Views

Please read the disclaimer first.

28 February 2010 – What a Difference a Year Makes

The depths of the global financial crisis occurred around March 2009. Many pundits were predicting doom and gloom, but only ended up with egg on their face. For example, Steve Keen predicted property prices would fall by as much as 40% (» read more) but they only fell by around 5% from their peak in 2008. One year on, sentiment has swung the other way. One newspaper recently forecasted that median prices in one Melbourne suburb could quadruple over the next decade and similar levels of growth in other suburbs (250-370%).

If prices quadruple over the next 10 years, then this is equivalent to 14% p.a. capital growth rate (using the Rule of 72). This does not take into account the net rental yield, which would increase total returns to 15+% p.a. There is Buckley's chance of this occurring because:

• Property valuations are at historical highs - the ratio of Australian median house price to average wages increased from 4 (1959-1988) to 5 in 989 and 8 from 2004 onwards. If wages increase at 4% p.a. over the next 10 years and property prices increased by 14% p.a., then valuation ratios will rise from 8 to 15-20.

• Over the last 100 years, the total return from shares is just over 10% p.a. The returns from real estate need to be around these levels over the medium-long term, otherwise arbitrage opportunities arise. Over the short term, strong returns are possible if prices are coming out of a depressed period. However, in the case of property, the exact reverse is the case. Property prices have risen strongly in Australia since the mid-90s.

Human nature is driven by fear and greed, which causes prices to overshoot long trends on the downside and the upside. In my experience, this also extends to forecasting.

17 February 2009 – Sydney: A Tale of Two Cities

Sydney has been the weakest property market in Australia since 2003, and at one stage, Perth and Melbourne median house prices almost caught up to Sydney. Over the last few years it has been a tale of two cities:

• The west is dominated by first home owners and property investors. Property prices were weak until around October 2008, dragged down by high interest rates (and bank foreclosures), which affected first home owners and property investors much more than the high-income owner-occupiers in the inner suburbs. Since then, property prices have strengthened, supported by demand from first home buyers looking to take advantage of the First Home Owner Boost Scheme. [For contracts made between 14 October 2008 and 30 June 2009, first home buyers receive an extra $7,000 for buying an established home or $14,000 for buying or building a new home under the First Home Owner Boost Scheme, in addition to the $7,000 First Home Owner Grant. There are also stamp duty concessions for first home buyers (for example, up to around $18,000 in NSW).]

• The inner suburbs (the eastern suburbs, North Shore and inner west) is dominated by high-income owner-occupiers. They were much less affected by the high interest rates, and as a result, property prices in the inner suburbs were much stronger until recently. However, the sharp drop in the stock market (resulting in lower bonuses, and margin calls) and job losses in the financial services sector has resulted in falling demand and hence weaker property prices in these areas. This has been partially offset by the weak Australian Dollar, which has improved the buying power of the expats and foreign investors that target these more affluent areas by 50% since the middle of last year.

In the short term, prices could pull back a little in the west as first home buyer demand falls after June 2009. There could also be some further price falls in the inner suburbs as the unemployment rate increases. When the property market is weak, sales volume falls and some of the reduction in median prices is due to sales being skewed towards cheaper properties. With interest rates so low, it is becoming more attractive to buy a property than to rent. This should put a floor on property prices and as economic conditions improve, lead to higher prices. If economic conditions worsen, interest rates will fall even further and it will be even easier to service a property.

2 January 2009 – Some Crystal Ball Gazing

There are two main economic views on where the property market is headed over the next few years.

1. There will be a substantial fall in property prices. The main proponents of this view include:

• Associate Professor Steve Keen of the University of Western Sydney, who recently sold his apartment and predicts price falls as much as 40% (» read more), and

• Morgan Stanley economist Gerard Minack who thinks that the top end and "discretionary" housing such as holiday houses on the coast could fall by 50% (» read more).

The reasons they give are:

• Houses are expensive on any measure, for example, price to income over time and compared to other countries such as the US, and

• Buyers are overextended with debt and many will lose their jobs in the forthcoming recession and be forced to sell, causing house prices to fall.

