Why am I so bullish about capital growth?

A friend and business partner asked me the other day – why so bullish on capital growth? I’ve made a few bold predictions nearer the start of this year around 25%+ capital growth over the coming 5 years in the UK property market.

Let’s start with my list of shortcomings. I’m a yield chaser – always building the business to cashflow, because lack of cashflow is what finishes 95%+ of businesses. In the pre-2022 days, this was, in reality, quite easy. Choose a decent yielding area, pick your “goldmine area” or equivalent, decent stock, working tenants, press on from there. So I’m tilted towards the sort of stock, and the sort of areas, that I buy in.

I have a share in only 2 units in the south-east of England, in spite of overseeing a large portfolio. I thus lack that sort of on-the-ground info.

The running costs are also a decent slug in terms of the percentage of the rent. If you only own units that rent at say £2000 per month plus, then your running costs might well come to £250-£300 per month per unit. That 15% sort of number. At £800 per month average rent, the costs might only come down to £150-£200 (and I’m allowing a percentage for rent collection/management there, rather than a flat fee, which explains most of the difference). (so that could be 25% of rent instead). There is much debate about this – with some tropes and classic views that are often not backed up in data, but there’s a decent slug of fact behind it too.

So – where else did I start? Buy well. I spent years and years (and still refine it to this day, of course) getting good, and then better, at buying. “You make your money on the way in”, they said. They definitely had a point. Add value – of course. Refurbishment is a known quantity if you always go for very significant refurbs – and a skill that needs a flexible budget if you try to keep things relatively tight. Doing that will give the properties a lifespan – to an extent – before you might want to move them on. A lot of people miss this nuance – and this needs to be considered because if you are “hanging on” to a roof which has say 5 years left in it, you need to remember to consider that before that 5 years creeps up on you and that roof needs doing, decimating any cashflow for a couple of years or more from that particular property.

Management needs to be efficient and on a tight budget. It is as simple as that.

So – what’s changed? Well, since I started in earnest in the early 2010s, yields have fallen in a relatively orderly fashion. “Luckily”, the rates fell along with those yields – so the effect wasn’t really felt from a cashflow perspective. Mortgage took less of the pie, even though the monthly pie got smaller (from a yield/percentage perspective versus the value of the asset).

Then – BAM. A big change, in a relatively short period of time. Today, the limited company BTL cost of debt is around 6% or just a shade over. This is about the right price at the moment, and lenders will struggle to compress this too much. Use my logic above – bearishly assume 25% for costs – and follow the maths. 8% yield will see 25% of that 8% (2%) burnt on costs and 6% (of 75% of it, if you use 75% LTV) burnt on mortgages. The remainder (25% of 6% – 1.5%) will represent your return on equity (on paper) in the property.

Some would argue that cashflow isn’t why you are in the game. To an extent, they have a point – but with no cashflow, there is no business.

What has this meant – well, many landlords have been sitting on variable rates (base plus margin) for a period of time. Those are now 7.25% or so (base + 2). Base is not looking to be dropping like a stone anytime soon, and this has now been the case for 9 months (but base has been “meaningful” for more like 20-21 months now), and so the only resort has been to raise rents.

Inflation has raised the price of everything, as well, of course. But this conversation needs to be split into NEW investments, and existing investments. New ones are hard to stack up. When they do, they are often about a good area, and a good prospect for rent growth as well as capital growth. The reality (when we talk percentages) is that the lower paid have had better percentage increases than anyone else in employment over the past several years, and whilst that isn’t politically expedient or popular, it does mean that they are comparatively better off – or soon should be. Why “soon”? Well, food inflation and energy inflation have both well outstripped CPI inflation, and both of those take a larger percentage of their household budgets than they do of a household with a higher income. Energy is coming back down – food has calmed, but is still going up above CPI.

Therefore, the scary-looking rent rises coming out of the ONS at around 9%, are not as terrible when put into context of a minimum wage household who have had a 9.8% income increase in April 2024 – although after tax, that is only a 7% increase. The increase for those who were already taxpayers has been a 4% cut in National Insurance in successive budgets, of course, which has helped.

