The Business of Housing

 

TH - Hello, I’m Tom Hosking. Welcome to Global Infusions, an investment podcast from the Liontrust Global Fundamental team that takes a long-term view of today's stories.  

 

Last episode we chatted about the business of fear from spooky horror films to the fear of missing out. This episode we’re looking at housing – from Japanese property bubbles to the affordability crisis. If your taste buds are tickled or you have any questions for our next episode, please do send them in via your client contact or through the contact us link on the Liontrust website. 

 

So sit back, grab a cup of tea, and remember that when we talk about individual companies we are not making a recommendation to buy or sell shares and that some of these companies may not be held across Liontrust’s global fund range. 

 

TH: Right, I'm thrilled to introduce this episode's guest co-host, Hong Yi Chen. Hong and I have worked together for... what is it now... 9 years? He is an expert in US equities in particular and his dry wit is unmatched in the team. Welcome Hong.

 

HC: Thanks Tom, pleased to be here. I think I am the first person ever to appear on the podcast that isn't called Tom! The Tom monopoly has been smashed.

 

TH: Ha! Yes I guess that's right. Global infusions is clearly breaking new ground!

 

HC: Which leads us on nicely to housing market, one industry where not enough ground has been built on! With almost whatever country you look at, housing supply has lagged housing demand.

 

TH: Indeed! And this imbalance has huge effects on society. Housing in some ways is a unique asset. It’s both an investment and a consumption good. Everyone needs somewhere to sleep but it’s also the biggest investment a lot of people will ever make.

 

HC: For most people it’s also the greatest part of their wealth. So house prices matter a lot. If they go up, homeowners feel wealthier, happier and they spend more. But if they go down, it can be a disaster. You can get into negative equity and the bank will seize your home.

 

TH: That’s why it’s a particular problem that property is an asset class that is prone to speculative bubbles. Take the financial crisis of 2008 as a prime example.

 

HC: Don’t you mean subprime example?

 

TH: Ha yes that is more appropriate. …the house price declines in the years that followed the crisis were staggering. Following a decade long property boom, US house prices fell by 27%, Spanish prices fell by 37% and Irish house prices fell by 50%.

 

HC: Perhaps they should have banned price cuts which is what some Chinese cities have done recently!

 

TH: Yeah that policy doesn’t sound very sustainable or wise does it… I’m sure we will get onto China’s peculiar market later.

 

HC: Anyway none of these property bubbles come close to Japan’s in the 1980s. Japanese property prices had risen so much that Tokyo real estate was trading for as much as $139k per sq ft. For context that was 350x more expensive than Manhattan at the time.

 

TH: Wow, 350x?!

 

HC: Yup, it meant the Tokyo Imperial Palace was worth as much as the entire state of California.

 

TH: That is unbelievable… and certainly an extreme case. What’s perhaps more concerning is that housing can become so unaffordable even when there is no credit driven speculative mania going on. It can happen for fundamental reasons.

 

HC: To take the UK as an example, the average house costs about 9x the average income now. 30 years ago, it was just over 4x.

 

TH: The result is that more than 1 in 10 of 30 year olds live with their parents in the UK now.  Using home value appreciation as an engine of wealth-building eventually runs into problems when the young people can't get on the ladder anymore.

 

HC: Agreed. The regional variance has increased too. The ratio in London is 12x income whereas it’s 5.5x in Scotland. 30 years ago affordability varied far less by region. The range was 3x to 4.5x.

 

TH: So why have houses become so expensive?

 

HC: It’s partly because of lower mortgage rates. In the 70s and 80s high inflation and high interest rates meant mortgage rates were well into the double digits, compared to <1% during COVID. Monthly payments became more affordable, which pushed prices up.

 

TH: Yes interest rates have a big effect. A famous example of this came in 1980 with US housebuilders imploring the Fed to lower interest rates. They would write Mr Volker’s address on unused planks of 2x4 wood, stick a stamp on it and mail it in. They are still in the Fed’s museum today!

