Showing posts with label Housing market. Show all posts
Showing posts with label Housing market. Show all posts

Thursday, September 1, 2011

Improving the house price and income debate

While the RBA has warned of the risks of leveraging into the housing market on national television, they, and other analysts, have also presented a stable picture of the housing market, by estimating a house price to household income ratio of about 4x, and accompanying such analysis with statements like the ratio of housing prices to income has been reasonably flat for a number of years

Or, when he is at his best, Glenn Stevens can calm the nerves of recent home buyers with comments like this -

The other thing I’ll say is that it’s quite often quoted very high ratios of price to income for Australia, but if you get the broadest measures, a country-wide price and a country-wide measure of income, the ratio it about 4 ½ and it hasn’t moved much either way for 10 years.

I think I can safely say that most of Australia would disagree with this assessment of stability in the housing market or support from economic 'fundamentals'. Indeed even the RBA's own representations seem a little schizophrenic on the subject, with a recent report noting that the price-to-income ratio actually increased by 50% between 2001 and 2004.

Dwelling price growth significantly outpaced growth in household disposable income, with the nationwide dwelling price-to-income ratio rising from around 2½ in the mid 1990s to a little over 3 by 2001 and then to 4½ at its peak in early 2004.

Which is it Glenn? Did the ratio increase by 50% in that period, or hasn't it moved much either way for ten years?

One reason for the clash between public views on housing and the 'stability stance' we see out of the RBA is that the RBA grossly overestimates household incomes.

I have examined the data used by the RBA and other analysts from the National Accounts (Table 14), and tried to replicate their method and reconcile the differences with ABS household survey data, which more accurately reflects household income available for current consumption. It is possible, and I have shown my results in shown in the table below.


ABS household survey data shows that at the beginning of 2010, the average household income was $88,113 before tax and $74,360 after tax. This closely reconciles with my own household income estimates from the National Accounts data in 2010 (within 1.3%). Unfortunately due to the need to estimate the total number of households between census years, this method has quite a large margin for error.

Given the average national dwelling price at that time was $447,994 and the median about $415,000, we are definitely in an uncomfortable range of price-to-income ratios, with 5.0x in average terms using before tax income data, and around 6.0x in after tax terms. In terms of median incomes and dwelling prices, the ratio is probably closer to 5.6x before tax, and 6.8x in after tax income (as recently estimated by fellow blogger Leith van Onselen).

This happens to match the data produced by Rismark (here), after they revised their average price-to-income ratio up after noting the discrepancies in the unadjusted National Accounts data.

While I don’t believe household income and house price comparisons are the best indicator of the state of the housing market (preferring comparisons of rents to incomes and yields to other rates of return in the economy), it does seem that we can use the national accounts data to give a decent regular estimate of household incomes for those who wish to use them for analysis.  Maybe the RBA should try it sometime.

Also important to note when comparing incomes to prices is that the debt service ratio, measured as interest payment against incomes, can be misleading.  Since this measure is also published by the RBA, I assume they rely upon it in some way. 

Below is the household finances graph from the RBA chart pack (available here). We can see that, following the declines in interest rates at the end of 2008, household interest payments have settled at around 12% of disposable income. Note again that the RBA disposable income measure is probably overestimated (there is no specific note about the treatment of imputed rents), meaning the both measures are probably underestimated. But in any case the trends over time still hold.


What we need to consider here is that the interest paid graph shows what might be called a 'debt-service' ratio (although not in the true sense which would cover principle repayments). In regard to the surging household debt the RBA notes that the ...structural decline in interest rates has facilitated the increase in household debt ratios because it reduced debt-servicing costs.

That is true, but would only explain an increase in debt that accompanied flat interest payments as a proportion of income, not increasing interest payments (as I have explain in detail here).

What is also overlooked is that at lower interest rates the difference between the payment of just the interest on debt, and the repayment of interest and principle (to actually reduce the loan balance over a fixed period), greatly increases. For the same interest payment, a high debt balance with a low interest rate is more difficult to repay than a low debt balance with a high interest rate.

The table below shows the amount of debt that a household with an income of $75,000 could service with 20% of their income ($15,000pa) at different interest rates. While a halving of interest rates means the household could double the loan amount and pay the same interest payment, the loan they could actually repay over 30 years increases by far less (as shown in the right hand column).