So – my overall (and general) view of the current rent increases – which are calming and likely to sit around wage increases or a shade more, for the moment – enough to tempt more investors into the market who have lumps of cash to invest and see property as a safe place for it, rather than the more technically-driven like myself – because they still “trust property”. Should they?

I believe they should. We need to move on now to the factor that most people consider the driving, critical factor when investing in property – capital growth.

Many if not all will know that Nationwide produces a house price index each month. Usually vying with Zoopla to be first out of the blocks, coming out on the last day of each month or the first of the new month. The May figures are just out; up 0.4% month on month, up 1.3% year on year. Everyone will also know that’s not keeping pace with inflation, even at our new “moderated” inflation down at 2.3%. Over the past 12 months, property has lost value in real terms, on average. In the 12 months before that, it had taken an absolute kicking – in real terms – mostly because inflation was so high.

Many might not know however – if you Google (other search engines are available) “UK House Prices Adjusted for Inflation Nationwide” you will find an Excel spreadsheet which adjusts prices for inflation as measured by RPI. This is an illuminating spreadsheet to say the least.

The first thing I would say is forget about the trend line. They fit this from Q1 1975 and I would throw this right out of the door. It is difficult not to cherrypick start dates because we all know what has happened in the interim but if we start 20 years ago, that would seem reasonable and give us plenty of data. It is “mid-boom” of the early noughties, including one crash and one significant bull-run of 2020-early 2022. Seems reasonable, although probably a bit bearish, because a crash like 2008 is more of a one-in-75-year event, if you consider it to be a massive debt deleveraging as it was.

If you re-draw THAT trend line, then house prices over that period actually come DOWN in real terms after RPI has been fitted. There are a couple of things to note. RPI is higher than CPI, which has been the accepted measure of inflation since late 2003 for the inflation target (the ONS have for 7 years now proposed that the better measure of inflation is CPIH – including housing costs – but we wouldn’t want CPIH here because we are talking about a significant part of CPIH, in discussing house prices!)

I don’t think house prices are trending downwards in real terms in reality. I think that the inclusion of the 2008-9 period offers a bit of a false flag – although things had to go up to come down quite so hard. There’s two more things to note of interest here though.

Firstly – the big one – even if you DID accept that house prices adjusted for RPI are coming down in real terms – and I’m only agreeing as to make my case as weak as possible, please note – I really don’t believe they are – that would see real house prices today at £280k, rather than the £260k they are on average (according to Nationwide) – 7% below the real terms “new” trend line.

If, instead, we proposed that house prices will keep pace with RPI – which seems a much more realistic position – the house price that most fits that 20-year trend of data is £300k, pretty much. That sees prices at 13.33% below that 20-year trend line, or, put another way, needing to increase by 15.4% in REAL terms in order to get back to the trend.

REAL is capitalised, because we need to remember that these numbers will be adjusted for inflation. Inflation over the coming 5 years is likely to run at around 3% in my view. We have a sustained period at 2 – 3.5% coming, and a hunger to cut rates to cut debt/deficit spending – and from 2010 – 2019, the average rate of inflation in the UK was 2.7% (another little-known fact). This was deemed acceptable – inflation shocks (e.g. the Brexit referendum) are largely to the upside.

To move up 15.4% in real terms (and the historical trend has always been to swing around the trend line, overshoot and then correct) – Q1 2022 we were 3% above my 300k figure, and so we have moved downwards 15.7% since then (or, reframed, we would need to grow by 18.7% in real terms to get back to that peak).

The last time the REAL average house price has been this low is 2013. That was a relatively depressed market – other than London – before the titans of Bristol, Oxford and Cambridge – darlings of the 2010s – really started to roar.