 

HC: The supply/demand imbalance also plays a big part. In the UK, there have been a number of impediments to housebuilding. For example, planning laws – you know, our beloved green belt.

 

TH: Yes building is restricted in 37% of the country and about a third of that is down to the various green belts around our cities. They were introduced in the 1950s, with the stated purpose of "checking the unrestricted sprawl of built-up areas".

 

HC: But in practice it means successful cities can't expand outwards and that restricts housing supply.

 

TH: Yes exactly. One estimate I read suggested that house prices in the south east would be a quarter lower without the London Green belt.

 

HC: What I hadn't realised is that more land keeps getting added to the green belt. The amount of land it covers had doubled since 1979. It's really popular with voters. It’s called NIMBYism.

 

TH: So remind me… that stands for Not in my backyard?

 

HC: Exactly. Homeowners may say they’re in favour of more housebuilding but when you ask them if they want that in their area, they say Not In My Back Yard!

 

TH: It’s quite hypocritical isn’t it. Planning laws give homeowners ways of blocking nearby housing developments. And government attempts to reform planning laws are deeply unpopular with voters because the demographics with the highest voting rates are... You guessed it... homeowners.

 

HC: It’s hard to get round that problem in a democracy with strong property rights.

 

TH: But there are examples around the world where NIMBYism is constrained.  In Tokyo, about 150k homes are built per year and that is because central government can overrule any local protests.

 

HC: But it’s not just planning restrictions that are limiting housing supply. There have also been changes to banking regulations after the financial crisis which made it harder for small builders to obtain financing.

 

TH: So that’s to do with risk weightings isn’t it?

 

HC: Yes, that’s right. After the financial crisis, regulators wanted banks to take less risk. So they increased risk weightings on loans to smaller businesses.

 

TH: What did that mean in practice?

 

HC: It meant banks had to put up higher capital buffers for these loans in case they went bad. They would then have to charge higher interest rates to small builders in order to make a good return. Small builders just couldn’t compete, because the larger builders had access to cheaper financing. And a lot of supply was removed when those smaller builders left the market.

 

TH: And that explains why UK housebuilding is a more consolidated industry now, with the likes of Persimmon and Barratt the largest.

 

HC: So according to the Federation of Master Builders, SME house builders delivered 40% of new houses 40 years ago compared to only 12% today.

 

TH: That’s quite a difference.

 

HC: There is one more important reason why we are building fewer houses today and it’s because of Mrs Thatcher. When she first took office in 1975, the UK built >300k houses per year, and half of those were social housing, built by local authorities and housing associations. By the time she left office in 1990, that share had fallen to about 18% and we were only building 200k houses per year.

 

TH: And that 200k number has remained pretty flat to this day. In fact I think the UK has only built that figure 6 times out of the last 30 years.

 

HC: That’s right. The decline of public sector housebuilding has had a big impact. Thatcher really wanted to encourage home ownership with policies like Right to Buy. In 1980, about 55% of people owned their own home and that increased to as high as 72% in the early 2000s. However, subsidies in favour of homeownership came at the expense of subsidies for housebuilding.

 

TH: Well Hong, there is one country in particular that went in the opposite direction to Thatcher’s Britain. And that country is Singapore, where 80% of the population live in government-built flats.

 

HC: That is surprising given that Singapore has the reputation of being a low-tax, low regulation business hub.

 

TH: Yes, that’s what I thought too. As our Singaporean listeners will know: Back in 1960, it was basically facing a crisis of its own success: housebuilding couldn’t keep up with the number of immigrants it was attracting. So it gradually moved people from low-slung villages to concrete high rises. All the flats come with 99 year leases and are sold at lower than market prices.

 

HC: Interesting...

 

TH: Indeed, the policy has been popular in Singapore overall. Lee Kwan-Yew, Singapore’s PM for 30 years, thought that promoting widespread home ownership would give every citizen a stake in the country.