It is also important to understand this relationship when comparing our household debt burden internationally. The RBA usually makes such comparisons without noting the importance that interest rates make to the burden of this debt on households. Given that mortgage rates vary between 7.5% in Australia to 2.5% in Switzerland and 3% in Germany and much of the EU (and noting the tax deductibility of mortgage interest in Netherlands), these differences are important. 

I will finish this analysis by presenting three graphs. 

First is a graph of the household occupancy rate. The reason to include this is that while household incomes may be still growing nicely, the number of people per dwelling has been increasing since late 2005, so in per capita terms incomes are not looking as good.
The second graph shows the contributions of insurance premiums and claims to household income (which I removed in my income estimation method). When this number is positive it means that household insurance claims were more that the premiums paid in that period. That’s why we see a massive spike in February 2011 from the claims relating to floods and cyclone Yasi (and amongst other things, the Black Saturday Bushfires in early 2009 – note the data is very cyclical with a summer peak). It seems odd to have either the insurance premiums or claims in estimates of household income (although makes up just a fraction of a percent of the total).


The third and final graph compares the growth in household incomes using each method with the ABS capital city price index. Of course, I have chosen an arbitrary baseline at June 2001, but I do note that mortgage interest rates then were the same then as they are now (indeed mortgage rates were about the same as now back in 1997 - see here), so the deviation observed could easily be interpreted as an overvaluation of housing.


What the graph mostly tells us is that there is a pretty solid reason so many people believe that house prices are historically high and are more likely to fall than rise in the near future, being supported only be our willingness to incur debt, and not our incomes. 

Wednesday, August 31, 2011

Property industry propaganda knows no bounds (+market update)


The above video is from Bernard Salt's presentation at the 2011 Property Council of Australia's 'Geared for Growth' Congress recently held in Darwin. In the presentation he calls for the construction, property and banking sectors to combine forces to fund a lobby group to infiltrate social media, and blogs in particular, to counter the negative sentiment that is leading property markets into the doldrums.

Astonishing. As fellow blogger Tony Harris notes in his detailed analysis of the video -

Who are you really chatting with, when you post on that property forum or blog? A regular person like yourself, or a paid spruiker, funded by the real estate industry?

Around the 8 minute mark Salt discusses the hostile reception to an article he published online spruiking the virtues of growth (population growth I assume). He had this to say about the reader comments -

Not one person in 230 put a reasoned, balanced, measured counter-response. I want to see someone actually in there. Every time you don't respond, negative sentiment extends just that bit further across middle Australia. 

After pointing the finger at 'negative sentiment' as the cause of the current economic slowdown he goes on to suggest his solution (screenshot below quote) 

I want to see someone, somebody, some group of people, counter the negativism in all theatres, social media, twitter, the blogosphere, seek out and, not destroy, seek out and balance every extreme view - take the fight to them. Sitting back is not an option. I do understand that individuals cannot do this, but surely there is a way to fund a group to do it on your behalf. This it not a pitch for me, but I am surely happy to advise on how to set it up. 


What is ironic, to me, is that the property and construction industry lobby groups might actually go for Salt's big idea, as if a few blog comments and Facebook pokes can stop Australia following the rest of the world to its economic destiny.

Salt suggests perhaps they need an (another) 'independent' pro-growth, pro-development sentiment-generating lobby group which could be funded by the BCA, the Property Council of Australian and of all things, the Australian Bankers Association.

The banks would probably join because of the negative sentiment towards them at the moment. Salt comments -

The idea that banks should not get a fair return on their investment is bizarre. We've got this disconnect in Australia between the way we want to live, our superannuation, and our objection to every development, to anyone making a profit.

I for one can understand the concern over bank profits. After all, bank executives and shareholders seem happy to take the profits while taxpayers insure the losses. All the while they have played a key role in the property bubble with their declining lending standards.

Face it Bernard, you can't stop the realities of economics and finance by tweeting 140 characters or less.

And speaking of the realities of economics and finance, that national house price slide accelerated in July according to Rismark.  Note that in Perth and Brisbane prices have been falling for more than 12 months, so the falls from peak are much higher than these figures show.  From my reading of old data I could guess that Brisbane prices are down about 11% over 15months.


