Does a home protect against inflation?
Inflation is back, and with a vengeance. The latest Dutch inflation number is 11.6%, a level we have not seen since 1975. Until very recently, the common opinion among economists, myself included, was that central bank independence and a better understanding of monetary policy had put away inflation risk. Just two years ago, the annual risk survey of the World Economic Forum concluded that inflation was a low probability – low risk issue, far behind things like terrorism, cyberattacks, and environmental disasters.
What a different world we live in now. A perfect storm of COVID emergency largesse in government spending, the closure of China, and the war in Ukraine creates a combination of lavish purchasing power with limited supply of labor, manufactured goods, energy, and basic foods. The result is a price spiral all over the world. It is not clear how long this situation will last, but it is of urgent concern to consumers, who see the real level of their income and wealth eroded.
The value of Dutch citizens’ bank savings have deteriorated with more than 11.6% this year, since most banks still charge their customers for depositing their money. On top of that, stock and bond markets are also taking big hits. So citizens’ wealth is being eroded. Fortunately, 60% of Dutch households own their own home. Could this be a more solid bedrock for our citizens’ wealth in inflationary times?
The economic literature investigating this issue is very limited: between 1977 and 2021, only 11 peer-reviewed articles concerning the inflation hedging characteristics of owner-occupied homes have been published. This makes some sense, since inflation appeared not to be a very important risk factor. Most of the available research covers the United States, but there is also some research for the Netherlands. The overall conclusion of this research is that housing does not offer a perfect inflation hedge, but that it is better than stocks and much better than bonds. In addition, housing’s inflation hedging potential goes up with the investment horizon, and it is stronger in times of more consistent inflation, likely because it is easier to predict inflation correctly in these circumstances, making it easier for investors to adjust.
All these studies are correlation studies, effectively investigating whether housing returns co-move with inflation. Indeed, that is the most commonly used way to study assets’ inflation hedging potential in general. If an asset’s nominal return moves in tandem with inflation, the asset owner receives a stable real return. In that case, movement of the real return is hedged away. However, that does not say much about the level of the real return. It is very well possible that the real return is stable but zero. The question is whether that does much good for an investor. Another, and possibly more relevant, way to look at inflation protection is to look at the level of the real return instead of its volatility, and then assess the chance of a negative real return over the holding period.
The Bank for International Settlements publishes house price series for a range of developed countries. These series concern the price development of owner-occupied homes, which is exactly what I need for my analysis here. I use their annual Dutch house price index, starting in 1970. I combine this index with inflation data from the Dutch Central Bureau of Statistics. For the 49-year time period I look at, the average real annual return to Dutch owner-occupied housing is 2,6%.
That is very nice, but the question is to what extent a homeowner can count on this real return under different inflationary circumstances. To investigate that, I simply count the number of years in which the real return was negative: out of 49 years, that was the case for 15 years, or about 30% of all years. But how relevant is an annual return is for an average homeowner? These typically live in the same house for one or two decades. So let’s take a look at the real returns to housing for longer time periods: two years, five years, ten, fifteen and twenty years. I look at moving, overlapping periods. It turns out that the chance of a negative holding period return after inflation hovers between 30% and 40% for time horizons of up to fifteen years. So inflation risk is relevant even for relevant holding periods for a typical homeowner. But when holding periods get longer than that, the chance of a negative real return over the holding period drops very quickly. For a 20-year holding period, the chance is just 3%. In other words, while home ownership does not guarantee protection against inflation risk, a very long holding period helps a lot.