I never understood this argument. Isn't it simpler to think of real estate more as a bond. Long term in the USA house value tends to match inflation. Many places you can buy for less than renting thus buying is probably the better option long term. Many places are the opposite. When buying and renting are not significantly different the math gets very difficult and can work out either way.
You can think of real estate as divided into two classes:
1) Places where it's straightforward to build more housing and the cost of housing rises along with inflation (most of the US excluding some big coastal cities)
2) Places where it's not straightforward to build more housing (no land and/or zoning restrictions) where housing rises significantly faster than inflation (SF, Manhattan, etc).
Class 1 behaves like a leveraged bond fund with high front end and back end loads that make it very expensive to trade into or out of.
Class 2 is a speculative bet that goes up or down with the economic prospects of the city in which the real estate is located (more like a leveraged stock fund) which is also very expensive to trade into or out of.
I'm guessing perhaps the UK has a much higher ratio of Class 2 to Class 1 real estate than we have here in the USA?
I’m intrigued by the idea that RE acts like a bond, with a yield matching investors’ collective expectations for long-term inflation. Thus, in today’s environment where basically everyone agrees inflation will be <2%, both long-duration treasuries and RE are priced very high, with low implied yields. (Note this is contrary to the idea that high inflation would raise the price of properties and low inflation would not. In the bond metaphor, value moves opposite inflation expectations, despite less change in the cost of construction. Realistic? Let’s see.)
Unlike the treasuries though, RE investors can raise their yields if inflation increases. This would seem to make RE something like TIPS. That added inflation adjustment option adds value to RE just as it does for TIPS. Therefore one might expect the earnings yield on RE to be similar to TIPS, and somewhat lower than treasuries.
Yet, if we look at the earnings yields of REITs, we see a very rich risk premium compared to TIPS. For example, I can find many with double-digit ROEs, high single-digit ROAs, and sustainable dividends in the 3-6% range.
This risk premium may be due to the capital structure of REITs. They never pay off the cheap debt they use to purchase assets, and instead are dependent upon continually rolling over the debt forever. To actually pay off properties would involve a sharp reduction in returns. This means REITs are vulnerable to increases in inflation, which would raise their interest expenses. More risk — more return.
Mom-and-pop RE investors who plan to lock in a mortgage and pay it off have a much better inflation hedge because they don’t just hold an interest-only loan like the REITs do. Thus they escape the requirement to refinance in a potentially higher interest rate future, at the cost of diverting funds toward principal payoff.
The question is, which type of investors set the price of RE assets which can either be an inflation hedge or not? I suspect it is the REITs because they have more purchasing power due to not sending their cash flow into payoff of principal. Thus RE is priced as if it is not an inflation hedge, when in fact it can be, provided one is OK with lower cash returns during the loan term. The mom-and-pop investors paying off their loans are still earning much better than TIPS in most areas, just not the class 2 properties described above.
That said, I agree there are 2 types of RE market described above. The class 2 properties are a bit scary to me, because the pricing is set by REITs and other interest-only investors who expect little more than treasury-level returns with the speculative option to profit on appreciation. That appreciation would be a greater-fool process unless rents increased faster than interest rate expenses. That exact outcome can only occur in weird situations like we’re in now, where coastal housing prices are rapidly increasing at the same time as interest rates are falling. How long can that continue as we approach 0% interest rates and 10% unemployment?
More concerning is the question of how this can continue when technology is steadily eliminating the need to live within certain metro areas to earn lots of money, or get a good education. The successors to Zoom and Microsoft Teams will eventually make it possible, for example, to be an investment banker in Montana instead of being limited to NYC, or to be a tech worker in rural Louisiana instead of having to live near Silicon Valley. Thus the scarcity factor that pushed urban housing prices to 4x or more what rural properties go for is being reversed.
Class 2 properties could be an extra-bad investment if interest rates / inflation increase at the same time as tech eliminates the urban RE scarcity problem. I don’t think class 1 escapes this scenario unscathed either; higher demand is offset by higher interest rates, and appreciation is capped by the cost of construction. In bond terms, class 1 can’t appreciate and class 2 is at risk of downgrade.