Australian Property: Crazy Bullish or Just Crazy?

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Yesterday we asked for your thoughts on the Australian property market. You didn’t disappoint. The inbox is heaving with responses. We’ll go through them and publish some, with our responses, in the next day or two.

In the meantime here’s something for property bulls and bears alike. From today’s AFR:

‘Contestants on the Nine Network’s hit reality series The Block were gasping with shock when their homes nabbed more than $200,000 above the reserve prices at auction.

‘All five apartments fetched higher than $1.44 million at the televised auction, beating the inner city’s suburb’s median unit sale price by more than $886,000.’

So just to clarify things, the units sold for more than $1.44 million which was 160% above South Melbourne’s median unit price.

That sounds crazy bullish, with an emphasis on crazy. But then again, we don’t watch The Block. With two little ones to feed, clean and then try to resist tranquilising in the evenings, the TV doesn’t get much of a run in our household.

So maybe the apartments were worth the price paid. Maybe there were some gilt-edged trimmings around the place or the rooms were packed with ‘European appliances’.  In the absence of knowledge of the intricate details of the fittings or the general quality of the apartments, let’s consider the earnings the properties must generate in order to deliver a half-decent return for their new owners.

As we mentioned yesterday, a property’s earnings is the rental income stream it delivers. This can either be explicit (assuming the apartment is rented out to a third party) or implicit (in the case of the owners staying put).

So, at a minimum of $1.44 million, plus 5% stamp duty in Victoria (add another $72,000), your cost base for the delightful and fleetingly famous South Melbourne apartment is $1.512 million. Gulp.

What would be the minimum return you would want from your new property? In this low interest rate environment, let’s say 3% gross. On a $1.512 million cost base, that represents rental income of $45,360 per annum, or a weekly rent of $872.

Call us sceptical, but we think it’s a stretch to think anyone would stump up that kind of money for an inner city apartment, especially with the glut of apartments in Melbourne. But the apartments are large and unique, so maybe they would.

So looked at through the lens of a rental (earnings) yield, the net return (after maintenance costs) on capital of these apartments will probably be in the sub-3% region. That’s hardly an efficient use of capital.

The cost of debt capital (which we take to be the cost of a home loan) is over 5% while the cost of equity capital (which we conservatively assume is the return you get from saving your deposit in a bank account) is around 4%.

(Keep in mind, that even if you don’t have to borrow a cent to buy property, there is still an opportunity cost involved. In this case, we have been as conservative as possible and assumed the cost is the interest rate in a high interest bank account.)

On these numbers, the property isn’t even covering its ‘cost of capital’. When companies listed on the stock market generate returns below their cost of capital it results in value destruction (diminished equity value) and a declining share price.

For buyers to willingly purchase property promising such low yields can only mean either the buyer doesn’t care and that they see the purchase as a store of wealth (fair enough) or that they expect to make money not from the rental yield but from the long term capital gain.

From our experience, this seems to be the overriding mentality of property buyers in Australia. That is, income is a side-show, it’s all about capital gains. And because they are tax free, it’s the only game in town.

We remember a conversation with a Melbourne real estate agent earlier this year. After enquiring about a house in St Kilda and the expected rental income, we remarked how poor the income return was. The agent quickly dismissed our schoolboy interpretation of return on assets. You don’t buy property for the income return…you buy it for the long term capital gain it delivers.

There you go…

Getting back to The Block sales, according to the AFR, buyers advocate David Morrell says ‘if it wasn’t for the commercial hype, there’s no way those apartments would have got those prices…anyone who buys an apartment like that, expecting to get a turnover, needs to get their head checked.’

But buyers agent Monique Sasson Wakelin ‘argued that prices paid are “not that crazy, or out of the ballpark” for the area. “South Melbourne is a highly sought-after area, and even though it’s not the prettiest end of Park Road, you’re still within walking distance to the city.”’

The property bulls certainly have the upper hand right now. Actually, they’ve had the upper hand for years, and bears like us have been proven wrong time and time again.

One thing the bears have got wrong is their ability to underestimate the impact of regulation on pushing costs up. There are multiple layers of government red tape and costs that adds to the price of land and the cost of building anything on that land. Add to that an expensive and in many cases unionised construction workforce and all these costs are added on to the final product.  

But the bottom line is that unless the earnings from an asset are greater than the cost of capital that procures the asset, it results in a destruction of wealth. That may seem like a weird statement given that rising property prices make many people ‘wealthy’.

But the cost of capital versus the return on capital is a fundamental law of finance. A company with a poor return on capital can keep its head above water by increasing borrowings and raising additional equity from shareholders as long as confidence in the business remains.

