A letter in today’s Australian Financial Review by Dr Philipp Hoflin, a member of Lazard Asset Management’s equities team soberly expresses the discomfort among sharemarket investors about the Giant Australian Land Bubble.

Property big short is long on price

In reference to the piece by Christopher Joye (‘‘Don’t believe the big short’’, February 26), I would like to offer three comments.

First, the concept of ‘‘affordability’’ is unrelated to valuation. At 1 per cent interest rates the average Australian household could ‘‘afford’’ to borrow $2 million, but the ability to cover borrowing costs at spot rates tells us nothing about whether the asset thus acquired would have been bought at a reasonable price.

Second, valuing a real asset by comparing its yield with a nominal spot interest rate is flawed. Consider what would happen in the limit of a country with no inflation, no growth and zero rates. This simplistic comparison would lead us to conclude that real asset prices should rise dramatically. This incorrect conclusion arises because a real asset’s value also depends on the future nominal growth of earnings, which in this scenario have similarly gone to zero. The example of Japan should make the flaw of this reasoning clear. Japanese property prices fell almost continually from 1990 to 2010, despite ever lower interest rates, which have now gone negative.

Third, there are valid ways to value homes, like any asset. Starting with the RP Data 3.4 per cent gross rental yield for eight capital city homes, we can deduct costs (utilities, insurance, rates, repairs) of 1.2 per cent and arrive at a net yield of 2.2 per cent. Assuming no debt, we can tax this at the corporate rate of 30 per cent and arrive at a net profit after-tax yield of 1.5 per cent. If the $6.3 trillion of Australian residential real estate was fully equity funded, which it isn’t, it would trade on a price/earnings ratio of about 65 times.

Dr Philipp Hofflin Ashfield, NSW