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Australia’s residential property boom

This article asks three questions. Is Australian housing overpriced? If so, why? And, what can the Government and the RBA do to prevent a bubble from forming?

Is Australian housing overpriced?

In short, yes. We believe that in the long run valuations of all asset classes mean revert. House price data exists in Holland dating back to 1650 (see chart below), demonstrating this mean reversion of residential house prices. It also shows that property bull and bear cycles can last an awful long time. For example, the market peaked in 1740 and didn’t start rising again until long after Napoleon had abandoned his attempts at world domination. A hundred year bear market? Ouch. The most recent housing bull market began in earnest in the 1960s and is now at stratospheric levels compared to the past. What goes up …

JH Chart1 051214

JH Chart1 051214

Source: Loanz of The Netherlands.

What about Australian residential property today? There are three good guides to understanding whether houses are cheap or expensive: how prices have changed over time relative to inflation; relative to wages; and relative to rents.

Here we review Australian home values (olive line) going back to 1979 against all three measures, and compare them to prices in the UK (light blue), the USA (dark blue) and Germany (green). The data is collected from The Economist’s excellent global house price online tool (Sources: Australian Bureau of Statistics; BIS; Bundesbank; FHFA; Nationwide; OECD; Office for National Statistics; Standard & Poor's; Thomson Reuters; vdpResearch).

i)   First, how have prices changed relative to inflation?JH Chart2 051214Whilst houses in the US and Germany are cheaper than in 1979, Australian homes are almost three times as expensive when adjusted for inflation. Most of the price rise happened between 1995 and 2005.

ii)   What about house prices relative to the rents they produce?JH Chart3 051214Whilst your friendly local real estate agent might try to convince you that ‘there has never been a better time to buy’, he is not strictly correct. The olive line above supports the case that ‘there has never been a better time to rent!’ Houses in the UK, the US and Australia rose rapidly compared to rents between the period 1995-2005. American home prices then crashed and rental yields have since returned to their long term average. However, rental yields are more than 50% lower than their long term average in Australia. In contrast, German rental yields rose for 30 years (prices fell relative to rents) and only started to decline in 2010.

iii)   And house prices relative to wages?JH Chart4 051214; overpricedAs the graph above shows, Australian house prices are about 30% above their long term average when compared to median wage income. This is our favoured long term measure of housing prices and the most significant of the three metrics.

So, yes, we can state the Australian residential home prices are high.

Why is housing so expensive?

In the long run, house values rise in line with incomes and standard of living (GDP). However, in the short term, there are two principal drivers of house prices; the availability of land, and the availability and price of credit.

Lower mortgage rates enable Australians to borrow more for a given level of income. The shift to lower rates in the mid-1990s has exactly coincided with the sharp rise in prices and also with a massive increase in household debt (see below).JH Chart5 051214; property boom; overpricedHowever, lower mortgage rates are only part of the story since low rates also exist in Germany and the US yet houses are much cheaper in both countries. What do the UK and Australian property markets have in common that have caused prices to remain so elevated? The answer is a lack of supply. Australia has restrictive land supply policies leading to an annual shortfall of some 200,000 houses. Very low vacancy levels and very high prices are the result.

A dearth of available housing can quickly become a glut as American homeowners in Florida and Nevada found to their horror in 2007, and Chinese apartment owners are now discovering. Here in Australia, higher home prices have resulted in a boom in building new homes. Will Melbourne be the new Las Vegas?JH Chart6 051214; property boomThe media and populist politicians have also blamed Self-Managed Super Funds, negative gearing and that perennial whipping boy, foreigners. But these are mere sideshows.

What can the Government do to limit further price rises?

So far, the RBA has maintained that the residential housing market isn’t in a bubble and that house price growth has been sustainable. Significantly, the RBA has recently changed its stance stating that it is now worried about the build-up in speculative investment activity in the housing market, and that it has been in talks with the bank regulator, APRA, to introduce ‘speed limits’ on credit creation.

So what can the government and its twin regulators, the RBA and APRA do to limit house price rises? Here we examine their options, how effective they may be and whether they are likely to be introduced.

