Houses may be a first rate investment once again

Regular readers of this column will not, I hope, be too surprised at the recent clear signs of improvement in the housing market. A significant revival in house prices was one of my "banker" forecasts for 1996, and the most recent statistics have clearly shown that it is now starting to come through.

As someone who is buying a new house myself, I am impressed by the anecdotal evidence that the price expectations of buyers and sellers are now converging rapidly to the point where (a) more good quality houses are finally starting to come on to the market; and (b) most of those that do are starting to sell both quickly and at, or relatively close to, the asking price. The third quarter of this year was one of the first for several years in which prices rose (a) by more than the rate of inflation; and (b) by more than the cost of a mortgage. As my charts show, the number of transactions is beginning to pick up and most of the other traditional indicators are now positive too.

Does that mean houses are a good investment now? The three key variables are house prices, mortgage rates and stock market returns (if, that is, you opt to go for an endowment policy or a PEP-backed mortgage, currently the cheapest option). It makes sense to look at these three in real terms - ie, after inflation - as inflation itself is hard to forecast and real returns are what ultimately matter.

House prices: Since the war, house prices have been notoriously volatile, but the long-term real return on houses from 1945 to 1995, according to the Bank of England, has been 2.7 per cent a year, and should continue.

Mortgage rates: In the short term, these are clearly heading up, but on a longer-term view, whatever happens to inflation, my view is that the most likely trend of mortgage rates in real terms is down. Mortgages costing 5 per cent in real terms are a historical aberration.

Stock market returns: The average long-run real return on equities has been 7 per cent to 8 per cent. After allowing for costs and charges, it is more realistic to call this a real return of 5 per cent to 6 per cent.

Adding all this up, if things go by the history book, someone buying a house today might reasonably aspire to generate a long-term real return of 2 per cent to 3 per cent on the house, plus (less certainly) 5 per cent to 6 per cent on a mortgage-funding PEP. The mortgage should finance the house at a real cost of 3 per cent to 5 per cent a year. That gives a potential overall return of somewhere between 2 per cent (2+5-5) and 6 per cent (3+6-3) a year in real terms.

Compound, this looks an attractive prospect to me. True, some of the factors that drove the bull market in the 1980s - for example, the value of Miras tax relief on high interest rates - are no longer as potent as they were.

But the underlying economics of house purchase, which are driven by a growing population with rising incomes trying to live in an increasingly overcrowded island, still look robust enough to assume there will be some positive real return over time. It could be a substantial one.

Just as importantly the downside risks now look to be limited. Higher real mortgage rates? Over time, I cannot see much risk of that. Demutualisation and the merger craze among building societies mean that more lenders are charging higher, market-led rates. But competitive pressures and consumer awareness work the other way.

The stock market is a bigger risk. Anyone buying a house must expect to live through at least one major bear market. I expect that a Labour government will also, however good its intentions, end up mucking around with the tax system to the disadvantage of income earners and house owners alike.

Overall, however, if these figures are right, and provided buyers can manage their liquidity, it is hard not to see some very real investment value again in today's housing market. How long, I wonder, before others come to the same conclusion and turn this into a self-fulfilling prophecy?