A plague on Aussie housing

by David Collyer on January 16, 2013

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By Philip Soos

Is Australia’s residential property market in a price bubble? This question has been much debated over recent years as housing prices leaped then slowly receded, resulting in entrenched views on both sides. Certainly, mainstream opinion is opposed to the idea that a housing bubble exists, with the government, FIRE sector (finance, insurance and real estate), and much of academia claiming that prices are linked to fundamentals or intrinsic value.

It helps to have a sound fix on what an asset bubble is when exploring this matter. Otherwise, it becomes like pornography: you can’t define it exactly, but you know it when you see it. A good starting point is the work of the late US post-Keynesian economist Hyman Minsky. His contrarian work revolved around developing a realistic model of how financial markets interacted with asset prices. This theory was called the ‘financial instability hypothesis’, arguing that financial markets continually misallocate substantial amounts of credit into asset markets, creating Ponzi (pyramid) schemes.

Minsky defined three phases of finance: hedge, speculative and Ponzi. With hedge financing, income flows from an asset are sufficient to pay down both principal and interest on the debt used to finance the asset purchase, and prices are based upon intrinsic value. Speculative financing results in income flows covering only interest repayments, not principal, requiring debt to be continually rolled over. Investors may experience financial stress, but it is not widespread and fundamentals valuations are kept largely in check.

The terminal phase occurs with Ponzi finance, as income flows cover neither principal nor interest repayments (including running expenses in the case of rental property). Investors rely solely on escalating capital values in order to realise substantial capital gains at sale to pay down the cost of debt and balance their income losses. Asset prices are completely delinked from fundamental valuations at this stage. Investors rely upon ‘greater fools’ to maintain positive price momentum, resulting in a bubble. Once there are no more investors willing to take upon staggering amounts of debt to finance asset purchases, prices stagnate then collapse, as the market finally realises that prices are based upon a pyramid scheme, not fundamentals.

With Minsky’s theory, it is possible to determine whether a housing bubble exists. Unfortunately, there is evidence to suggest that Australia’s residential property market is experiencing said bubble. Figure 1 shows the long-term trend in housing prices, adjusted for inflation and quality. The 1996-2010 period is the largest single boom on record, rising by approximately 130 per cent.

The latest housing boom provides one piece of the puzzle: rising asset prices. The next aspect to consider is whether investors are running current income losses. Figure 2 indicates that this is indeed the case as aggregate net rental returns are negative, with losses escalating from $1 billion in 2000-01 to $5 billion in 2009-10. Losses peaked at $9 billion in 2007-08 when interest rates were relatively high, though rate cuts during and after the GFC relived some of the pressure.

There are more than 1.7 million investors with an interest in one or more properties, owning close to two million rental properties. Absolutely and relative to the total housing stock, this is a large sample. If investors are running current income losses of this magnitude, the imputed rents on the stock of owner-occupied housing would bear a similar resemblance, though owner-occupiers treat their properties as security rather than as an investment.

The reason for the sustained net income losses is the combination of rental costs and interest deductions outweighing gross rental income. The ATO does not provide data on principal repayments as they are not deductable against rental income. Accordingly, the rental losses would be larger if these principal repayments were included as they must be funded out of current income. Figure 3 illustrates the growth of aggregate rental costs and interest deductions as a percentage of gross rental income.

Another indicator is the rising levels of household debt used to speculate on housing prices. Household debt is overwhelmingly composed of mortgage debt, whereas personal debt is a small fraction. Figure 4 shows the recent and considerable increase in the household debt to GDP ratio, peaking at 97 per cent in 2010 when housing prices did the same. The ratio has fallen slightly to 93 per cent, which may explain the falls in property values over the last two years, including the historically-low growth in housing finance data (Housing finance misses expectations in November, January 14).

A troubling fact is that almost 60 per cent of investor loans are interest-only (25 per cent for owner-occupier loans), signifying the speculative motive of property owners.

Lastly, a classic sign of a bubble is the price to rent ratio. The reason why this metric is often used in housing analysis is because debt speculation effects capital values not rental incomes (the latter is determined by wages and population growth). Given that the denominator (rents) tends to remain stable over the long term, it is the numerator (housing prices) that comprises the deciding variable. The following figure illustrates the uptick in the ratio commensurate with the boom in housing prices as shown in figure 1. From the trough in 1997 through to 2011, this ratio indicates an overvaluation of 44 per cent, similar to the figures that were recently released by The Economist. The largest surge occurred post-WW2 when the government released price controls on housing, but took until the 1970s to remove all controls on rents.

Minsky’s financial instability hypothesis can help to integrate the occurrences seen in the data. The speculative financing phase likely corresponds to the 1996-2000 period, as housing prices steadily increased but rental income still covered mortgage interest repayments and rental expenses. This relationship, however, broke down from 2000 onwards as housing prices rapidly escalated. Investors were then dependent upon rising capital values in order to realise a profit at sale and to cover the cost of mortgage debt.

This resembles the terminal Ponzi phase, where housing prices and the household debt to GDP ratio have boomed while net income losses have escalated. Accordingly, by these measures, the evidence suggests that the residential property market is currently experiencing a bubble, with prices detached from fundamental valuations. This appears to be the largest bubble on record, orders of magnitude larger than all preceding bubbles. When it does burst, heavily indebted property owners (recent home-buyers, negative gearers) will experience financial trouble, including the economy at large.