  1. The RBA can raise interest rates. A pre-emptive rate rise would seriously curb house price growth. But it would also damage confidence in the broader economy. We view this option as highly unlikely.
  2. The RBA introduces ‘macro-prudential’ measures specifically to target the housing market. For example, limits on loan-to-valuation ratios; limits on debt repayments to borrower income or loan size to income; forcing lenders to lift the interest rate buffer test they use for loan serviceability; placing high risk weights on particular types of loans in particular geographical areas; or forcing banks to reduce the number of loans to certain individuals and to certain geographical areas. This has been introduced in New Zealand with mixed results. We see this as more likely.
  3. APRA forces banks to lift their capital requirements – this is likely to emerge as part of the Financial System Inquiry. Given the increasing size of the banks’ residential mortgage books and their all-time low provisioning for bad and doubtful debts, they may not be adequately capitalised in a severe housing market downturn. In this instance, they will have to be bailed out by the taxpayer.
  4. APRA forces the banks to increase home loan risk weightings – extraordinarily, banks have been able to ‘self-assess’ the riskiness of each loan and assign to it their own risk weighting! Risk weights vary globally, but the global average is around 30% and is mandated by a regulator (ie. no self-assessment). The abolition of self-assessment will lead to lower share prices but more stable banks.
  5. Abolish negative gearing on property investment – and additionally remove the 50% capital gains tax discount for investment properties held longer than 12 months. Politically unpopular. Very unlikely to happen.
  6. Introduce a levy on foreign purchases of Australian residential property – press speculation is of a $1,500 levy on foreign buyers of Australian residential property, which would raise some $400 million. Whilst $1,500 is likely insufficient to curb foreign buying demand, a percentage levy based on the purchase price (ie. 3% or 5% of the purchase price) may do the trick whilst raising much needed funds for the Australian economy.

In conclusion

House prices are high. They are high because of a combination of low mortgage rates, a healthy banking system and a lack of supply (for now). The RBA is becoming increasingly nervous about excessive speculation and may act to limit further price rises. We expect much noise but little action.

In the long run, property has been an excellent wealth creation vehicle for Australians. Whilst returns haven’t quite matched equities (and the data is often of dubious quality as it invariably omits maintenance capex), they have been achieved with lower volatility. A diversified mix of property, bonds and shares has produced strong returns with reasonable volatility. The past, though, is no guarantee of the future. Whilst there will always be a place for property in investment portfolios, returns from this asset class are likely to be more subdued over the next 10 years.

 

Jonathan Hoyle is Chief Investment Officer at Stanford Brown. Any advice contained in this article is general advice only and does not take into consideration the reader’s personal circumstances.

11 Comments
Doug Pendegast
March 20, 2017

Why not consider a tax or levy on "land banking" also a tax on resales of property with permits for Multi storey developments obtained simply for short term Capital Gain/Profiteering!

Steve
December 24, 2014

Good article Jonathan and I agree that something will be done. The difficulty with most broad based policies is that not all property markets across Australia and within states and suburbs are at the same point of the property cycle or are experiencing the same 'boom' phenomena. For instance I'm not hearing or seeing the same level of heightened interest from foreign buyers in the Perth market. Certainly interest but not to the same level of the Melbourne and Sydney apartment markets. Hear say comments that Sydney / Melbourne developers have been paying 8 - 10% commissions to Asian agents to move stock would have to artificially increase the sales price of stock. Expect some big capital losses in the next few years and declining rental yields as a result.
Singapore has introduced changes to transfer duty on property transactions which raises revenue for the country and targets certain buyers rather than a broad based approach. I was recently told this has resulted in capital declines in house and unit prices. Perhaps its something our government should look more closely at.

Damien
December 09, 2014

That comment from Tim is completely ill informed. It sounds like someone with a self interest in property trying to muddy the waters.

I am a financial planner and I do not know any colleagues that are invested in that manner.

I would go so far as to say that if a financial planner has "...their entire net wealth wrapped up in residential property..." then they should not be practicing as a financial planner.