Coinciding with their press release was the most bizarre property analysis yet from Rismark data guru Chris Joye. Joye's analysis of late has been squarely aimed at providing evidence that current house prices are supported by 'economic fundamentals', including the once-off adjustment in interest rates, higher household incomes, and so on. 

This time he mightily proclaims to- 

... show that by indexing up median Australian dwelling prices by per capita disposable incomes and changes in borrowing capacity (as determined by mortgage rates) one can account for around 90 per cent of the rise in Australian housing costs over the last two and a half decades

Which I guess is a roundabout way of saying prices are 10% overvalued at most. Joye presents the following graph to demonstrate his result, but I can't help wondering why he chose 1986 as a start date. Had he chosen 1990 as the start date he could have shown that houses are undervalued according to his fundamentals, but had he chosen 1998 as his start date, his fundamentals would have only explained about 50% of the house price. Most bizarre.


As I have said before, yes lower interest rates and higher incomes do explain some of the growth, but only about 70% of today's prices.  There is also always the risk that incomes will fall as house prices fall, but always the chance that mortgage interest rates will drop to slow any accelerated price declines.  The downside risks are far greater than any upside potential in the housing market at the moment, and I do wonder why Chris seems so keen to give the impression that this is not the case.

In other housing news today, Leith van Onselen from the Macrobears superblog [just kidding guys ;-)] has explained in detail in this SMH article why the RBA appears to underplay the risks, and underestimate the size of, the bubble in the Australian housing market. Simply, they use a measure of average household income about 33% higher than actual household incomes. Who would have guessed that the average household disposable income was actually $74,360, and the median just $60,580 - not the $100,000+ used in the RBA's analysis? Not the RBA it seems. Oops.

Finally, I stumbled across this article (somewhat belatedly) arguing essentially that housing supply is driven by housing turnover, and is completely unrelated to price. This might come as a shock to the 'elastify the supply side' believers.  It is also odd that mostly valuers and honest property developers seem to be the few groups who argue this concept.

Let me give a few practical examples – First, imagine the construction of a residential unit block – the developer, because of cash flow or financier requirements, needs to sell a large proportion of the development “off-the-plan”.

Simply, until pre-completion sales are locked away nothing gets built. 

Second example - for house and land packages in new estates, buyers purchase the block of land first and arrange the construction afterwards. In either case there is no “build it and they will come”. It is the demand that sets the pace.

Which is what I have tried to say for some time, and said back in April like this -

The rate of land and housing supply is determined by the rate of sales of new stock (known as the absorption rate). It has nothing to do with the rate of development approvals or even the price level.

Monday, August 15, 2011

Households better of than 1994... just

Housing market data provider Chris Joye has written a great deal of analysis on Australian housing recently. However his latest graph (above), showing households have more money left over after buying the average home today than any time since 1994, is very confusing.

He explains the data and method as follows.

We decided to simply look at the "average household"--calculated by dividing the ABS's quarterly disposable national income estimate by the number of households each quarter--buying the "average dwelling" in Australia, which is defined as the average sales price in a quarter.

And he explains the findings

Like the RBA, we find that--contrary to popular myth--today's households actually have more disposable income than at any other point since we began our analysis in 1993.

One would hope that with 28 years of economic growth in the mean time household would have FAR MORE disposable income today (after housing costs). What is surprising is how little disposable income has grown because of increased housing costs.

Even Joye’s own graph shows that home buying households were worse off between 2000 and 2009, because any income growth was more than offset by the cost of homes. It also shows that home buying households in 2004 were no better off than in 1994. In fact, if this analysis was undertaken any time prior to 2009 the popular myth would be shown to be true.

I also have some other concerns:

1. The income measure in the national accounts is 57% higher than measured by the survey of Survey of Income and Housing Costs (SIHC) and does not reflect actual household income (see here)

2. The outcome does not pass the common sense test. $43,000 of disposable income left over after mortgage payments, in 1993 dollars, is actually $73,350 in 2011 dollars. This seems like a lot of disposable income for the average household to have left over considering the national median dwelling at $418,000 dollars and the associated mortgage cost of $35,000 per annum. These figures therefore assume that $113,000 after tax is the average household income. This makes no sense to me. You need to have one income of approx $170,000 or two incomes of around $75,000 to meet this income level – that is FAR above average.

3. The outcome appears inconsistent with previous data. For example, mortgage rates in 1998/99 were a little over 6% (compared with a little over 7% today), and prices were about 60% lower than today, according to Joye’s own recent published graphs.

