The residential property puzzle

Australian residential property does not behave like other investment classes, writes Tim Farrelly. He explains why this is the case, and makes some forecasts about the future direction of the sector.

Much has been written about the apparent ability of the Australian residential housing market to defy normal investment principles.

Using Occam’s razor (ie, the simplest explanation is often the best), the key determinants of future returns for any asset are growth in income and price to earnings (PE) ratios. Both have little to no relevance when attempting to forecast returns on residential property.

The PE ratio for property (value divided by net rents) has hovered in the 40 to 70 range for years.

And growth of rents over time often seems to bear little or no semblance to growth in prices.

Not a normal market?

Why does the residential property market seem to defy all normal investment principals? Put simply, it is not a normal market.

In a normal market, investors buy the assets they believe are most likely to give high returns, and sell assets they expect to give low returns. In a normal market, if something appears likely to rise in price, investors want to own it; if it looks like it might fall in price, they stampede to the exits. 

In contrast, the residential property market is dominated by homeowners (ie, people who primarily want shelter, which, along with food, is a basic human need). Do supermarket shoppers stampede for the exits if they believe that prices are too high? No, they simply adjust their shopping list and keep buying – what they buy may change, but they keep buying. The majority of homeowners are just the same. 

Consider a pair of homebuyers after their first day of house hunting. Invariably, they return home deflated, disbelieving how little their money buys them. The strategy becomes clear – they work out the maximum they can possibly spend and then go looking for the ‘least worst’ place they can buy for that amount. What do they spend? Whatever the bank will lend them.

Compare that to a canny equities investor who has spent some time studying the market and concluded that stocks seem very expensive. Is it likely this investor would head down to the local bank manager to beg for the biggest loan the manager is willing to advance, in order that the investor can maximise his/her exposure to the sharemarket?

But that is what happens every day, over and over again, in the residential property market.

So why do housing prices seem so high?

Farrelly’s believes it is because the demand for housing is greater than the supply – and, in such an environment (when simply staying out of the market is not an option for most) the only thing that limits the price paid is the supply of money (ie, the amount banks are willing to lend).

In deciding how much they’ll lend, a bank looks at how much income the borrower earns and where current mortgage interest rates are, and use that information to calculate how much debt a potential borrower can safely service.

So, when potential buyers’ earnings rise or interest rates fall, they can borrow more; similarly, if interest rates rise, the banks reduce the amount they are willing to lend.

Of course, homebuyers don’t automatically pay more for a given property just because they have had a pay rise.

However, in the medium-term, the impact of thousands of buyers, all making similar assessments, will gradually move house prices up when average weekly earnings rise, or if interest rates fall. Similarly, prices should fall, after a suitable lag, when interest rates rise.

Key drivers of housing prices

If this view of the market is correct, then prices should move up and down at about the same rate as property affordability over the medium term.

Affordability is proportional to average weekly earnings divided by home loan interest rates.

As earnings grow, households can afford to service larger loans and so property becomes more affordable. Similarly, lower interest rates also make property more affordable. 

As shown in Figure 2, there is quite a lag between changes to the median and changes in affordability.

This makes sense.

Buyers don’t all rush out and pay more the first day interest rates fall.

It takes a while to work through to prices paid.

But in the longer term, affordability has moved much more in line with actual prices than have either rents or inflation.

Over the most recent five years, outside of the Sydney market, prices have moved much more quickly than the affordability framework would have suggested (see Figure 1).

We believe this is due to a variety of factors, including the market not yet digesting the interest rate hikes of the past year, and some lingering effects of the First Home Owner Grant. 

In the long term, affordability gives a good guide to price behaviour, both conceptually and in practice.

Note: this framework is predicated on the idea that there is a shortage in the supply of housing and that homeowners will pay whatever they have to so long as the shortage of housing remains.

This relies on continued population growth in the major cities, as well as councils continuing to limit the density of dwellings and the release of land for development.

Without insufficient supply, this model falls down and prices would begin a long slow slide back to more conventional valuation levels.

This is what happened when the Japanese population stopped growing in the early 1990s: Japanese residential property prices began a slow but steady fall that has them nearly 60 per cent lower than their peak 20 years ago. 

It’s a frightening possibility – but an unlikely one.

Triggers that could cause such a change include a freeze on immigration or a change in policy on population density in the cities – but these scenarios are unlikely any time soon.

The resources boom will lift the need for immigration and, in any event, current demographics suggest increasing demand for housing out to 2040 at least.

A substantial lift in population density in our major cities would have to be accompanied by a massive boost in spending on infrastructure to support the large increase in population in those areas – something councils and state governments seem fiscally ill-equipped to do.

A more likely possibility is that the resources boom will result in a major population shift away from Sydney, Melbourne, Adelaide and, possibly, Brisbane.

If this occurs, expect mayhem in the property market as prices return (slowly, but inexorably) to levels more akin to conventional investment valuations. It’s yet another reason to watch the way the various arms of Government tackle the issues created by the resources boom.

Tim Farrelly is principal of specialist asset allocation research house, farrelly’s, available exclusively through PortfolioConstruction Forum.