

One possibility is that people are being very short term in their thinking. Although the all important long-term interest rates haven't changed a lot, the Bank of England base rate has dropped from 5.5% in November 1999 (and 6.0% in February 2000) to 4.0% now. That's a significant move and it makes houses more affordable (and the rental income they produce relatively more valuable) in the short-term, though there is no real long-term effect. If this was happening, then the property market might indeed be getting overheated relative to shares.

Another possibility is that shares had simply gone up a lot, relative to property, before 1999 and that property had some catching up to do. The following table shows the average house price and the level of the FTSE All Share index, both re-based so that they're value at the end of 2001 equals £100,000. I've gone back to 1983, when the Halifax data stops.

Year     Property        Share
            Price        Price
            £'000        £'000

2001          100          100
2000           90          118
1999           85          128
1998           76          106
1997           72           96
1996           69           80
1995           64           71
1994           65           60
1993           65           67
1992           64           54
1991           70           47
1990           72           41
1989           72           48
1988           68           37
1987           51           34
1986           44           33
1985           39           27
1984           36           23
1983           33           19

The total price increases over the 18 years are 9.8% for shares and 6.4% for property. That difference of 3.4% looks very roughly like the extra you might get from renting a property (less a few costs) compared to dividends from companies, so the overall returns are probably pretty close. Anyway, the thing to note is that the prices swing around relative to each other, but you couldn't really say at any stage which was going to do better simply on the basis of a big move over the previous couple of years. In 1991 and 1992, property got a lot cheaper relative to shares, but you would still have been better to have been in shares since then.

So it's very hard to make any judgments about the relative value of property and shares. Certainly the relative performance over a couple of years doesn't tell us much. There are two further issues to consider: the costs of making the switch and the risks involved. I'll look into these in Monday's Fool's Eye View.