4. The graph shows that mortgage repayments have gone from 25% to 32% of the average household income over the period (which is consistent with Steve Keen’s observations – second graph). To get back to 25% of average income, prices need to fall 20%, or mortgage interest rates drop below 5%.
5. The graph, probably unintentionally, shows that incomes grew 40% in real terms over the period, but after housing costs, they only grew 26% (with most of that growth the past 4 years).

6. Indeed, the 2008 and 2011 blips show that when prices fall home buying households are BETTER OFF. The same applies to interest rates.

I sincerely hope this type of analysis is not interpreted as a reason for house prices to rise and I hope nobody leverages into the housing market because of it without properly understanding the risk they are taking.

Monday, August 8, 2011

Chart of the day: Shares v houses

I have noted before at this blog that comparing share prices and house prices is a terrible way to examine the real differences in returns in these two markets. My key arguments are:

1. The share market is and equity market, and to compare like with like you would need to subtract the debt against housing to compare the volatility of equity.

2. The negatively geared investor usually sets the market price (they are the marginal buyer). That means they are losing money each year on the house, so a certain degree of price growth is necessary to break even.

3. The cost of home ownership is high, as are the transaction costs. In one trade of a home you would need to make an additional 10% return compared to a share trade.

So today I note again that an incomplete comparison has been undertaken by a prominent property analyst. The general finding is clear.  There is no doubt that property (in Sydney and Melbourne at least) has outperformed the share market over the past four years. But I thought is wise to add some modifications to compare like with like.

The original graph is below.

Again, the problem is that this graph fails to consider returns, and in particular, comparing the position of a negatively geared property investor. So I made my own comparison of the house price and ASX200, along with my own housing equity accumulation index taking into consideration the negative returns (and tax breaks at the highest marginal rate), compared to the ASX accumulation index. I also added the returns to cash at 5.5% average over the period (a bit of a guess at the average term deposit rate), and an accumulation index for residential property bought with cash (click for larger image).


As you can see, when you consider the higher annual positive returns on shares, the losses are not a severe as the price index would make out. For housing bought with cash, the accumulation index shows the same effect of increasing returns, but to a lesser degree due to the lower net rent compared with dividends in the ASX200.

What stands out is the tremendously better position the leveraged housing investor is in if they bought a home in 2007 with a 20% deposit (and capital growth similar to the index – this is not the case in Brisbane and Perth). This investor would have made over 80% on their equity in 4 years due to capital growth alone. This is especially impressive since the annual cost of ownership is 9% of their equity. (As a side note, the high transaction costs in property mean that to convert that return to cash will cost in the order of 3.5% on the purchase price, and 3% of the sale price, or 36% of the original equity, giving a 'sold up' return of 46% return on equity of over the period- still VERY impressive.)

However, there are important things to note. First, leveraging works both ways. The leveraged accumulation index fell for 3 months longer in 2008, and for a house price drop of just 4.9%, the index fell by 27.5%. Also, at the April 2009 trough, although the house price was still 4.1% higher than when they bought in June 2007, their equity was only 3.7% higher.

This is particularly important to note during the current falling trend in house prices, which has so far amounted to just 2%. The leveraged investor has already lost 9.6%, and every extra percent decline leads to a 5% decline in this index (and more still for a similarly leveraged investor who bought during 2010 or 2011).

Given these leverage considerations, the question of whether housing investment is a way to soften the downside from your investment portfolio is not so clear cut. For someone with plenty of cash looking for a home, perhaps a cash purchase of a well located home with potential to add value is an option. Of course, you need to expect some early losses in value, and low returns, but when the alternatives are looking quite bleak, there might be no harm. I would be waiting a couple of years to buy in Sydney and Melbourne, but perhaps sooner in Brisbane and Perth where prices have already fallen substantially.

Of course, in the mean time, anything could happen. Please don't take this as investment advice.

One final question for readers. If Australia is headed the way of the US, with negative real returns to bank deposits, and housing market that will seemingly not find a bottom, will we see a surge in the share market simply due to lack of other options to invest locally? Perhaps the bottom of the share market will be in later this year and some good value can be found.

*note to readers, the CBA cut its fixed rate mortgage rate this morning. Next interest move is down.

