The prices of houses in London have risen by 26 per cent in the last 12 months, according to new figures published by Nationwide, Britain’s biggest building society.
I’m a London homeowner, so this is a story of more than passing interest.
The macroeconomist within felt uneasy. How can assets rise by more than a quarter in a single year when the economy, at best, is expanding in real terms by 3 per cent?
Something must be wrong; or, at least, something isn’t right.
Commentators are arguing whether this is a bubble or markets rationally adjusting to the economic recovery. Sterling is now at its highest point against the dollar since before the 2008/09 bust. Perhaps this has played a role in the past year as overseas investors, anticipating exchange rate trends, bid up house prices in Britain?
Effectively-zero nominal interest rates and low global growth have left investors looking for yield. Property in London, a safe and well-regulated tax haven for rich people not domiciled in the UK, is a prime alternative to equities and bonds.
But the scholarly reaction was overwhelmed by guilty pleasure. If the trend is true, I’ve become richer quicker and for less effort than at any point in my working life.
My personal story may appear to be petty and self-indulgent. But you can learn a lot from personal experience about the failings of contemporary economics, particularly when it comes to valuing assets in economies dominated by services.
The simple question an economist should be able to answer is: how much richer have I actually become because of London house price trends?
They can’t. Here’s why.
The first problem is that an average is precisely that. Home price increases in London will have a normal distribution and some will have risen more than others. The data shows that, but it still suggests the rise anywhere in Britain’s capital has been at least double digits.
But how confident can I be that my house has enjoyed similar price increases?
Some investigation is needed.
So I did some checking and noted that a similar house in my street was sold earlier this year for 15 per cent more than I had previously valued the own I own.
But should I consequently mark up the value of my house to this level? Could I go out and spend the amount my house is supposed to have increased in value without becoming poorer than I was this time last year? Or give to charity with the same outcome?
The answer is no.
Can it be said that my house is exactly the same as the one down the road? It’s in a different location, although by a few metres, and may be objectively different in some substantial way. I’d have to get inside to find out.
What about the buyer? He, she or they might have a special reason for buying that house at a premium. There might not be a similar buyer in the market soon or ever again.
Then there is the question about what the price paid for the house down the street actually signifies. Logically, the seller will only sell if he, she or they get the best price. This means that the price for the house down the road is the maximum someone selling that house could get at that particular moment.
It should be at the extreme upper end of the possible price range. Or perhaps not. The buying and selling of houses in the UK is not done through a “perfect” auction. Normally, it’s listed by a specific estate agent and held on the market for a specified period of time. Impatient sellers are known to slash the price prematurely. Those in a comfortable position failing to get the required price simply take the house off the market.
The circumstances governing a sale might have been unique and provided an exceptional upward twist to the price for that house at that moment only.
And if that can be said about this one house, it can be said about them all.
And what happens if confidence among house-buyers generally gives way or interest rates rise? So the mood in the market, and not just economic facts, matter too.
Turnover in London houses is a fraction of the total housing stock. It’s not as if all the houses and apartments in the city are being put on the market to all the possible buyers at the same time. Only a small proportion of the total is in play at any moment.
It would be peculiar if the prices asked and bought weren’t unique to each transaction.
The price down the road therefore could signify nothing at all. Or a lot. Or a bit of both.
So where does that leave me?
I could revalue my house at the new market level and forget about it. But that’s difficult. The additional value is significant. It’s potentially decisive for someone close to making an important life decision.
For many, the increase in the value of a property at the right moment is enough to make the difference between a straightened and comfortable retirement. It encourages a feeling of being wealthier and that in turn encourages consumption and philanthropy.
You are bound to have a reaction to a sharp rise in the value of your home, which normally is the largest single asset most of us own. It’s only human.
More cautious people might say: half the estimated price increase, just in case. Others would say: don’t even take it into account because it’s an illusion and may be nowhere near what I’d get if I sold. That could be embarrassing if I’d previously quit for a life of leisure based on a misplaced belief that I could sell my home in due course for the price someone I don’t know for reasons I can only guess at bought the one down my street.
It is, therefore possible to justify pricing my house in a range of at least 20 per cent. This is neither precise nor useful for people whose home accounts for the majority of their savings.