Philip Soos is a researcher at Deakin University’s School of International and Political Studies.

6 Comments

  1. Kurt17-01-2013

    Great read. It explains why I am reading your article from Germany where you can buy an apartment in Berlin for considerably less than the price of a unit in regional Australia. I think Darwin, which has a population of around 100k and is around 1500km from the next town with 20k people (Alice) would be double or triple the price of Berlin, which is of course the capital of the largest economy in Europe.

  2. hidflect18-01-2013

    The great flaw in this analysis is it assumes Oz is the only country on Planet Dust. With near Trillions in investor hot money floating the globe, a country like Oz is a magnet for foreign money dumping. And the stats are useless to me anyway. I live in Perth which might as well be on planet Venus as far as the Eastern States is concerned. Is Perth in a bubble? Yes. One that will last for the next 10 years. 10′s of Billions in projecrs will have that effect.

  3. Snail Cafe18-01-2013

    From Kurt’s comment, being able to buy an apartment in the capitol of Europe’s largest economy for considerably less than nearly anywhere in Australia, and, from hidflect’s comment that Perth ” might as well be on planet Venus as far as the Eastern States is concerned.”…..shows how out of balance this country of Australia has become.
    The eastern states and southern states are all hollowed out with Dutch disease.
    Good luck to those that have and are benefiting but at what price to everyone else.

  4. Bobby Fischer20-01-2013

    Hidflect said:

    “With near Trillions in investor hot money floating the globe, a country like Oz is a magnet for foreign money dumping. And the stats are useless to me anyway.”

    Hidflect – you shouldn’t be so quick to ignore available statistics. The amount of foreign investment in property for 2010-11 is available, thanks to an FOI request from Chris Vedelago. Phillip already covered this in another article here:

    https://theconversation.edu.au/dont-blame-foreign-investment-for-rising-house-prices-8340

    Key stats:

    “While clearly dominating the number of applications, real estate investment comprised only $42 (23%) out of $177 billion of investment across all sectors. This is due to the relatively small nature of investment in real estate, compared to the larger scale of business investment.

    While the number of applications is overwhelmingly lopsided, both residential and commercial sectors received the same amount of investment at $21 billion.

    Within the residential sector, 3,885 (41%) applications were for existing properties and the rest for purposes of property development at 5,671 (59%).

    Hmmm so statistics tell us:

    - only $42 billion in foreign investment in one recent year for real estate and when you take out the commercial property, it is only $21 billion; and
    - of that 21 billion, only 41% of applications were for existing properties – the rest was for property development

    Conclusion: foreign investment is sweet FA of the total investment in real estate in Australia in a given year, and the concept that ‘hot foreign money’ pouring into real estate will keep the Ponzi alive is simply naive.

    So, the crux of the article stands: Australia is seriously overdue for a hard fall in property prices given prices have outpaced all fundamentals and the foreigners definitely won’t be saving us.

    The 1.2 TRILLION in total DOMESTIC mortgage debt is the primary reason for ponzi prices being driven into unsustainable rarified air. Note that this has massively increased from around 45% of GDP at the turn of the century to around 85% of GDP in 2012 – see here: http://cdn.debtdeflation.com/blogs/wp-content/uploads/2012/08/080212_0205_AustralianH3.png

  5. Karl Fitzgerald
    Karl Fitzgerald21-01-2013

    Well said Bobby. Remember tho that such ponzi debt is only possible because we prefer to tax our wages rather than the naturally rising value of land. Cause and effect – tax the land price away (leaving only the rental ‘value’) and no matter how dodgy the banks are, we wont have the sort of debt pyramid we are stuck with today.

    Land Tax is the counterweight to mortgage debt.

  6. Paul Meleng03-02-2013

    The property fans and vendors are grabbing at a recent rise and announcing the start of another price boom. I’m scratching my head because the hard working skilled young Australian people I know are having trouble right now paying for the $400,000 mortgages they took on in the last “boom”. At least half of the early baby boomers I know are downsizing for retirement because they have to. The story in Perth sounds convincing because of all the huge development projects and predictions of doubling Perth population over the next 40 years. But as son in law said. “We are paying 60% of our income now so how could people pay more ?”. Maybe if the boom story is true but affordablility is not improved it means that young people will be taking out those big loans to live in a small box an hour out of town. But will they? Pretty demoralising.
    At the same time the Liberals and industry are saying they want a “more flexible” workforce to improve productivity. Maybe those big projects will not get out of mothballs unless wages are kept down and work hours and hiring and firing are more “flexible”. Catch 22 then is how do people with no work stability (opposite of “flexibility”) get the big mortgage or find the courage to sign up for one. How does the great mass of the workforce take on even bigger loans for even more overpriced houses than now unless there are big permanent wage increases? They are paying 5 to 6 times annual income for a home vs long term normal of 3 times. USA is moving off the bottom because they painfully dropped back to 3 times first, over 5 years. The first home I bought in 1974 was 3 times average family income and I had a 40% deposit and an above average income. “Back in the good old days” yadayada
    I must be getting old and losing my courage.

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