Wednesday, August 3, 2011

Chart of the day - long run house price comparison

Many thanks to Chris Joye for putting in the leg work to produce the below graph and associated analysis.  I recommend reading Joye's analysis before drawing any conclusions.

Tuesday, August 2, 2011

Current account deficits and house prices

As I alluded to in recent posts, Australian banks reliance on foreign funding has lead to the alarming situation whereby we (as a nation of households) have borrowed from the rest of the world to buy existing houses from each other at inflated prices. As I said, “it makes me quite frustrated to even suggest that a fair portion of foreign debt incurred in the past decade was used to pay each other higher prices for existing houses”.

I made that claim without evidence – it was an intuitive interpretation of the data in the balance of payments and in particular, the interest payments heading abroad in the primary income account. But, in the interests of an informed debate, I have digested some of the literature on this matter and found that the intuitive principle is well supported.

In February this year, Andrea Ferrero, of the Federal Reserve Bank of New York, published this paper arguing that “a progressive relaxation of borrowing constraints can generate a strong negative correlation between house prices and the current account. Households increase their leverage borrowing from the rest of the world so that the current account turns negative”.

The following plot is from the paper (p2).

The model demonstrates the mechanism by which relaxed lending standards decreases domestic saving, increases foreign bowings and decreases the current account. The model also shows that prices vastly overshoot the new equilibrium point. The quote below is from p14 (my emphasis).

The key shock that generates a house price boom and a contemporaneous current account deficit in the model below is a reduction in the parameter that measures the loan-to-value requirement. At a broad level, lower collateral requirements capture easier access to credit for housing finance.
...
The main experiment consists of shocking the collateral constraint parameter. In particular, financial innovation corresponds to a higher loan-to-value ratio.
...
At a very basic level, the model captures the negative correlation between house prices and current account balance. In response to the shock [relaxation of collateral criteria], house prices persistently increase while the current account worsens, at least for a couple of periods, before slightly overshooting its long run average of zero. A more realistic sequence of shocks approximating a progressive relaxation of collateral constraints (the process of financial liberalization) is likely to generate a run-up of house prices and a deterioration of the external balance more in line with what observed in the data.

This appears to support the idea that simply constraining lending criteria would have been an effective measure to contain house prices, and reduce the current account deficit. Steve Keen would not be surprised.

Indeed, the evidence of this relationship appears quite strong, and it is easy enough to find other articles supporting this argument empirically.

My main criticism is the timing of the house price growth measure. China for example appears to have flat real price growth in the above graph for the period 2001-2006. That would seem consistent with the arguments surrounding the relationship between the current account and house prices. However, since that time credit standards in China were reduced, prices shot up (around 2007), then access to credit was subsequently tightened, and prices flattened (around 2008). To me, a good experiment to demonstrate this relationship, although hampered by global conditions at the time. The below graph from The Economist house price comparison tool shows China’s house price growth in this period was far below that of the US, UK and Australia. More recent data shows strong house price growth since 2009.

One stand out example of where the relationship  between house prices and the current account fails is Japan in the 1980s.  A housing bubble coupled with a current account surplus and a large growth in ownership of foreign assets is not what these models predict. 

Out of interest, here is a list of countries according to their current account balance. Eyeballing this list it is pretty easy to find the prominent housing bubble markets near the bottom.

To be clear, the access to credit is the key (and this may provide the explaination of the Japanese experience in the 1980s). Lower LVRs force domestic saving and limit the need for foreign borrowing, meaning asset prices can reflect the economic reality of that country alone. (One might argue that Japanese saving was high enough that the current account was simply lower tha it woul dhave otherwise been, but not negative.)

I will present one final conclusion from here, with my emphasis.

We find robust and strong positive association between current account deficits and the appreciation of the real estate prices/(GDP deflator).

