One of the most common things people say when discussing the residential (capital city) property market goes along the lines of “the property market seems vastly overpriced, but I can’t see any reason for it to drop”. Bear in mind, these statements have been made not by the financially illiterate, but by investment bankers, lawyers and fund managers, who, despite their considerable intellect, are a prone as anyone else to being caught up in a bubble. In making such a statement, one is effectively saying that they believe an asset class has become removed from its intrinsic value, but that the market is permanently broken and the assets will remain overpriced indefinitely.
It is not a surprising thought pattern, especially if someone has only been aware of the property market in the past 13 years. Moreover, given the government and Reserve Bank have provided unprecedented assistance to property sellers in 2008-09, it is forgivable for thinking that the moral hazard created by low interest rates and the first home owner’s grant is permanent.
Alas, the federal government can only stick its finger in the property dyke for so long.
One of the few legitimate reasons for the recent increase in property prices in capital cities has been increasing rents underpinning investment yields. While those rents have been far outstripped by price gains, the increase has at least in some small part vindicated the dwelling price appreciation. However, rentals are dependant on demand (and, of course, supply) factors — if there are a large number of potential tenants seeking a property, that will provide a very accurate indicator to property managers (who often manage a portfolio of more than 200 dwellings) that rental prices can increase. This has occurred in recent years as “cashed-up” foreign students moved to Australia to study, leading to a significant increase in demand for rental properties.
However, it appears like young love, demand from foreign students is not forever. Last week, the (admittedly self-interested) International Education Association of Australia warned that foreign student numbers would drop by 100,000 (or just under 20%) this year, due to a combination of a high Australian dollar, new visa requirements and attacks against Indian students. If this forecast drop occurs, then the inner-city rental market in capital cities such as Melbourne and Sydney will damped substantially. This will lead to already depressed yields dropping even further.
Apart from reduced immigration, there are three likely key drivers for a potential housing correction.
First, the growing risk of a global “double dip” recession leading to higher unemployment. One of the key reasons that the property market in Australia avoided the downfall witnessed in the United States and Britain (as well as Ireland and Spain) was because the flexible Australian workforce encountered minimal levels of unemployment. While recorded US unemployment is 9.9% (but really, closer to 17% when long-term unemployed are considered), and UK unemployment is 8%, the rate in Australia is a mere 5.4%. According to Fujitsu, mortgage stress affected 900,000 households in August 2008, this fell to 561,000 in March 2010, largely, because most Australians were able to keep their jobs. If unemployment in Australia did rise to overseas (or 1991) levels, expect a substantial property correction.
(The unemployment risk has been heightened by government stimulus, specifically the first home buyer’s grant, which effectively “brought forward” housing demand. As Dan Denning from the Daily Reckoning noted yesterday, “when you ‘bring forward demand’ you bring it into the world prematurely. In a financial sense, this means home buyers who, financially speaking, may not be ready to endure the hardships that come with rising interest rates and unemployment. They can only hope that things don’t happen. If they do, the demand brought forward could get crushed.”)
The second possible catalyst for a property correction is if the reverse happens — that is, the global economy overlooks European and US debt concerns and a possible China bubble and continues to grow in earnest. While less likely, if this happens, expect the RBA to further tighten monetary policy and increase interest rates to prevent inflationary pressures.
As this graph, prepared by Chris Joye and Rismark, indicates — higher interest rates are a considerable factor in determining house price-income ratios. The higher the prevailing level of interest rates, the lower the house price to disposable income ratio. Presently, with historically low interest rates (even after the recent rate rises), Melbourne and Sydney house prices are tending to be about six times household disposable income — around double the historical rate.
The third possible catalyst for a housing correction is a possible Australian bank funding squeeze. It is no coincidence that banking and residential property sectors have been two of Australia’s strongest performing areas since the financial crisis. Courtesy of a government guarantee on foreign funding, banks have been able to continue to support the housing sector. This has allowed property prices to continue to rise (and also, importantly, for banks to maintain the value of their security on their balance sheet, making them appear “safe”). The problem is, about half of Australian banks’ funding comes from overseas. If European debt worries continue, and Australian banks need to rely on local savings to fund loans, then the housing market will slump as loan-to-valuation ratios drop and lending tightens.
