Property investors are delusional: house prices will fall

House prices are being propped up by delusional investors clinging to their memories of the property boom. But if they don't wake up soon they'll be in for a big surprise, says Tom Bulford.

Three subjects never fail to upset my readers and guarantee a sack load of abusive letters. The three are: implying that anybody with ahouse full of pets is mildly peculiar; claiming that inheritancetax is a good thing; and arguing thatproperty is a bad investment.

So let me tell you about the nutter who owned a dogs' home and wanted to pass it on to his children...

I am joking. But I was not joking three weeks ago when I said that I believed land prices were certain to fall. Back came my readers with predictable ferocity. "Look at all the money I have made on my property portfolio", said one. "Tom has a poor grasp of economics", said another. So much for my University degree!

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But with the annualIsa investment decision now upon us, I for one will not be putting any of my investmentfunds anywhere near property. People always delude themselves about this. They boast that the house they bought for £100,000 is now worth £200,000. But they forget to mention the costs of buying it, of furnishing it, of repairing the roof, paying the council tax and insurance and the £20,000 that they spent on the new conservatory.

Property investors see what they want to see

And they delude themselves in other ways too. A 2008 study by a group of academics in the USA compared people's estimates of the value of their homes with the amount they actually got when they sold. The study concluded that homeowners, on average, overestimate the value of their properties by between 5% and 10%.

"While most individuals overestimate the value of their properties", the study revealed "those who bought during more difficult economic times tend to be more accurate".

On the other hand, those who buy their homes when prices are high and rising - which applies to most UK home owners - expect that this happy state of affairs to persist and are prone to being over-optimistic. This is an instance of 'investing by the rear view mirror', by which our view of future trends in asset prices is biased heavily by recent experience.

We see what we want to see. If our financial hopes for our old age rely upon the value of the family home, we convince ourselves that property is a great investment. We convince ourselves that it is safe, even if it might not be.

Despite the collapse of house prices, another survey found that two-thirds of Americans rate property as a safe investment. This even applies to those who, having seen the value of their home fall below the liability of their mortgage, have certain evidence that it is not.

House prices simply must come down

I don't buy any of the arguments for investing in property. In this country the housing market is artificially supported by low interest rates. I am sick of hearing house building executives and estate agents moan that if only the banks would lend more money the housing market would be fine. The housing market is under pressure not only because the banks have finally come to their senses, but because incomes are static, taxes are rising, and rises in the daily cost of living are reducing the surplus available to service the mortgage.

The point I was trying to make in my earlier article is that this will hit the value of land. The cost of building materials and builders' wages is fairly constant. But there is no reason why house prices should not be lower if builders pay less for building plots.

And a weak housing market is not the only thing pushing down the cost of land. Last week the tenpin bowling operator Essenden (AIM:ESS) said that many of its sites were 'over-rented' - meaning that the only thing preventing the bowling alleys from making money is the rent they are paying for the building. Essenden now wants the rents reduced and with the landlords having few - if any - alternative tenants, Essenden should have them over the barrel.

This type of thing is going on all over the country. House builders hate reducing asking prices - they would far rather throw in free carpets instead - and landlords hate reducing rent because this is an admission that their land values are too high. But the economic predicament of this country dictates that land values and house prices must come down.

I am sticking to shares in wealth creating companies. I suggest you do the same.

In the meantime I'll look forward to receiving the usual torrent of abuse....

This article was first published in Tom Bulford's twice-weekly small-cap investment email The Penny Sleuth.

Tom worked as a fund manager in the City of London and in Hong Kong for over 20 years. As a director with Schroder Investment Management International he was responsible for £2 billion of foreign clients' money, and launched what became Argentina's largest mutual fund.

Now working from his home in Oxfordshire, Tom Bulford helps private investors with his premium tipping newsletter, Red Hot Biotech Alert.

Follow Tom on Google+.