Our results are consistent with the notion that for all countries, current account deficits are associated with sizeable appreciation of the real estate. This effect holds controlling for the real interest rate, GDP growth, inflation, and other conditioning variables. We also find evidence consistent with the growing globalization of national real estate markets. These findings are consistent with various scenarios explaining patterns of capital flows across countries, including differential productivity trends and varying saving patterns. In the absence of pre-existing distortions, financial inflows are unambiguously welfare improving. Yet, in a second-best environment, public finance considerations imply that inflows of capital may magnify distorted activities, increasing thereby the ultimate costs of these distortions. Arguable, the experience of emerging markets in the aftermath of financial liberalization during the 1990s illustrated these concerns. Needless to say, this second-best assertion is not as argument against financial integration, but a cautionary tale – greater financial globalization implies the need to be more asserting in dealing with moral hazard and other pre-existing domestic conditions. (p20)

Wednesday, July 27, 2011

The housing market's 'once-off adjustment' meme

There is a meme floating around which has its origins in Chris Joye's numerous articles on the Australian housing market. While I often challenge Joye's economic arguments on this blog, I hope that readers realise this is simply part of a rigorous intellectual debate, and not a personal attack. Indeed, I admire his quest to provide better housing data, and agree with quite a few of his economic and political beliefs.

The meme is that the surge in debt levels and the price of Australian homes since the late 1990s was a once off adjustment to a period of low interest rates and inflation. Therefore, if these conditions hold, current prices are sustainable.

RBA Governor Glenn Stevens mentioned this 'once-off' adjustment in his recent speech 
The period from the early 1990s to the mid 2000s was characterised by a drawn-out, but one-time, adjustment to a set of powerful forces. Households started the period with relatively little leverage, in large part a legacy of the effect of very high nominal interest rates in the long period of high inflation. But then, inflation and interest rates came down to generational lows. Financial liberalisation and innovation increased the availability of credit. And reasonably stable economic conditions – part of the so-called ‘great moderation’ internationally – made a certain higher degree of leverage seem safe. The result was a lengthy period of rising household leverage, rising housing prices, high levels of confidence, a strong sense of generally rising prosperity, declining saving from current income and strong growth in consumption. (here
Chris Joye recently reiterated the argument here
This was a once-off "level-effect" (ie, sustainable adjustment reflecting the huge reduction in the cost of debt), not a permanent growth effect, and now these ratios are flat-lining. This is why the household debt-to-disposable income ratio, as shown below, has gone sideways since 2005, years before the GFC first materialised. That is, credit has been tracking incomes, as you would expect.
The household debt to disposable income graph is below, as is a graph demonstrating the structural adjustment of interest rates.

What makes this meme powerful is its truth. Australian interest rates did see a structural adjustment in the mid 1990s. There is also no denying that lower interest rates should lead to asset values rising relative to other prices in the economy. It also makes sense that the level of debt able to be sustainably managed, as a portion of incomes, is greater.

In the housing context, the 'once-off adjustment' argument can be demonstrated as follows.

Prior to the structural adjustment in interest rates, a buyer looking to buy a home that rents for $15,000pa, who is willing to pay a 20% over the cost of renting to buy the home, would capitalise $18,000 at the going rate of 12.8%. That's a price of $140,625. After a structural adjustment, the cost would be capitalised at 7.3%, giving a price of $246,575. A 75% real price increase should be as sustainable as the previous price (almost).

The same calculation can be made against household income, where for a fixed percentage of incomes, a 75% greater price, and level of debt, can be sustained.

Unfortunately, this logical argument only accounts for a part of the debt build up and house price growth since the mid 1990s. The RBA graphs of household finances and real house prices (below) show clearly why this is the case.




The graph of interest paid as a proportion of disposable income shows that the actual cost of debt relative to incomes has doubled (4% to 8%) since the mid 1990s. This is clear evidence that much of the debt binge, and the subsequent house price inflation, is not attributable to the 'once-off adjustment'. This adjustment would only account for the amount of debt, and home prices, that could be supported with interest costs of 4-5% of household incomes - not 8%.

The RBA also shows that real home prices have more than doubled (100% growth) since the mid 1990s to 2007, rather than seeing 75% real gains. Indeed the 2009 boom saw real home prices inch up again (with some subsequent falls in real terms).

The ABS home price figures (though not ideal for this purpose) suggest that real home prices gained approximately 150% since 1996. That's twice what is expected from interest rate conditions alone.

To get back to that 'sustainable' point, either home prices need to fall by around 30%, or interest rates need to fall by 30% (mortgage rates to 4-5%), or some combination of the two (noting also the geographical disparity any correction is likely to have). With today's CPI print surprising many on the high side, the market prediction (and mine) of rate cuts by year's end seems far less likely.  The negatively geared housing investor should take note.  