2. There will not be a large fall in property prices. For example, Saul Eslake, ANZ's chief economist gives the following reasons (» read more):

• Australia does not have an excess supply of housing like the US, due to a shortage of supply and increasing demand from immigration.

• Australia does not have an overhang of houses for sale like the US. This is due to the higher percentage of subprime loans in the US that were made when interest rates were much lower than Australia's. Many of the subprime borrowers could not afford to service their loans when interest rates rose from their lows and after the honeymoon period of the loans, resulting in much higher foreclosure rates in the US. In addition, the housing loans in the US are generally non-recourse, allowing borrowers to walk away from their loans when the value of the property falls below the value of the loan, without affecting their other assets or income.

• Interest rates are falling, and provided that unemployment does not rise sharply, will reduce mortgage defaults.

I think scenario 2 is much more likely and in fact, house prices will start to pick up soon for the following reasons.

Vacancy rates are at their lows of the last thirty years. The vacancy rate measures the interaction of supply and demand for real estate. When they are at their lows, there is a shortage of supply relative to demand. Landlords can afford to increase rents and property prices will start to rise. In the figure below (page 93 of my book), which overlays Sydney median house prices with vacancy rates, notice how prices rise sharply after the lows in vacancy rates, as indicated by the arrows.

Source: Real Estate Institute of Australia

The relative rental yields are rising off their lows of the last thirty years. The relative rental yields measures rents as a percentage of of the cost of funding a property (I use the standard variable rate as a proxy). When they are at their highs, real estate is cheap relative to the cost of funding. It becomes more attractive to buy than rent (and the returns from real estate are relatively more attractive than cash and bonds) and property prices will start to rise. In the figure below (page 97 of my book), which overlays Sydney median house prices with relative rental yields, notice how prices rise sharply after the highs in relative rental yields. Okay, at the end of 2007 relative rental yields were at their lows over the last thirty years. However, since then the standard variable rate has fallen by over 20% and cash rates have fallen by over one third. The standard variable rate has not fallen as much as cash rates due to the drying up of global credit markets. However, this situation will correct itself in a few years' time. In addition, rents have continued to rise in most areas. As at the start of 2009, the relative rental yield is now around 45%. If the standard variable rate had fallen by as much as cash rates, then it would be around 55%. With further interest rate cuts in the pipeline, the relative rental yield should approach the highs of the last thirty years shortly.

Source: Real Estate Institute of Australia, Reserve Bank of Australia

Other factors that support strong property prices include:

• Opportunity cost: lower interest rates will force investors back into the equity and real estate markets to take on more risk to try to generate higher returns.

• Weak stock market: after the October 87 crash, property prices surged as investors diverted funds into real estate. We won't see this kind of increase in the current environment due to investors' concerns about their jobs. However, the weakness in the stock market is a positive for the property market, even though shares appear to be much more undervalued than property given the 40%+ falls from their highs in 2007.

• The First Home Owner Boost Scheme (which pays an extra $7000 for buying an established home or $14000 for buying or building a new home for contracts made between 14 October 2008 and 30 June 2009, in addition to the $7000 First Home Owner Grant) will provide a short term stimulus to property prices in the cheaper areas.

These factors are irrelevant if the economy heads into a prolonged recession and unemployment rises significantly. However, despite the extreme forecasts of one or two doomsayers, most economists do not think that the unemployment rate will reach anywhere near the recession levels of the early 1980s and 1990s, when it rose above 10% (» read more). This is because the cost pressures (interest and wages) on businesses now are much less than during the last two recessions. The extent of business debt is less (offset by greater household debt), and while some highly geared companies have already gone bust, these are the exceptions rather than the rule. In addition, interest rates are much lower than they were in the past (» read more), and the Reserve Bank has indicated that it is prepared to cut interest rates further if necessary.

Despite the turmoil in the financial markets in 2008, the possibility of further cuts in interest rates combined with the government's $10.4 billion stimulus package and lower petrol prices should boost confidence and help kick start the economic recovery in 2009.