 

HC: So, in a way he had a similar philosophy to Thatcher, except the execution was very different.

 

TH: Yes in a way, these are two countries where home ownership has very much been promoted. However in the UK it has fallen a bit from its peak down to 63% today as affordability has deteriorated. And most recently, COVID has had a part to play in that.

HC: Why COVID? We can’t just blame everything on COVID!

 

TH: No, it really is COVID! In a paper published earlier this year,  researchers found that remote work increased household formation in the US. And remote households also spent more money on rent and mortgages than non-remote households.

 

HC: Yes, I guess that makes a lot of sense because you need more space to work from home. So if you were sharing before, you’re much more likely to get your own place . Or if you already had your own house you might move into something bigger with more office space.

 

TH: Exactly. Remote work did lead to migration from cities but this counterbalancing effect helps explain why house prices and rents didn't collapse, but have now risen to all-time highs

 

HC: And why you still hear stories of bidding wars before even a single viewing, and sky high rents in a very tight rental market.

 

TH: We’re living less densely now because of remote work and so the demand for space is greater than before COVID.

 

HC: Talking of remote work, I saw a chart the other day. It looks like office occupancy has stopped recovering and has plateaued at around 50% in major US cities.

 

TH: Yes, it looks like these working trends are here to stay.

 

HC: Well, here’s a bright idea. If we’re spending more time at home and less time in the office, can we not convert some office space into residential space?

 

TH: It’s not as simple as that unfortunately, offices were not designed to be lived in. They have, what are called, deep floor plates.

 

HC: What does that mean exactly?

 

TH: In simple terms, these spaces are too big. The people living in the middle of the building won’t have windows.

 

HC: Yeah, not ideal, unless you’re a vampire.

 

TH: Yes, that’s a niche market. There are other problems as well, because 50% occupancy doesn’t mean 50% of offices are empty, it means offices are empty 50% of the time.

 

HC: So my idea isn’t so great after all

 

TH: Speaking of not great ideas, let’s briefly cover China’s efforts to avoid a housing crisis.

 

HC: This is a country that is uniquely intertwined with its property market.

 

TH: Indeed, in China, households invest in property because there aren't many options for their savings. Capital controls mean you can't exchange your RMB into hard currency like USD very easily so it's stuck inside the Chinese economy. So people invest in property because it's a physical asset that seems safe.

 

HC: And also because prices were going up and everyone loves to speculate in something that seems a one way bet.

 

TH: Well quite. And this has resulted in property values heating up to 20-30x people's incomes.

 

HC: That makes London look cheap!

 

TH: I know! So that’s households. And on the other side of the equation you have local governments who are in the tough position not being allowed to levy their own taxes.

 

HC: So how do they finance themselves then?

 

TH: By selling land because that is the one thing that they own. In the late 90s, central government came up with this system where local governments could either (a) collateralise their land and borrow from the central government or (b) sell it to a developer who would clear off anybody who was living there and build large residential towers.

 

HC: And residential land is worth a lot more than industrial land so there would be this big incentive to classify more land as residential so that the local government could borrow more.

 

TH: Exactly. So you have households who don't have many other investment opportunities and local govts who are desperate to sell the land.

 

HC: And in the middle you have the heavily indebted property developers, the likes of Evergrande and Country Garden. They can't pay their debts or their suppliers and the building sites become inactive.

 

TH: And this is where it gets even worse… Developers have been using pre-payments from ordinary households as a key source of liquidity for building homes. About 50% of Country garden's total liabilities are to households, not just banks or bondholders.

 

HC: So people have ploughed their savings into these projects and there's a risk they never get the keys.

 

TH: Prepayments hit a peak of 89% of all new housing transaction in mid-2021, that figure fell to 76% this year so still very high.

 

HC: This could lead to a social problems.

 

TH: yes that is why the government is trying to make sure that incomplete projects get built. But when local governments step in, they don’t have the supply chain expertise that the developers have in managing these projects.