In all, the meme is powerful because it is true, but dangerous because alone it is an incomplete explanation of debt and home price trends of the past two decades. What appears clear from the data is that we have overshot the expected price and debt adjustment due to the changing interest rate environment. With this in mind, the downside risks for property values appear to far outweigh any upside potential.

Thursday, July 21, 2011

The Sydney housing boom ripple effect

Sydney is different. Since 2003 rents have risen faster than prices. I imagine the rest of the country would find that hard to believe, given their experience. But this is just one piece of evidence to show that the property cycles in Australian cities are nonsynchronous.

The past twenty-five years of data show that the Sydney residential property market is the least volatile, and is always first to boom. In fact, you can chase the price growth ripples from Sydney and Melbourne across the country – to Adelaide, Brisbane, Perth then Darwin. This might be one reason that such divergent opinions exist in the media, academic and professional circles.



If we looked only at the above graph, we would note that the two biggest markets, and arguably most attractive cities, have had the least growth since 2000. That seems particularly counterintuitive.

But if we look long-term the explanation is clear – Sydney and Melbourne had their major boom years before the other cities in the late 1990s.

Each of the charts that follow this post compare the timing of booms in capital cities against Sydney’s booms. The blue background shading matches the Sydney boom periods, with the red shading the boom periods of comparison cities. This exercise reveals a number of things.
  • Sydney and Melbourne booms in the 80s and 90s started and finished within a year of each other. In fact, their cycles are the most in synch of all markets. 
  • Brisbane lagged Sydney’s late 1990s boom by 4 years – making it an early 2000’s boom. This appears connected to the fact that Brisbane’s 1980’s boom lasted about 4 years longer than Sydney’s. 
  • Adelaide followed Sydney’s lead more closely than Brisbane in the 1990s, and lagged Syndey more closely in the late 1980s. 
  • Perth’s 2000s cycle was similar to Brisbane, although in the 1980s it had sharper and shorter price rises. 
  • Darwin is a world of its own - booming when other capitals had prices tracking below trend. 
  • Brisbane, Melbourne and Perth prices have been ‘catching up’ to Sydney over this 25 year period. This could be because the quality of homes is catching up to those in Sydney, and also due to a convergence of income levels between the cities. 
  • For some reason, Adelaide is falling behind other major cities (lowest long term growth trend) 
  • Sydney never falls as far below its trend as any other city. My eyeballing suggests that price volatility is lowest in Sydney. 
This might have lessons for property investors outside of Sydney. If you are in Brisbane, Perth or Adelaide and follow the Sydney trend a couple of years behind, you will do well. If prices are flat in the major capitals, take your money to Darwin.

What about from 2011 on? Sydney appears below its long term trend, and it rarely drops far below this trend. The other capitals are above their trend and do fall quite far below trend during economic downturns. My personal view is that Sydney stability will continue.

The other question to ponder is the trends in this period could validly be applied from now on. Deleveraging is the most important new consideration, and we have seen the dramatic affects this can have on asset values if we simply look to the US and some European property markets.

My expectation is that prices will fall until such time as yields are high enough to be attractive to investors who aren’t expecting capital gains in the near future. To me, this might mean yields might get higher, relative to interest rates, than we have seen for 30 years. And for that to happen, prices will fall. Of course, if the RBA drops rates significantly, this will dampen falls, but I doubt lead to the market grinding out modest growth (ie. matching inflation) for a couple more years yet.







Sunday, July 17, 2011

Retail in detail

My recent post on broad retail trends might have provided a reasonable picture of the sector as a whole, but retailing is a diverse beast. One aggregate number is insufficient to describe the performance of the sector.

My approach is to examine retail from a household perspective. Rather than look at total turnover in current prices, I will examine real spend per capita in each of the main retailing subsectors. I do this because economic theory has a lot to say about changes to household spending patterns during economic cycles.

Economic theory would suggest that in boom times, retailers of luxury goods would see turnover increase more rapidly than incomes. As Wikipedia explains - In economics, a luxury good is a good for which demand increases more than proportionally as income rises. The reverse should also be true for these goods.

Importantly, retail trends need to be seen in the context of a housing driven wealth effect. The wealth effect is an increase in spending that accompanies and increase in perceived wealth, rather than spending which is driven by growth in incomes

The wealth effect is also behind many of the saving decisions of households. Since 2005 the trend of declining household savings rates was dramatically reversed. We now have a household saving ratio not seen since 1987 (see the RBA’s chart below). This is an important backdrop to the retail story.

