Tunaru writes (p.30):
… it can be argued that the buyer of a house is not the equivalent to an investor buying a house as an investment asset. For the majority of buyers, houses play the role of a consumption asset and not that of an investment asset. There is no evidence that rental yields are driving future house prices so the expected house prices at various future long horizons cannot be determined with growth models in the same way expected share prices may be determined with growth models linked to dividends.
First point: the whole ERM valuation question applies to institutional investors, namely ERM lenders, who want to acquire residential property exposure, and who are not using the property as a consumption asset, but rather as an investment asset. Imagine the reaction of the board if the CFO tells them she has acquired a portfolio of properties for possession at some point in the future, and has got a good deal by paying the price of immediate possession. What kind of commercial decision is that?
Second: why in fact would the ordinary buyer of a house view the situation any differently from the board? Suppose I, currently locked into a leasehold, am looking to move into a property in 2 years time after my tenancy agreement runs out. You are looking to move out of your property at the same date, but need money now. So I agree to pay you money now in order to possess the property at that future date. We both benefit, but the price I pay now will be nothing like the price of immediate possession. Why should I pay the full price of the property now if I cannot move in, or rent it out or whatever, for a full two years?
Tunaru writes ‘there is no evidence that rental yields are driving future house prices’. Whether that claim is true or false, how on earth is it relevant? It is not future house prices we are concerned with, but rather the price now of a contract for possession in the future. We are comparing the current price of two different contracts, one for immediate, the other for future possession. Future prices of anything are irrelevant. As we wrote in our December paper (p.4)
… a number of practising actuaries in the UK equity release sector have convinced themselves that the underlying price that is relevant for put option pricing is not the forward house price for year 𝑡 but the future house price or expected future price for year 𝑡. However, forward and future prices are very different and to confuse the two is to commit a major logical error. This error is a big deal because inputting the expected future house price into the option-pricing equation gives very low NNEG valuations, whereas inputting forward house prices into it gives much larger NNEG valuations. This second, incorrect, approach is commonly referred to in actuarial circles as the “Real World” or “Discounted Projection” approach.
Of course, anticipated future prices may be relevant if it is the decision that is deferred. Do I buy now, or do I wait for two years? If I expect prices to rise, I will pay for immediate or deferred possession. If I expect them to fall, I will defer my decision to buy, whether that be immediate possession or deferred possession. But decision is different from possession. If I pay now for deferred possession, I am already exposed to future house prices. If I expect prices to fall, I will pay neither for immediate nor deferred possession. Rather, I will wait, i.e. I will defer my decision. That is all.
This is elementary pricing economics. It is astonishing that the Institute and Faculty of Actuaries has chosen to commission, then publish, a paper that apparently revolves around such a basic conceptual muddle.