- A Federal Reserve Bank of New York paper examines the long-run returns on residential real estate in 15 countries over 150 years.
- They find that, while house prices tend to grow faster in large cities, the rental returns are as much as 1.6% higher per annum in small cities. This disparity more than compensates for the capital gains difference.
- For example, a UK-based investor buying a property outside of London 70 years ago would have amassed double the cumulative return relative to buying a property in the capital.
- As house prices decline sharply across the US, UK, and Europe, the paper’s results remind investors of the benefits of buying property outside major cities.
House price growth is slowing. This may concern many, but for a few, it provides an opportunity to enter residential property markets. Before any such endeavour is taken, however, it is important to understand what drives real estate returns over the long run.
A Federal Reserve Bank of New York paper looks at annual house prices and rents in 27 superstar cities across 15 countries to find the best long-term returns. By breaking these returns down into capital appreciation income and rental income, the authors identify the most important component for a property market investor.
They show that rental returns drive overall returns in real estate markets and that those returns are higher outside of major cities. This could be for behavioural reasons or because of the relative illiquidity of investments in less urban cities. Regardless, it highlights the importance of widening your property search beyond the most popular locations.
Data and Methodology
Accessing historical housing and rental price data is challenging. The authors use a broad range of sources, such as past academic research, city yearbooks, newspapers, tax records, notaries, archives of real estate agents, and other archival data. In some cases, they had to use hedonic regressions to construct price indices based on transaction and advertising data.
In all, they collect annual house and rental price data for 27 cities and 15 countries, dating back to the 1870s (Table 1). Using this data, they construct housing returns, which comprises capital appreciation and rent. Capital gains are proxied by the YoY percentage change in house prices, while rental income factors in the cost of renting and is normalised by house prices (Equation 1).
Armed with the housing returns for each superstar city and country, the authors can back out returns in the rest of the country (by subtracting superstars from the national series). In comparing house price growth and rental returns in superstar cities vs the rest of the country, they can establish where the best ROIs are found.
Returns in Superstar Cities
Since 1950, the sum of capital gains and net rental returns has been largest in Berlin, Paris, and Amsterdam (Chart 1). Inflation-adjusted housing returns in these three cities averaged over 8 log points, or roughly 9% per year. Across all cities, the average is 6.4%, which is driven by rental yields of approximately 4–5% (Chart 2). Capital gains are inconsistent over time, averaging 2% per year, with a range of -10% to +6%.
Not all cities experienced larger rental returns than capital gains. In Paris, for example, the data suggests an investor who bought an apartment in Paris in 1950 realised an average yearly capital gain of 4.85 log points (or 5.41pp) until 2018. Meanwhile, the average annual rent return in Paris was 3.66 log points (or 3.74pp), resulting in a healthy total annual return of 8.33 log points (or 9.15pp).
This housing return is impressive. For context, an investor in the CAC 40 would have only gained roughly 4% per year in real terms. But could a residential real estate investor have earned more by investing in property outside of Paris?
Returns Outside of Superstar Cities
The authors compare the log-point gains in different superstar cities against national returns. The results for France paint a very representative picture of other countries. While capital appreciation outside of the capital was lower over the 70-year period, rental returns were significantly higher. These rental returns more than offset Paris’ advantage regarding capital gains – total returns were nearly 1pp higher per annum outside of the capital.
In all but five superstar cities, the difference between city-wide capital gains and national capital gains was positive (Chart 3a). Meanwhile, the opposite is true for rent returns (Chart 3b). Across the 27 cities, real rent returns have been around 1.5pp lower per annum since the 1950s. As a result, the total return is nearly always higher outside of superstar cities (Chart 3c).
Cumulatively, the difference between investing in superstar cities relative to smaller ones in the same country is massive. Had an investor bought a property outside of London 70 years ago, their cumulative return would have been double that of a city-based property. That is because, while London properties have appreciated roughly 4% per year in real terms since the 1950s – around 1pp more per annum than the rest of the country – rental yields in the city are lower (Chart 4). And because rental yields make up most of the ROI on property, the higher rental yields elsewhere more than offset the lower rate of capital appreciation.
The finding that smaller cities have higher rental yields than larger cities is evident across countries. In the US, rental yields in the 5% most populated cities earn a real rental yield of around 60bps lower than the smallest 5%. In Germany, the authors plot the gross rental yield in 2018 for each city against their 1989 population showing a clear negative correlation (Chart 5).
Explaining the Difference
So why do these differences between large and small cities exist? Expectations for house price appreciation may be too optimistic in large cities, or investors may be focusing on higher capital gains in the superstars and neglecting rent returns.
From a risk perspective, two sources can explain the empirical differences. First, co-variance risk. In smaller cities, investors may have less diversified investment portfolios (because they may have lower incomes), making them more susceptible to real estate shocks. The authors find that to compensate, investors charge a higher premium.
Second, it is easier to find buyers and sellers in larger cities, meaning real estate markets in superstar cities are more liquid. A less liquid housing market in smaller cities results in homeowners and investors charging a rental premium to account for greater idiosyncratic risk.
Three important points can be made from this paper. First, rental returns drive overall returns in residential real estate markets, and higher yields are typically found outside of major cities. However, and to my second point, if house prices fall over the next 12 months, the best way to capitalise on any future appreciation is, at least according to history, by buying property in major cities.
Last, and perhaps more UK-specific, rental yields are increasing, especially in London. While costs have risen for landlords (higher taxes, bills, and mortgage payments), gross returns could reach record highs if prices fall – they are already at their highest point in over a decade. It is unclear whether London’s rental yield growth will continue to outpace the UK average, but alongside capital appreciation, London property may become a better investment.
We shall see, but the bottom line of this paper is to not automatically assume superstar cities provide the best opportunity to capitalise on the next house price crash. Other cities may well provide better ROIs.
Sam van de Schootbrugge is a Macro Research Analyst at Macro Hive, currently completing his PhD in Economics. He has a master’s degree in economic research from the University of Cambridge and has worked in research roles for over 3 years in both the public and private sector. His research expertise is in international finance, macroeconomics and fiscal policy
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