 

HC: It’s not ideal. The reason this hasn't fully blown up is because the state keeps a firm grip on the sales prices of new homes. Local authorities limit how much developers are able to lower prices if at all.

 

TH: The answer in Xi’s China is always more state intervention. But structurally this is unsustainable. China has urbanised rapidly over the last 40 years from 20% of the population to 65% today. But that shift can only happen once.

 

HC: And demographics after almost 40 years of the one child policy means there will be fewer people buying homes in the future compared to the past so the property sector can't remain the cornerstone of the economy.

 

TH: On that note, we may have to move onto the news. Looking down at my notes there are so many topic areas left to discuss for housing but there’s a risk our cups of tea may start to get cold if we don’t move on. Hong what news have you got for us this episode?

 

HC: Let’s talk about this month’s saga at OpenAI.

 

TH: Ah yes, it all started with Sam Altman, the CEO of OpenAI, being unexpectedly fired by the board didn’t it?

 

HC Yes and then he was reinstated 72 hours later after huge backlash from employees. OpenAI is of course the creator of ChatGPT, the generative AI large language model that can seemingly interact like a human.

 

TH: Yes we discussed it on the Global Infusions last year in our Christmas episode, and I think in our alcohol episode too if I remember correctly. It’s amazing what it can do- kind of like an all-knowing assistant. So, why did Sam Altman get the sack?

 

HC: Well, the official reason given was that, quote, “he was not consistently candid in his communications with the board.”

 

TH: What was he not candid about?

 

HC: They never said, but there’s been a few theories, one of which is related to safety. You see, OpenAI has a really weird structure. It was originally set up as a non-profit research organisation with the stated aim of developing “safe and beneficial” artificial general intelligence or AGI. They define AGI as “highly autonomous systems that outperform humans at most economically valuable work.”

 

TH: So, something that can steal your job?

 

HC: Yeah, something like that. They assembled a dream team of AI researchers to solve AGI. In 2019 they created a for-profit arm to attract investment from venture capital and incentivise employees with share options. This was so they could compete with top the tech companies for talent. Microsoft invested $1bn in 2019 and another $10bn in 2023 to access their technology, which now powers Microsoft Co-pilot, their AI assistant.    

 

TH: But, what’s that got to do with Sam Altman?

 

HC: Well, the for-profit arm is fully controlled by the non-profit arm. This was done to align both entities with the same mission. In fact, on their website it says, “It would be wise to view any investment in OpenAI Global, LLC in the spirit of a donation, with the understanding that it may be difficult to know what role money will play in a post-AGI world”

 

TH: Wow, have they been reading too much science fiction?

 

HC: Or is science fiction becoming science fact? Anyway, because one of the stated aims of OpenAI was a commitment to safety, it was the fiduciary duty of the board to do something if they thought safety was being compromised. One theory was that an internal project called Q* was a breakthrough in the search for AGI. In a letter to the board, researchers warned of the potential danger, and this was what catalysed Sam’s exit. 

 

TH: So the board had to shut it down for the benefit of humanity?

 

HC: Yeah, perhaps Sam wanted to just keep going despite the dangers. What gave some credence to this theory was that his short-lived replacement, Emmett Shear, tweeted that he wanted to slow down the pace of AI development for safety reasons.

 

TH: But Sam is now back, how did that come about?

 

HC: After Sam was fired, he was immediately hired by Microsoft to lead their AI efforts. Then over 95% of OpenAI employees signed a letter threatening to resign if he wasn’t reinstated. Other companies saw this as an opportunity and circled like sharks. Microsoft and Salesforce offered to hire any OpenAI employee that wanted to leave and match their pay. OpenAI would have been hollowed out.

 

TH: There was a lot of money at stake wasn’t there? OpenAI was about to do a new funding round at $90bn valuation. And employees would be able to sell their shares to investors.

 

HC: Yeah, I mean, if you were an employee you would be really angry, because all your wealth evaporated overnight.

