Some illustrative estimates for returns on housing vs equities/gilts to 2025

Housing

 The PwC model median projection is for real (CPI inflation-adjusted) growth in average UK house prices of around zero between 2007 and 2025[1].

But real house prices have already fallen by around 20%between 2007 and 2012, so this implies some real growth between 2012 and 2025, averaging around 2% per annum. This reflects the fact that, while demand for housing (and credit availability) may not be as strong as in recent decades, housing supply is still likely to remain relatively constrained in the UK.

 A 2%average real rise would nonetheless represent a modest rate of increase relative to historic average real UK house price growth of:

-       around 4% per annum between 1984 and 2007

-       around 3% per annum between 1984 and 2012. 

Our probabilistic model shows that, while the median projection might be for 2%pa average real house price growth in 2012-25, the 90% confidence interval for this is around -1% to +5% per annum (i.e. there is a 90% chance that average real house price growth over the period would fall into this range, with a 10% chance that it might be higher or lower).

In addition, housing purchased on a buy to let basis might yield a net rental return (after running costs, management costs, voids and depreciation) of, say, 1% per annum with a plausible range of, say, 0-2% per annum. We ignore the possible effects of leverage here (i.e. the property is bought outright for cash).

So the total real return on housing, before tax, might be expected to have a median value of around3% per annum on average in 2012-25, with a 90% chance of this lying within a range of around -1% to +7% per annum. 

Equities

Long-term historic average real returns on equities for 1900-2009 according to analysis by Dimson, Marsh and Staunton (2010) were 5.3% per annum in the UK (this includes reinvested dividends) - global average real equity returns were similar at 5.4%. At present, equity market yields in the UK are around 3.4%, so this would be consistent with real dividend growth of around 2% per annum, which is close to average independent estimates of plausible trend growth in the UK economy over the period to 2025.

We might therefore plausibly assume an expected real equity return in 2012-25 of around 5.5% per annum, but this would be subject to great uncertainty. Based on the data in Dimson, Marsh and Staunton for the UK, we estimate a 90% confidence interval for average real equity returns over a 13 year period of around +/- 10% per annum. 

So we might assume average real equity returns in 2012-25 of around 5.5% per annum and a 90% chance of these being within the range -4.5% to +15.5% per annum. These are all pre-tax returns.

A balanced index-linked gilt/equity portfolio

Index-linked gilts with a maturity date around 2025 currently yield a real return of around -0.5% per annum relative to RPI, which translates to around +0.5% relative to CPI. This rate of return is more or less guaranteed given that the gilts are held to maturity. 

Assuming, for the sake of illustration, a 50:50 mix of index-linked gilts and equities, this might therefore give an expected real return in 2012-25 of around 3% per annum and a 90% confidence interval of around -2% to +8% per annum (all in real pre-tax terms).

Summary of illustrative relative real pre-tax returns and ranges for the period to 2025 

Asset type	Median real return (% pa)	90% chance of being within this approximate range (% pa)
Housing (buy to let)	3%*	-1% to +7%
Equities	5.5%	-4.5% to +15.5%
Index-linked gilts (ILG)	0.5%	0.5%**
50:50 equity/ILG mix	3%	-2% to +8%

*Includes 1% net rental return after all costs borne by landlord including voids (with a range of 0-2%)

**Assuming that these index-linked gilts are held to maturity and so are effectively risk-free.

Source: Illustrative PwC estimates excluding the effects of leverage and tax

Significant additional complications would result from trying to take account of tax, which would depend on particular investor circumstances as well as the form in which investments were held, and also the possible effects of leverage in increasing both risks and expected returns on all types of assets. Transaction costs other than taxes are also not included in this analysis, but will generally be higher for housing than for financial assets.

Subject to these important caveats, however, we can see that projected real returns on housing in the period to 2025 are intermediate between those of equities and index-linked gilts, but broadly similar in terms of both risk[2] and expected return to a 50:50 equity/ILG mix. This is what you might expect if markets are setting relative asset prices in a broadly efficient manner that avoids leaving significant unexploited gains from arbitrage between asset classes.

John Hawksworth
Chief Economist, PwC
August 2012

 

 

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