Messenger: Beware the bubble bursting

Naïve investors are flooding the property market. Most planners have recognised the emergence of bubble conditions. It may aid discussions with clients to analyse the factors that support this caution.

Those who are optimistic about residential property invariably refer to demand, for example, population growth partly driven by immigration. Even where it is acknowledged that the whole market is vulnerable, they refer to particular areas where they believe demand will not vary. Frequently these areas are those which command a premium, such as waterfront property, and some areas on Sydney’s north shore or eastern suburbs.

Great care needs to be exercised to not focus solely on demand. Supply is increasing at a faster rate. There has been an explosion of new apartment developments in most capital cities. Supply increases by the inexorable sprawl outwards of cities and the move to higher density accommodation.

Occupation demand for property comes from two sources: renters and owner/occupiers. If supply outstrips aggregate occupancy demand, vacancy rates rise — and they are climbing. Consequently, the price of rental occupancy, rent, is falling.

As demand is not keeping pace with supply, all arguments that prices will be sustained by occupancy demand are flawed.

One significant demand factor, which has contributed to the residential property boom extending longer than expected, is the shrinkage in average household size. In 1991 there were 3.3 people per household. In 2002 this had dropped to 2.5. The same number of Australians now require about a third more residences to live in.

Despite this, supply is outstripping demand.

A typical life cycle of home ownership involves a young couple or individual buying a lower priced first property and trading up to better properties over time. Then in later years, after their children have gone, perhaps moving to smaller premises, and finally moving into aged care facilities.

The people with the most expensive properties sell to the next group trading up, who in turn sell to the next generation. At the end of the chain are the first homebuyers coming in. Except that, today, they are not buying.

Imagine all the houses and home units as packages being passed along in a multiple game of pass-the-parcel, and suddenly the people at the end of the line are refusing to play. The effect will eventually work its way back up the line as no one can take the next parcel until they have handed over the last.

Fewer first homeowners are joining the buying line. These usually account for 25 per cent of owner-occupied home loans, but this has dropped to 14 per cent.

With the median house price in Sydney approaching half a million dollars, the only way a young person can enter the market is if they can afford to take on a huge debt. The only way the ‘Great Australian Dream’ of home ownership will be fulfilled by the next generation is if prices fall.

Affordability is generally calculated as the proportion of disposable income required to pay the mortgage on the average house. According to the Commonwealth Bank/Housing Industry Association measure, affordability has fallen to levels not seen since the start of the 1990s but it remains far short of those reached in 1989 when mortgage rates were above 17 per cent.

Affordability measures are not much worse than was prevalent in the late 1980s. However, it would be unwise to take much comfort from this. Real Estate Institute of NSW (REI) data shows median Sydney house prices fell 25 per cent in the two years after December 1988.

In any case, in the 1980s, inflation was very high. Although this meant that interest rates were also high it brought rapidly increasing wages, making a stretched level of borrowing quickly more manageable.

We now have a low wage growth environment. A mortgage repayment that stretches the budget today is likely to stretch it for many years to come. High inflation rates reward borrowing by depreciating the real value of the debt; low inflation rates do not. Thus, debt is more dangerous under these conditions — although this is not recognised in simple affordability comparisons.

The measure also assumes a constant percentage of the property is funded by debt. Yet currently there is an exceptional level of borrowing. We can conclude that affordability measures are telling us that property prices are too high.

But in the face of this, Australia has taken on record levels of borrowing. Currently, 45 per cent of loans are for investors compared to a long-term norm of around 25 per cent. TheReserve Bank of Australia(RBA) claims this is globally unprecedented.

Lenders have increased the availability of credit. Bank debts have been securitised and the funds recycled into further loans. The RBA believes banks no longer have the same incentive to monitor the financial health of the borrower, as they no longer bear the ultimate risk.

Loan to valuation ratios have risen. Once the ceiling was 90 per cent, now lenders offer not only 100 per cent but also incidental costs such as stamp duty. Some lenders offer Low Documentation (LoDoc) loans where the borrower does not have to prove their income and capacity to save.

Finally, as the cherry on the top of reduced lending standards, one Melbourne-based lender now allows customers to use the equity in their car to support house borrowings!

The net rental return from the median Sydney CBD unit is, say, 2-2.5 per cent. This is a price to earning ratio (PE) of 40-50 — if described in stock market terms. The average Australian share sells on a PE of 16. Sydney CBD units should be spoken of as being high risk, the way any share with that high a multiple would be — especially as their ‘profit’ (rent) is falling.

However, many people have trouble dispassionately recognising that the laws of financial markets ultimately apply to property, because they want it not to be so.

We are seeing a speculative bubble in property, similar to the stock market boom that preceded it. The last two busts in median Sydney house prices saw a fall of more than a third in real terms, according to REI data. This fact is long forgotten. The same amnesia beset the share market in the technology boom, with disastrous results.