Well that’s all right then. The head of the Reserve Bank’s financial stability department, Luci Ellis, reckons Australia will avoid a US-style house price meltdown. Speaking at the Australian Mortgage Conference yesterday (where, let’s face it, you’re not going to get well-known Australian property bear, Steve Keen addressing the audience), Ellis gave a whole host of reasons about why Australia – and the Australian property market – is different.
And after reading her speech, they are eminently sensible. Australia didn’t have lax lending standards and a big sub-prime market. We had good prudential supervision. On average, Aussies put down bigger deposits and pay debt down faster than people elsewhere.
But Ellis also said to expect house prices to experience more frequent price falls than in the past. Here’s the relevant part of her speech:
A note of caution, though: housing price growth is no longer running ahead of income growth the way it did during the 1990s and early 2000s, when the economy was still adjusting to disinflation and deregulation (Graph 3). And because inflation and thus income growth are lower than in the 1970s and 1980s, soft periods in the housing market could now be more likely to involve falling housing prices.
The last bit is classic bureaucrat speak… soft periods in the housing market could now be more likely to involve falling housing prices. In the good old days, a ‘soft period’ might have involved an annual price rise of 2-3 per cent. Now you’re looking at declines of 5 per cent or greater.
Despite what the local property spruiker might tell you (it’s usually that ‘things will pick up’ at some point – six months or longer – down the track) there’s a high probability that Australian property prices will correct lower for many years to come.
Why? It’s simple economics.
Check out the chart below from Ellis’s presentation. It shows house prices as a percentage of annual household disposable income. The ratio peaked in around 2003. Then, the China boom came along and boosted national and household incomes, helping to push the ratio down even as house prices continued to rise.
The spike down in 2008 relates to the GFC. The subsequent bounce reflects the government’s attempts to reinflate the market with the first homeowners grant. But that boost was temporary. As you can see, since 2010 the ratio has again fallen…a result of weaker house prices and still rising incomes.
Looking at the chart from 1980, it is easy to make the argument that abundant credit – boosted by financial deregulation – was the primary driver of house price appreciation. Easy credit allowed a household to double its borrowing power (and therefore purchasing power) from around 250 per cent of disposable income in 1980 to over 500 per cent in 2003.
Now the era of easy credit is over – and the ‘age of deleveraging’ has begun – we would expect the ratio to begin the long journey of ‘mean reversion’. So over the next decade, it would not surprise us to see the ratio fall to somewhere between 300 and 400 percent.
If you think China will continue to boost household income for another decade then house prices don’t have to fall precipitously for the ratio to correct. But if you think China will get indigestion in trying to deal with its credit boom in the years ahead – as we do – then falling house prices will account for most of the mean reversion.
That’s all conjecture though. What about some facts? Here’s some anecdotal evidence for you to contemplate.
We’re in the process of moving the family to Melbourne. Rents are expensive. To get a family home, we’re looking at a weekly rent bill of at least $650. That’s $33,800 per year…that’s hefty.
What if we wanted to borrow to buy? We plugged some numbers into an online mortgage calculator. To get the equivalent weekly bill of $650, we could borrow $400,000 over 25 years at 6.99 per cent.
Now, with house prices where they are, there is not even a remote chance that we could buy a property for $400,000 that would resemble the quality of the house rented for $650 per week.
In fact, based on our research the asking price for a house that rents for $650 per week is around $800,000. So along with the $400,000 loan we would need to chip in 400 grand. In this example, our combined capital would therefore yield, implicitly or explicitly, 4.2 per cent.
If the cost of debt is 7 per cent (the interest rate on the bank loan) then it follows that our equity capital (the deposit) must be earning a very low rate of return.
The conclusion is you get much more bang for your buck by renting. The only way buying makes sense is if you think house price appreciation will compensate you for the very poor income return (implicit or explicit) you are getting by paying such high prices.
But as we’ve shown, the era of easy house price gains is over. As this realisation dawns on more and more people, we would expect house prices to drift lower. Ellis is probably right. There’s no major reason why you should expect a US-style collapse (unless China experiences a very hard landing). But years of grinding lower is no fun either…unless you’ve been waiting for a good time to buy.
The other point to consider here is the capital structure of the housing market. The marginal buyer is highly leveraged. Let’s assume that most new buyers can muster up a 10 per cent deposit. So you’re looking at a capital structure of 10 per cent equity, 90 per cent debt.
Asset price changes impact on equity, not debt. A rising market boosts returns on equity. That sounds good. But if you think of the housing market as an operating business, you would consider its returns as ‘low quality’.
By that we mean returns have not come from operating income (the equivalent of rent) but from constant asset price revaluations. Homeowners have booked the revaluation through the income statement and this has made the overall return look much better than the underlying fundamentals suggest.
Given existing income returns, a stagnant housing market will result in very poor returns on equity. A falling housing market will lead to equity writedowns, i.e. the destruction of capital.
When a company’s return on equity is less than the cost of its capital, the share price falls. It reflects the poor decision of management to invest capital in a low returning asset.
So what is the equivalent of the household sector’s share price? Is it consumer spending? If it is, the slowdown in consumption you’ve seen over the past 12 months may still be in its early stages.
for The Daily Reckoning Australia
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