From 2012 to 2019 households saw their real household disposable income (RHDI) grow each year. This is one of my preferred metrics of the performance of the true economy – it accounts for inflation, it looks at households (households rent property as a rule, rather than individual people – different for HMOs of course) – and it looks at after tax income. All in all – pretty solid. Their best performance was in 2015 when it grew 6.4% (remember, this is INCOME – so it could be benefits, it could be lower taxes, it could be wage growth – or a blend). I expect a healthy year this year, because wage rises are still catching up with a fairly rampant inflation rate – in between large wobbles, we had real household disposable income grow each year between 1982 and 2007.

Growing RHDI means more affordability for house purchases, rather than less. Either way – does it “feel” at the moment like it could be a bit of a 2013 moment? We must remember that investment at its peak really has only driven around 20% of the lending in the current market (currently 7%). That’s a massive marginal difference, but as rents continue to rise ahead of house prices, and IF – not a massive if, but an if – IF rates on borrowing come down relatively slowly, then everything is going in the right direction.

That’s before I’ve even started on supply and demand – but there’s no real surprises in that analysis, rental stock is lower than it has been for years with much larger demand, and that is very obvious in numbers of applicants for properties, or any of a dozen other metrics you could use.

Rent demand significant and, whilst calming down a little, still way ahead of pre-pandemic numbers

New units coming online in very small numbers, both in terms of build and new rental stock – way below replacement of landlords getting out/organic wastage due to age/retirement/passing

Yields moving in the right direction

Inflation doing a sterling job, quietly, in the background, for those holding nominal debt

Wages increasing well above inflation.

I could raise another half a dozen points, but hopefully you start to see why I am feeling we are close to the perfect storm here for capital growth. Inflation on its own can carry prices forward in nominal terms, but above-inflation wage growth can also make a difference of course.

One final note, a nuance that I think is often missed. People “can’t afford” these new mortgage rates. It is nonsense – and I will tell you why. It is highly possible that they enjoyed the very cheap rates for much of the 2010s and are still enjoying some of them whilst on their nice long fixed rate that was taken out.

However. Since 2012 the households on the retail side – representing 80 to 93% of all mortgages, using the inverse of my figures from above – have been stress tested at a pay rate for their mortgages of 5.5%. The current best buys on the high street are around about 4.31%. The average interest rate paid on newly drawn mortgages at the last count – data from March – was 4.73%.

Now I’m not going to pretend that’s a “ton” of headroom. It definitely isn’t. It’s tangible, and it’s there. However – if every residential mortgage written in the past decade and above has been stress tested, and lending restricted, to that interest rate – where is the problem likely to come from? The PROBLEM, if you like, is that that excess disposable income, which was spent elsewhere, is slowly evaporating as 100k, or so, people drop off those fixed rates each month. All the 2-year cheap money is about 75% gone (offered in Jan 2022, completed May 2022, are dropping off now) – yields really started to move in H2 2022, and so estimating that 25% of that is left seems fair. That’s about 23% of the loans on UK housing. 5-year was more like 50% around that time, and about 30% will have dropped off, with 70% left to go (so the bigger impact is yet to come).

However, I said problem. The problem is that of that RHDI measure – more and more is therefore going on housing costs. What does that mean? Less is there for either saving, or spending on non-essentials. Instead, savings have taken a large boost – as people have been so concerned – so it is consumption taking the kicking, which is bad for the economy – bad for economic growth, bad for employment, etc – although we are not yet seeing it. Why not? This is the argument that the one committed Dove on the Bank of England Monetary Policy Committee – Dr S Dhingra – has been making for some months now (doves always prefer lower interest rates). It is an argument that I have some sympathy with (for technical reasons, although I have an obvious conflict of interest in wanting rates to come down).

We haven’t seen it yet in the figures, and perhaps with energy prices coming down again in July, we will “get away” with it. We could do with food prices coming down, of course. We might well see less money chasing the same goods and services though – which, of course, would be great news for inflation. The best cure for inflation is for the economy to do poorly – which has other impacts, but does mean rates are more likely to be cut. So, you see how that squares the circle – how to keep an eye on all of this? Real-time insolvencies and recruitment data are two good ways to do this.

I hope that you found that of interest – it certainly helped me to organise my thoughts!

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