Just to clarify — what will make house prices correct? If the economy dips, then unemployment will lead to increased stress and foreclosures, and a dramatic shift in buyer expectations. By contrast, if the economy strengthens, then the RBA will most likely be forced to raise rates to more natural levels, resulting in higher service costs and lower price-disposable income ratios. Finally, if Australian banks are no longer able to service their considerable funding costs overseas, then they will not be able to continue to bankroll the bubble. Can the housing bubble burst? You bet.
Good article, Adam. I’m just a mug amateur, but aren’t there strong public policy measures that keep the housing price bubble inflated? For example, negative gearing seems to outweigh the risk of falling rents and keeps investment in property more advantageous than, say, equities. Also, people on reasonable, even modest, incomes still manage to get into housing at current prices because reasonable quality residential stock doesn’t hang around long, in Sydney (even outer metro areas) anyway.
Then there are the other public props to the housing market, such as those found in this week’s NSW budget – stamp duty concessions, grants etc together with other incentives and bank finance guarantees, as you mentioned. Despite all the talk about the need to increase housing affordability by governments, they’re scared to death of a fall in property prices because of the implications for lending institutions’ balance sheets, aren’t they?
Waiting for the bubble to burst..waiting..waiting… waiting…so as to buy..buy.,…buy…how long must I suffer..the aged old man waiting for the bubble to burst!
While I agree that there is a reasonable chance of a drop in property prices, I question some of the reasoning. The question on whether the property market balance is ‘broken’ is a difficult one because property should be expected to behave differently to other asset classes.
For owner occupiers, who are still a very large part of the market, property is not merely a speculative asset, it dictates lifestyle outcomes such as commute, local services and community etc etc. Ratios of income to house prices are useful to an extent, but there is a possibility that people are prepared to spend more of their disposable income on property to get what they want and that this is a permanent or at least long term change in the way households use their income.
So if someone says that the property market is overpriced and not behaving as an asset market should, I would want some solid substantiation.
In terms of the risk of a strongly performing economy driving up interest rates and depressing the market, this doesn’t really stack up. If a significant number of people are squeezed by interest rates (enough to impact the market supply and demand balance) then they will be tightening their belts and the reduced spend in other categories would remove the inflation trigger which would cause rates to rise. Further, economic growth is associated with low unemployment and increasing labour costs (ie salary) which in turn drive inflation, but also enable people to weather higher interest rates.
Is there any historical precedent for a fall in house prices when the economy is growing strongly?
Even the potential for banks to tighten lending terms is tempered by the fact that they know that if they rein back lending too much and it causes the market to drop then it is their collateral which will devalue. So they will act to prop up the property value, unless overwhelming global factors force their hand.
A significant downturn in the local economy leading to much higher unemployment or global factors stopping banks from lending money on current terms could result in a big downturn in property prices, but there is a bit too much rhetoric floating around about overheated markets and inevitable crashes. Any market can crash if demand is removed, Australian property is no different, but that doesn’t mean that it is overheated.
Dear Adam
Thankyou very much for this very well explained article.
Both Julie and I agree with you that the banks will struggle to hold pace with future mortgage financing.
With 50% of their funding coming from offshore sources even they are held to ransome on the cost of money and this will obviously be passed on to potential borowers and will certainly cool demand.
We also believe that the employment rate will go the way of Shackelton due to the fickle condition of the minning sector and manufacturing…..manufacturing, well there’s not much of that anyway.
Just to let you know we still have n’t found a property to our liking or affordability.
But help is at hand. Chris Stabarakis from the realestate agency Coniatis Lialls and Deceto, said we should buy off the plans down at one of the Docklands developements.
He reckons that we should buy two, rent one and live in the other one. He said we can secure both properties by financing them through Kim Faithfull ( not his real name but changed by deed poll ) from Defrautis & Burns International, a local Finance Broker down in Melbourne.
Anyway, just letting you know that your well researched articles are very much appreciated.
Yours Sincerely
Kevin & Julie Harris
But wasn’t it Warren Buffett who said he decided it was time to get out of the market when even his cab driver offered him investment advice?