But when confidence goes the flow of money stops, finally revealing the ugly economics of the business…which should’ve been there for all to see for years.  

Regards,

Greg Canavan+
for The Daily Reckoning Australia

Join The Daily Reckoning on Google+

Visit the Remembering The Future Facebook Page for more on Australian Property.

From the Archives…

Has the Chinese Economy Hit the Great Wall?
26-07-13 – Bill Bonner

Crisis, Capital Controls, and Accidents of Birth
25-07-13 – Doug Casey

Australia’s Mysterious Natural Gas Shortage
24-07-13 ­– Nick Hubble

Bernanke’s QE Train Wreck That’s Heading Our Way
23-07-13 – Vern Gowdie

The Misallocated Savings of the Chinese Banking System
22-07-13 – Dan Denning
 

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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8 Comments on "Australian Property: Crazy Bullish or Just Crazy?"

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pizapete
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have just sold a property in a good suburb in newcastle…….purchased 4 years ago ago for 675,000 plus stamp duty approx. 25,000…….700,000 all up…..sold for 675,000 less agents fees…..all up a loss of 40,000…..thats not all….then add mortgage payments of 100,000 for 4 years……im starting to feel sick…..plus minor improvements maybe 10,000……not funny………if you purchase a house for 500,000 you need to sell it for 540,000 just to break even …..good luck.

Nexus789
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Investors in property can at this instant possibly gloat about the property market and they will. However, history tells us the the global and Australia economy has experienced downturns. This is inevitable. Either as a result of global downturn or one linked to the decline in China’s fortune. It is inevitable and when it comes the fall will be calamitous as there is so much debt entrenched across Australia.

garry
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Still haven’t got it, eh. High prices in Australia are a result of a top down reaction, whereby foreign buyers are now sitting in direct competition with us in our housing marketplace, and it is they who are scooping up the very best properties. In turn, driving the local citizenry to nearby suburbs. Thus increasing prices there. It’s mostly a big city, inner living, phenomenon at the moment, however in due course the buyers will spread their wings, given that China alone has far more people with deep pockets than we have. A trawl through “Juwai” or maybe “http://www.gifang.com/” or… Read more »
Ross
Guest
Bad collateral makes the liquidity which makes the market and high prices. The questions is for how long? In the US sales are down but the latest report says prices are up the highest since mid 2006. Don’t use your head but rather your nose when evaluating the so-called market which is just the muck fed to the useful idiot pigs. It matters not whether you call them greedy or needy by nature, debt slaves, or little league overseers of those unwashed renters without the capital to little league players along way down the line in the game; rather it… Read more »
Ross
Guest
“Blackstone has emerged as the biggest investor in single-family rental homes, spending more than $5.5 billion since the beginning of last year to acquire about 32,000 homes in around a dozen major U.S. markets. Other companies, such as American Homes 4 Rent, Colony Capital LLC and Waypoint Real Estate Group LLC also have been snapping up thousands of foreclosed homes, revamping them and renting them out. American Homes 4 Rent, with 19,000 homes owned or controlled, is expected to price shares of its stock Wednesday in a bid to raise $750 million in an initial offering on the New York… Read more »
Don't Prop Up the Ponzi
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Don't Prop Up the Ponzi
“But when confidence goes the flow of money stops…” Of course, the $64K question is, when will confidence go? As long as the government keeps the bubble inflated through massive immigration, unrestricted foreign investment, FHOG and negative gearing, and as long as the MSM keeps publishing articles spruiking real estate without allowing any commentary in opposition, and as long as vested interests ranging from banks, the real estate industry and property owners themselves pushing the real estate always goes up mantra, then how and when is anything going to change? It is the government (both sides) who will do anything… Read more »
Justin
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I agree that property is overvalued (and think our cost of capital assumptions are very conservative), but note that your analysis does not look at the increase in rent over time. E.g. If a rental yield is 3% and cost of debt service is 5% now, in the future the rental income will increase (at some point above the debt service) while the interest paid is on a fixed period. I agree with your conclusion, but I think that if you want to value using discounted cash flow principles rather than expectations of capital gains, you should consider rent increases… Read more »
Acid Tester
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I still dont understand why people are so concerned about foreign eg. Chinese buyers, negative gearing, rba rates, media spruiking, bank profits, gov buyers grants… This is now determined at a macro economic level, and also it is big enough that it is impacted by international financial markets and economies. The reason why the aus economy didnt tank in 2008 has little to do with mining or Rudd’s economic stimulus, it didnt take because of quantitative easing, ie. mass injection of US dollars into international markets. This effect just fed through to aus banks which allowed local investors ammunition to… Read more »
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