No rational valuation measure produces a number for local house prices that even remotely approximates what houses and real estate sell for in Australia. But does it follow that a bursting is the only route from here?
For decades residential housing has sold on gross yields of 2% to 5%. Inverting the yield – and remember we are talking ‘gross’ yield here, which does not count the cost of maintenance, taxes, interest payments or management fees – houses have frequently traded on multiples of 25 to 50 times the gross earnings. Let’s agree houses aren’t cheap.
What drives house prices?
In the very long run, it isn’t demographics or interest rates or immigration or construction costs or any of those things that makes investing in your home a sensible decision. What makes residential real estate investment essentially a sensible decision is that you are effectively short the Australian dollar. Not against other currencies but against itself, its purchasing power.
Housing becomes worth more over long periods of time because the purchasing power of the dollar declines due to inflation. The house that was bought decades ago is worth more in dollar terms, especially based on the land value (so the argument is not as strong for densely-built apartments).
In Australia, home ownership is hailed as a worthy aspiration. Tax structures such as zero capital gains tax on the primary place of residence and the deductibility of interest costs against residential property income as well as legislated incentives such as the first home buyers grant, have contributed to the pursuit of real estate as a worthy investment. That feeds its popularity and Australians’ predisposition to it.
Then add to the mix the accessibility of credit. With a deposit of 10% or less and low interest rates, and many properties become relatively attainable and even affordable.
What has happened to long term house prices?
If one believes that housing is a way to short the dollar, then it should be that house prices will generally follow inflation. The Herengracht Index is the longest study ever of house price changes - following house prices along the Herengracht canal in Amsterdam. Created by real estate finance professor Piet Eichholz of Maastricht University, the index goes back to the construction of the Herengracht in the 1620s and was first published from 1628 up to 1973, later extended to 2008.
The strip of homes in the index has always been some of Amsterdam’s most favoured and attractive real estate. This stability renders the index a useful tool for understanding how inflation-adjusted real estate prices change over time.
It shows that between 1628 and 2008 – 380 years – house prices rose and fell but on average the real price merely doubled. This corresponds to an average annual real price increase of about 0.1%.
In Australia long term studies have also shown prices followed inflation but only until the 1970’s when prices in Australia detached from their correlation with inflation and started to follow incomes, in particular the rising incomes of the baby boomers.
Demographics and immigration are supportive, on a net basis, for house prices in Australia. While individuals are studying longer and starting families and careers later, all cohorts from their early thirties onwards provide support to house prices.
Finally, in the shorter term, interest rates, employment, foreign investment and lender behaviour will have an impact on house prices as will changes to zoning and other government interferences.
When crowd psychology takes over
From time to time, these short-term influences combined with the mystery of crowd psychology corrupt an otherwise sound premise and an appropriate valuation.
In all bubbles the sound premise that once catalysed the favourable change in prices is forgotten and all that matters is that prices are expected to rise materially in the future as they have in the past. At some stage, if prices keep rising they become self-reinforcing. The mere fact that prices are rising confirms to the onlookers that the original premise remains sound. And those commentators who might warn of impending doom are discredited by the rising prices.
The price one pays always determines one’s return, so the higher the price, the lower the return. There is also a difference that exists between investing and speculating. Investing is where funds are committed today in the expectation that more funds will be produced later from the operations of an asset. Investing therefore doesn’t care whether the stock market or property market is open or not. A sufficient return can be made from long-term operation or development of the business or the property. Speculation, on the other hand, cares less about the asset and more about the change in price.
Combining the concepts together produces some insight into the development of a bubble from otherwise more normal changes in price. When activity switches from being investment-like to speculative the risks of a bubble forming are heightened. And when speculation is justified by apparently rational arguments - such as the weight of money argument that Chinese investment in Australian property will keep house prices supported – the risks that the seeds of an even bigger bubble will germinate start to increase.
The role of banks
Those risks are also fuelled by profit-motivated financial institutions holding the keys to the cash register amid cheap credit. In the pursuit of growth and maintaining their competitive position, lenders can fuel the already speculative flames by loosening otherwise sound lending practices.
And this happened in Australia. Earlier this year, ASIC found ‘troubling’ flaws in credit standards in the interest-only mortgage market, which represents 37% of home loans held by banks, building societies and credit unions. Interest-only loans have grown by about 80% since 2012 and we now have low and no deposit loans, which leave the borrower with little or no margin of safety if their circumstances change. A pin awaits every bubble and how toxic the aftermath becomes is directly proportional to the level of gearing that fuelled the rise.
ASIC’s review of 140 customer files held by banks and credit unions revealed that lenders incorrectly calculated how much time the borrower had to repay the principal when the interest-only period ended in 40% of cases. In about one-third of cases, ASIC found no evidence the institution had assessed the appropriateness of the product for the borrower and in more than 20% of cases, the lenders had not appropriately assessed the borrowers’ living expenses.
When house prices compared to incomes are stretched and those incomes have been estimated incorrectly, the seeds for an ugly reckoning are planted. The question is whether they will germinate and mature, resulting in a bursting.
If in the US, a decade ago, Freddie Mac and Fannie Mae had been required by regulators to lend only based on 30% deposits, and to verify incomes and expenses, and to ensure loans were limited so that payments only amounted to one-third of incomes, the bubble in property prices that preceded the GFC might have been prevented.
The average house price in Sydney consumes more than 65% of the average income of a borrower geared to 80%. The reversal of the resource boom and the end of automotive manufacturing in Australia will leave holes in job prospects. We also know that throughout history prices for assets have risen spectacularly when interest rates are low.
The signs are changing
Unlike the US a decade ago, we have already seen regulatory changes to investment lending growth, lending practices and foreign investor permissions that may just be enough to prevent any bubble from inflating too fast or too far. The increase in bank capital charges for residential mortgages has already forced banks to increase their rates on investment loans, and last week, Westpac took the highly unusual step of increasing rates on owner-occupied variable rates out-of-cycle with a change in the cash rate. Other banks will follow.
Plus the banks are imposing quantitative limits on investment lending, and publishing postcode lists where they believe valuations are stretched and warrant extra deposit margins. Anyone who has tried to borrow to finance an apartment in the last few months has experienced a different attitude to a year ago. Auction clearance rates are now at their lowest level for three years.
All of this suggests some of the steam will come out of the housing market now. Of course asset prices never move in steady straight lines so a smooth transition to lower prices might not be possible. The oversupply in apartments currently under construction and the replacement of local bank lenders (who are baulking at oversupply and poorer developer standards) by Malay, Japanese and Chinese banks suggests the road could still be bumpy for investors who have overstretched.
Many investors buy and then worry about a crash. Perhaps the solution is to wait for a crash, or at least a long pause, before buying and have a lot less to worry about.
Roger Montgomery is the Founder and Chief Investment Officer at The Montgomery Fund, and author of the bestseller ‘Value.able’. This article is for general educational purposes and does not consider the specific needs of any individual.