 

TH: If Sam’s back, does that mean it wasn’t about safety? Weren’t there alternative theories that it was about conflicts with his outside business interests?

 

HC: Well, we may never know. But safety is definitely the cooler theory, so that’s the one I’m going with.

 

TH: OpenAI also have some new board members now, including – strangely – Larry Summers, the former Treasury Secretary.

 

HC: You know who would have been a good board member?

 

TH: Who?

 

HC: Arnold Schwarzenegger.

 

TH: Yes, he would know a thing or two about shutting down rogue AI. One piece of news that has rocked the investment world this month is of course the death of Charlie Munger at the age of 99. He was Warren Buffett’s business partner and Vice Chairman of Berkshire Hathaway for over 40 years.

 

HC: You’ve pilgrimaged to Omaha and actually saw him in person did you not? Which year was that?

 

TH: Well remembered, yes I did. The year? I believe it was 2010.

 

HC: So back then he would have been a mere adolescent at 86.

 

TH: Ha! Yes, young Charlie just uttered one or two witty zingers and left most of the talking to Warren.

 

HC: Yeah, I did read that he was famously quiet during the Berkshire meetings.

 

TH: Munger was a great investor in his own right. Prior to teaming up with Buffett he had his own investment partnership from 1962 to 1975. He was able to compound returns at 20% a year during that period, compared to 5% for the Dow.

 

HC: He was also a multi-talented man. He studied maths at the University of Michigan, but then dropped out to join the Army during WW2. Because of his high test scores, he was ordered to study meteorology at Caltech. He was then posted to an airbase in Alaska where he was a weather forecaster.

 

TH: Yes, after the war he went to Harvard Law School and became a lawyer. He started his own law practice and that’s still around today, called Munger, Tolles & Olson. In fact, it was ranked the nation’s top law firm by American Lawyer magazine three years in a row in ‘08, ‘09 and 2010.

 

HC: Talking of multiple talents – I hear he was also something of an amateur architect.

 

TH: Yes, in 2021 he donated $200m to the University of California to build a new dormitory called Munger Hall. There was one condition though – they had to use his own design.

 

HC: Okay... was that a problem?

 

TH: His design was so controversial that the consulting architect called it an unprecedented “social and psychological experiment” and resigned in protest! Paul Goldberger, the New York Times architecture critic called it a “grotesque, sick joke – a jail masquerading as a dormitory.”

 

HC: Wow, that’s a pretty strong reaction. Was it really that bad?

 

TH: Well, Munger thought it was brilliant. The building would make ultra efficient use of space and encourage social interaction by forcing students into communal areas. The bedrooms would be small and windowless, which would force the students to spend more time in the communal areas where there was natural light. In other words the building had...

 

HC: ...deep floor plates! Didn’t he have that famous phrase “show me the incentive and I’ll show you the outcome”?

 

TH: Yes, he’s really taken that to the extreme in this case.

 

HC: So did it work?

 

TH: Unfortunately (or fortunately), the plans faced a lot of opposition and the building was cancelled this year. BUT, he did design and build a similar building for the University of Michigan in 2015.

 

HC: What did the students think of that?

 

TH: The feedback was at best very mixed. It ranged from “not ideal” to “terrible”. Although, students DID say it forced them to work more in common areas, it also contributed to problems such as depression and sleeping disorders.

 

HC: So there’s a reason even prison cells have windows! It is curious that Munger and Buffett were both born in Omaha. What were the chances that two of the world’s greatest investors came from the same small city?

 

TH: Must be something in the water

 

HC: Did you drink any when you were there?

 

TH: Clearly not enough!....  And on that note, Thank you for listening to Global Infusions – a podcast that believes that the best discussions are had over tea and cake. We hope you've enjoyed your cuppa and our thoughts on Housing. Please do subscribe through Apple or Spotify and with that we wish you goodbye!

 

HC: Goodbye!