In a recent posting Guy Thomas takes issue with my new friends at the Prudential Regulation Authority on Consultation Paper CP13/18 which deal with the valuation of the no-negative-equity guarantees (NNEGs) in equity release mortgages. Dean has responded to Guy here, but I would like to stick my own oar in the water too, particularly on the issue of whether the deferment price on a property should be less than the current price.
Let me give some quotes from Guy’s article with a running commentary:
In the prescribed NNEG formula [in which S is the spot price and q the net rental rate], the PRA calls the quantity S exp{-qt} the ‘deferment price’ of the property, that is the price payable now to take possession on a future date. There is no meaningful market in deferment prices over the periods of 20-40 years most relevant to NNEGs. [xii] The PRA nevertheless asserts that the deferment price must always be lower than the spot price of the property, on the following rationale:
“This statement is equivalent to the assertion that the deferment rate for a property is positive. The rationale can be seen by comparing the value of two contracts, one giving immediate possession of the property, the other giving possession (‘deferred possession’) whenever the exit occurs. The only difference between these contracts is the value of foregone rights (eg to income or use of the property) during the deferment period. This value should be positive for the residential properties used as collateral for ERMs.”[xiii]In isolation, this appears a reasonable argument.
I have set out my own elaboration of the argument for the deferment price being less than the current price here. The gist of it is that most properties most of the time generate a positive net rental stream. Therefore, when looking for a general rule to assess deferment value, the sensible such rule is to presume a positive rental stream – and a positive rental stream implies that the deferment price will be less than the current property price.
Consider the alternatives:
If all deferment rates from now till forever are positive, then all net rentals must be negative, and in that case the value of the property would be negative. How many times do we see negative property prices? Chernobyl perhaps, but not even Detroit.
If some deferment rates are positive and some negative, then some net rentals are negative and others positive. The value of property would then be the sum of net present values of each set of net rental streams, but one would presume that the latter exceed the former or else the property would not have a positive price.
So the for the most part, if not entirely, it makes sense to project positive net rentals and therefore the deferment maturity curve would mostly if not entirely, slope downwards.
The general rule is that to have positive value, a property should have a rental stream that is (at least mostly positive) and what would be the point of inserting the odd negative rental here or there to get a deferment curve that was other than always downward-sloping?
To return to Guy:
But there are also reasonable counter-arguments.
Housing today is owned mainly by owner-occupiers. They have a preference for a current interest to a deferred interest, because they need a roof over their heads, they like long-term security of occupation, they like being able to make their own choices on extensions and repairs, etc. In other words, they like the practical and sentimental benefits of home ownership. A minority of owners are buy-to-let landlords: they like understandable form of the investment, the unusual ability to finance it largely with borrowed money, and perhaps the disengagement it facilitates from the distrusted pensions and savings industry.
I would put it a little differently. Anyone who lives in a property gets the ‘net rental services’ of that property – the use-value benefits of a roof over their heads and so forth. Some people choose to obtain those benefits by buying their property and others by renting it. In the latter case, the property owner gets the benefit of the rent tenants pay, and in most plausible situations, the owner who rents out their property will receive a rent that more than covers the costs of maintaining their property.
There are exceptions but these are highly unusual. I remember from my days as a student when some friends of mine rented a down-and-out property from the Archdiocese of Liverpool: their rent was minimal, but their living in the property was a deterrent to vandals. It was a temporary arrangement that suited both parties, largely because they were both hard up and Liverpool was what it was. None of my other friends had similar arrangements, however.
For an insurer, on the other hand, these practical and sentimental benefits of a current interest in a house have no relevance.
Insurers are an unsentimental lot.
The main potential benefit of a current (as opposed to deferred) interest is the potential income from letting.
True, and this point applies to any owner who rents out their property.
But a current interest also has several disbenefits: tenants need to be managed, houses need to be maintained, from time to time there are costs (Including possibly PR costs) of evicting tenants in arrears, and there is a possibility (through existing or new legislation) that tenants might acquire new rights.
Yes, there are costs and risks to having tenants.
If on the other hand houses are kept vacant, this gives another set of problems: council tax, security and maintenance costs, and possibly very considerable PR costs of owning substantial amounts of empty housing.
And, yes, there are also costs from keeping properties in vacant possession.
These disbenefits are not fanciful; their materiality can be inferred from the observable fact that despite the excellent long-term performance of housing as an investment, neither insurers nor any other financial institutions have shown any enthusiasm over the past several decades for housing as an asset class.
Of course there are benefits and costs of owning property but if an owner regards the costs as outweighing the benefits, then the sensible choice for the owner is to sell and perhaps invest the proceeds in another asset class. In that case the property will end up in the hands of an owner who does value the benefits as more than the costs – otherwise they wouldn’t have bought the property and someone else would.
The lack of enthusiasm (or otherwise) of financial institutions for housing as an asset class is another question. But accepting that Guy is correct on this point, then their limited presence in the market tells us nothing about current versus deferment prices nor about net rentals in this market.
So current interests in houses are evidently not attractive to insurers and other institutional investors. Deferred interest might well be more attractive, particularly if in the form of cash-settled financial contracts, so that all the problems of current interests are permanently avoided. Even if a deferred interest is not strictly preferred, the relative valuation of a deferred interest compared to a current interest seems very likely to be much higher for an insurer than a typical individual owner. (My emphasis)
Maybe, but as Guy himself suggests a little later, “the market for deferred interests does not exist on any meaningful scale” so he is comparing one hypothetical non-market valuation (i.e., insurers’ valuations of current possession) against another (i.e., their valuations of deferred possession). Such a comparison tells us nothing about the market prices for current possession or the market prices (to the extent there are any) for deferred possession or any relationship between them.
Now if there were a substantial market for deferred interests, the money weight of individuals’ preference for current interests versus insurers’ [KD: I would say the market’s] preference for deferred interests would determine the relative market prices for the two types of interest (i.e. what the PRA calls the ‘deferment rate’). But we have the same problem as with the hedging arguments: the market for deferred interests does not exist on any meaningful scale. (My italics)
We already know that the market for deferred interests does not exist on any long scale, but it does not follow that it is reasonable, in general, to presume that deferred, forward or future ‘interests’ have no value.
And this is not mere happenstance or oversight; to create such a market would require the development of legal and governance frameworks covering maintenance, insurance, the rights of occupiers during and on maturity of deferred interests, etc.
Maybe, but sometimes the absence of a deferred market is because there is no need for one. I might not want to buy deferred possession in 20 years just now because I might not be sure of my situation by then and in any case I might be confident that I will be able to find whatever I will need when the need arises.
In the absence of such a framework, the relative values of current interests and deferred interests remain a matter of conjecture.
Only up to a point. If one agrees that it is reasonable to presume that deferred benefits have value, then it is reasonable to infer that the deferment price (or value) would be less than the current price. There may be unusual special cases where the deferment price (or value) might rise over a short horizon, but I can’t think of any plausible non-Chernobyl or non-Liverpool examples in which the deferment price (or value) curve would rise continuously over a long-term horizon. And if one could find such a case then the value of all those net rental services would be negative and the property would not have a positive current price.
The PRA’s argument is a reasonable one, but not the only reasonable one, and therefore not as conclusive as CP 13-18 asserts.[xiv]
The only reasonable one, I would say. But if there is a reasonable alternative, give me an example or tell me what it would look like or where it would apply.
In short, the argument that the PRA makes in CP 13/18 can be buttressed by sound economic theory and empirical evidence, but the counter-argument cannot.