The problem doesn’t only apply to London. It’s a problem for every homeowner and saver in the land.
What is reported to be the value of your home could be nothing like what you could get when you sell it.
Practically all homeowners are consequently miss-stating, and probably over-stating in present circumstances, the value of the house or apartment they live in.
And this is for an asset practically everyone understands. Homes are normally built from brick, mortar and tiles. We know what to do with them. And the quantities of materials involved in building one are easily checked.
If valuing a home is tricky, then how much more difficult is it to price a more complex product. What chance do we have accurately valuing a painting, a sculpture or a vintage car particularly if it’s rarely or never actually sold?
Even more challenging is identifying the “real” value of intangible assets, things with no physical characteristics that now dominate the balance sheets of most companies in advanced economies.
How, for example, can you value a brand, an intangible that looms large in the balance sheets of companies like Coca-Cola and Facebook?
A brand is not like a building that can be measured and compared physically with another. It is derived from the idea that a product or a company denotes superiority in the mind of consumers or investors or both. So a can of Coke might appear to be better than another can of cola-type carbonated drink and a consumer might be prepared to pay more for the former than the latter.
At a corporate level, Virgin Atlantic might appear to an investor to be a superior business as a result of its brand image than another transatlantic airline. In the same way as a consumer might be prepared to pay more for a canned carbonated drink because it has the word Coke on it, an investor might be prepared to pay more for a share in Virgin Atlantic because its name is on its planes.
The present value of the brand therefore can be derived using well-established techniques which involve three steps:
- Isolate the additional cash flow associated with the brand over time
- Apply an appropriate annual discount rate to the projected future cash flow streams associated with the brand
- Apply to the final year cash flow figure a terminal value divisor.
Even in tangibles, this methodology creates a host of challenges. You may be able to isolate the impact on future cash flow of a particular product or asset. But the discount rate applied over time is always arbitrary. And the terminal value, which is calculated applying an appropriate discount rate to the final projected annual cash flow figure, can have a decisive impact on an asset’s valuation.
Valuing an intangible using this methodology is close to impossible. The first problem is isolating the impact of a brand on price. For makers of Coke, this involves comparing the market price of Coke with that of the price of non-Coke colas. Then the analyst has to be convinced that the Coke brand is an intrinsic value and not simply the result of marketing expenditures and advertising (if it is, then the brand premium will evaporate as soon as that marketing and advertising stops).
For a company, separating brand value from the underlying value is complex to the point of being impossible. Take Virgin Atlantic. Which factor should be seen as the source of the brand premium? Is it the uniform its cabin crew wear? Is it the name? Or is it the face of Richard Branson that invariably springs to mind when people think of any product and service with the Virgin brand?
The challenge gets even more intense when you try to work out a cash flow projection. That means grappling with isolating a brand’s cash flow premium in one year and then projecting it over time. How confident can anyone be that the subjective view of Coke or Virgin won’t change radically in 12 months let alone in five years?
The tendency is to look at past performance and project that forward. So if the business has recorded a 10 per cent annual increase in profit in the past five years, analysts will tend to project that trend forward. Such an approach is intellectually spurious, particularly when dealing with subjectively-defined intangible assets.
Setting the right discount rate is always arbitrary. As is the terminal value which is worked out using the idea of a perpetual rate of return.
The conclusion is inescapable. Valuing an intangible asset over time is always the result of guesswork. It’s normally dominated by wishful thinking.
These technical issues are unknown to the ordinary person. The pages of data and highly-technical language all company annual reports contain are almost wholly indecipherable. For the ordinary person, this is something that is of little concern. Their savings in companies are managed by professionals they don’t known and will never meet.
That is why a homeowner’s experience when looking at stories about house price trends is so important. It’s probably the only time an ordinary person is forced to deal with the valuation challenges normally left to technical specialists working in financial institutions and insurance firms.
The simple questions asked about what the right valuation of my home is are those that a high proportion of the adult population of the UK are themselves grappling with.
The fact that there is no right answer, let alone a simple one, exposes — like a light being switched on in a darkened room – the deficiencies of conventional economics.
It is a very short intellectual journey from this realisation to the broader critique of conventional economics represented by Economics2030.
Conventional economics is bad at valuing assets.
Its ability to value intangible assets is close to zero.