Dug
December 08, 2014

Kevin, I think the measure of debt to income you are looking at is total debt amount in dollars (i.e. principal, not mortgage payments) as a % of disposable income. So at 150% your net household income is $100,000, your debt is $150,000. If you look at it in terms of income, this is where you get to the rule of thumb that a household experiences 'mortgage stress' where mortgage repayments exceed 30% of disposal income.

Ian McKenzie
December 08, 2014

I'm not convinced that there will be a property bubble bust. Although the disparity between incomes and the price of property is alarming. I think the mistake many Australians are making is that they are too complacent with the current low interest rates, not factoring in possible interest rate rises like 2%-3% and the impact that this would perhaps occur. I'm wondering if the banks (mortgage lenders) should be blamed for this.? If you have a free capital markets economy you cannot expect the RBA and the Government to prevent a property bubble forming. Since Financial Deregulation by the Keating / Hawke Government, we have had ups and downs, the standard normal economic cycle that happens in any economy. How governments manage the economy is the key by using monetary and fiscal policy. (?) Is it being used effectively. (?)

Capital Markets Guy
December 27, 2014

Actually Ian, it has been about 23 years since Australia has seen a recession, so the "normal ups and downs" you refer to have been anything but normal, compared to our long-term history and the experience of similar economies overseas. You imply people (and banks) are unlikely to be prepared for significant rate rises - a statement that I would agree strongly with.

I would also say that having a free market economy and the formation of asset price bubbles is something central bankers do worry about a lot more since the GFC. These events have real impact on people in the economy (e.g. the difficulty experienced by first hom buyers).

You have seen APRA move to introduce small "macro prudential measures" and there will be capital and risk weighting changes to follow the Financial Services Inquiry. They are also requiring banks to stress test their home mortgages with a minimum interest rate of 7% p.a. and a potential 3% increase from current levels at any point in time.

It doesn't mean that bubbles can't form, but I rate APRA and the RBA highly compared to other financial regulators because they have been more proactive about such issues. I hope they are successful once again.

Jonathan Hoyle
December 08, 2014

Thanks for your comments, Kevin.

There are two key measures of a household's ability to make a mortgage payment. The graph above shows the first, which is the amount of mortgage debt in relation to net income. The second is the serviceability of that debt and is driven by the level of interest rates. The former is very high by historical standards; the latter much less so.

Kevin
December 06, 2014

Great article Jonathan!

In the diagram ‘The boom in Australian house prices has gone hand in hand with surging household debt’ it shows household debt has been sitting at ~150% of annual household disposable income for the last few years. Presumably ‘disposable income’ is the money you have to spend after tax, from which you must pay for essentials such as food, electricity, water etc. So how can mortgage payments be 150% of disposable income? I’ve heard this used a lot in the media and have never understood it, so would appreciate your insight.

David
December 05, 2014

Hey Tim,

I don't know how you thought up the statement "that they themselves have their entire net wealth wrapped up in residential property and have no exposure to managed funds or shares themselves."

One of the strong points of advice that a financial planner will provide is 'Don't have all your eggs in one basket.' This means they will recommend a diversified portfolio that will contain shares, property, fixed interest and cash. A diversified portfolio will provide some protection against market corrections because normally, not all assets fall at the same time. Additionally, investing in residential property is an expensive exercise both purchasing and selling, plus takes up a fair amount of the purchase price of the portfolio, which of course, leaves a lesser amount for diversification.

Tim, you stated "In my experience." Perhaps your experience is that you have not been dealing with a real financial planner?

Jonathan Hoyle
December 05, 2014

Tim,

I refer you to my final paragraph.

'In the long run, property has been an excellent wealth creation vehicle for Australians.......a diversified mix of property, bonds and shares has produced strong returns with reasonable volatility.'

I'm not quite sure of your point.

Tim
December 05, 2014

In my experience, the problem with financial planners preaching about how overpriced property is, is that they themselves have their entire net wealth wrapped up in residential property and have no exposure to managed funds or shares themselves.

 

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