The Cyclical Pattern
Property prices follow a cyclical pattern. Property prices rise and then property prices fall. The reasons why will become apparent further on, but for some reason they do rise and then fall. So what is the best time for an investor to become interested? When the prices start to rise, of course!
If we were to speed up this process over a notional 12-hour period, with 12 noon being the point when they first rise and 6 o’clock being the point when they first start to fall, then we would have the following diagram:
At 12 noon prices increase until 6pm and then they start to fall. We can see that anyone who has any sense gets interested anywhere between 12 noon and 6pm. So who buys between 12 noon and 6pm? Everyone! Who is everyone and why do they buy? The following people buy exclusively and their reasons are as follows.
So who buys between 6pm and 12 midnight? Prices are falling now so the novice/speculative investor becomes uninterested as there are no capital growth prospects and the owner-occupier will wait until the prices drop further. The only buyer remaining is the professional investor.
Based on the table above we can see that:
- The professional investor buys on known information i.e. the property purchase puts money in their pocket.
- The novice/speculative investor and owner-occupier buy based only on the fact that the trend of prices is rising.
So how does the professional investor estimate whether a property will put money in their pocket? It’s called gross yield. Gross yield, in mathematical terms, is:
Now annual rent is a pretty static figure. Rents do not rise and then fall. They simply rise slowly and steadily the same way wages do. So in real terms they remain the same. However, property prices are far more volatile. Property prices gather momentum far in excess of the rate of wage inflation and hence rise and fall at a greater rate than the rate of inflation – but we will get to that later.
Assuming we agree with the stability of rental prices and the volatility of property prices, we can show that:
That is to say that as property prices rise the yield falls. Let me show you this example:
Yield is then:
Now let’s say that property prices increase to £110,000 in six months. A professional investor considering the market will now consider the yield to be:
So we can see that as the property price increases from £100,000 to £110,000 the yield decreases from 10% to 9.1%.
Using this same example let’s say that property prices fall from £100,000 to £90,000 in six months. A professional investor considering the market will now consider the yield to be:
So we can see that as the property price decreases from £100,000 to £90,000 the yield increases from 10% to 11.1%.
This is called an inverse relationship as the yield and property price move in different directions. So if we were to create a yield vs time graph then it would be the exact opposite of the real price vs time graph.
Fitting the yield curves into the clock it will look like this:
