Sensationalist headlines about Australia’s property market sell papers. The Economist has been talking about this bubble since 2001, when they compared (from Washington DC) various statistics about housing markets from around the world, and concluded that Australian property was the most over-inflated in the world.
On the other hand, nearly every bank economist in Australia insists this is not the case and they all have the charts to prove it too. Below we summarise the two opposing cases, and then look at what a bubble might look like in the extreme outside case.
Is Australian Residential Property Overvalued? The case for and the case against
Case against the bubble: Supply not keeping up with demand
House prices, Australia 1987-2014, compared to changes in supply and demand
(Source: ABS, FIRM, RBA)
No one factor can be blamed for the housing market price increases, rather it is four compounding forces:
- Net migration has doubled
Net migration has been more than double the long term average since 2005 - Foreign investment has also doubled
While the numbers are small , foreign investment has more than doubled since 2005 - Natural population increase
Not as dramatic, but the annual increase in population due to births less deaths shifted to new records from 2005 - Supply inflexibility
New dwelling starts haven’t increased since the 1980s
Case against the bubble: Fundamentals out of whack
Price/rent index, various countries, 1975-2014
(the higher the ratio, the more expensive the capital values compared to rental income)
(Source: The Economist)
The case against relies more on the idea that Australian housing should comply with some global benchmarks such as the ratio of prices to household incomes (as shown above); or rental yields, adjusted for inflation. Regardless of which of these fundamental ratios are used, Australia comes across as one of the most expensive housing markets in the world:
- Rental yield vs long-term averages
Only Britain and Canada are further from long term averages than Australia. China is far below Australia on this measure. - Inflation adjusted price increases
“Real” prices in Australia are up 2.8 times since 1975, compared to Canada, NZ, France and the UK at 2.2-2.3 times; the US at 1.3 times and then Japan and Germany at 1.0 times (that is no change in 40 years).
If Australian housing did fall, what could we expect?
As Australia hasn’t had a major housing price correction for decades, we need to look to other advanced economies for some examples.
The IMF did a study of housing market corrections in advanced economies (US, UK, Canada, Europe, Australia and NZ) over the past 50 years*. The average correction when markets did correct was around 25-30%, after considering inflation (around 15-25% in normal terms). This would take prices back to 2009, suggesting it’s not an unrealistic fall, just unprecedented for Australia.
APRA, the Australian banking regulator, used a 40% drop in home values in its a recent stress test of Australian banks. That’s quite extreme, in line with Dublin’s crash in 2008 in fact.
*This measure is the average fall in markets where housing prices corrected. For example, in 2007, markets in the US, UK, Netherlands, Spain, Italy and France fell by an average of 31.2%. It is in “real” terms, that is, it excludes inflation. A 31.2% real price fall means a fall in value of around 21.2% when inflation is added back, i.e. a house worth $1,000,000 in 2007 would be worth $788,000 in 2012 according to this data, but because of inflation between 2007 and 2012, the purchasing power of this house value would be $100,000 lower again.
So what’s the answer? Of course no-one really knows. So all you can do is make sure that you are prepared, that is not over exposed to the risk of there being a bubble, while not over reacting, putting all your cash in the bank and thereby reducing your income too far1.
Early in 2015, we will be publishing a review of the implications of the outlook for property and of the implications for all asset classes should this extreme scenario occur. The purpose of this is not to suggest this is our expected case – far from it in fact – but to help investors to plan their investment strategy to ensure they will be prepared if there is such an event in Australia, like that seen in the US or Europe.
There is a middle ground between owning property and taking all of the downside risk, and shifting to bank deposits where you have no downside but very low income. The middle ground in the case of property is “mortgage backed securities” such as Residential Mortgage Backed Securities (“RMBS”).
Just as many SMSF investors are shifting some of their equity positions into bonds in the same companies to lower capital risk and increase income, they are also investing in property backed debt securities such as RMBS to reduce their exposure to the risk of a downturn in Australian property.
FIIG has access to several lines of RMBS issues offering yields from 3-4% p.a. for the very conservative issues to as much as 9-10% p.a. for much riskier issues. Investments are available from $50,000, but only available to wholesale investors.
1In forming your own views, the above is a very brief summary of the key arguments. You might also want to turn to those without vested interests. The IMF (International Monetary Fund) has launched its “Global Housing Watch” which provides some useful insights (http://www.imf.org/external/research/housing/). They provide the balanced view that data above historic averages does not portend a crash, but then warn against complacency as housing price falls are responsible for two-thirds of banking crises.
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