These factors are important to consider if you foresee near term home price declines. In this scenario, spending in wealth driven retail sectors would be expected to fall more than flat or falling household incomes, and increased savings alone would suggest.


Now to the detail.

The graphs below show the performance key subsectors in retailing. Note the log scales, which mean a straight line indicates a constant rate of growth – the steeper the line, the higher the rate of growth. Note also that this is a real per capita measure, which is indicative of trends in household spending decisions. Quarterly chain volume data is used, with May 2011 current price data adjusted to substitute for June 2011 data. The ABS explains some of the trends in more specific subcategories here (definitely worth reading the context of this post).



A few points jump out at me from the graphs. First, household goods (maroon in first graph) have outperformed by a long way, for a long time. This category includes furniture and appliances, hardware and gardening, floor coverings and electrical. This sector also appears to have seen the sharpest shock around the end of 2007 – from having the strongest rate of growth to nearly the weakest. The rising part of the curve might partly be attributed to a greater appetite for expensive furniture and appliances, which is indicative of a luxury good effect. Also important is the impact of the construction boom of the early 2000s which has since collapsed in many areas.

Second, clothing and accessories (green line) was on a declining trend for 14 years until 1997. For a decade since then, the growth rate in this sector was only bettered by household goods. Spending recovered strongly since the GFC. I’m not exactly sure why this might be the case. Perhaps some readers have experience in this sector.

Food retailing has been the steadiest (as you would expect) with only a slight easing from the growth trend since 2009 (maroon in second graph).

Other retailing (which includes pharmaceuticals, recreational goods, cosmetics and books) appears very sensitive to the housing wealth effect, seeing big spending boost during the 2002-03, the 2007, and the 2009 house price booms. Surprisingly spending has remained strong since the GFC – the only retail sector where this has occurred.

We might attribute some of the recent robustness to the high Aussie dollar. The ABS explains that pharmaceuticals and cosmetics and toiletries are the strongest components of this sector.

Cafe and restaurant spending (orange line) also appears sensitive to the wealth effect, and is noticeably one of the more volatile sectors.

Department store spending has been declining steadily since the end of 2007 (purple line). Anyone who had closely examined this data would not have been so surprised about David Jones’ recent profit downgrade. Spending at department stores is now back where it was in 2003 on a per capita basis. 

Finally, the second graph has the period of 2002-03 circled. This is simply to highlight that all retail sectors grew at abnormally high rates during the house price boom of this period. Indeed, we can see the wealth effect correlation between house prices and retail growth in many sectors in 2007 and 2009, although to a lesser extent.

My near term outlook is for a subdued retail sector. As I have said before, I believe that in these challenging times for retailers, innovation will be the key to staying ahead. New business models that use internet shopping to good effect, with a small physical store presence might be one path for many. Those companies who adapt quickest will benefit.

Thursday, July 14, 2011

Bundle of rights explains planning and prices

I have never heard the phrase 'bundle of rights' used in any property market discussions, yet the principle forms the legal basis of property itself.

Put simply, when one buys property they are actually purchasing a bundle of property rights associated with that land title. These rights are granted to the title holder by the State. This bundle of rights approach allows us to distinguish between, and appropriately value, different types of tenure, such as freehold and leasehold, and for differing levels of planning regulation, native title rights, and rights to minerals (which even freehold land owners does not have rights to).

When you value property, you value just those rights that are granted to the title holder by the State. A block of land where the title grants a pastoral lease with 10 years remaining will be valued differently if it was a freehold parcel. Changing the legal rights of the owner may vastly change the market value of the property because the property is different – it is a different set of rights, even though the physical land has not changed.

And so we move on to town planning. Local governments have the power to decide what rights, in terms of land use and scale of development (amongst other things) to grant to which parcels of land through their planning regulations.

When people argue that town planning restricts land market activity and leads to higher values, they are generally confusing basic economic theories of production with fundamental theories of valuation of property rights.

Tuesday, July 5, 2011

When to Buy and Sell houses

I came across the Commonwealth Bank - RP Data Home Buyers Index recently. It is designed to estimate the balance of supply and demand in a suburb to indicate whether it is currently a ‘buyers market’ or a ‘sellers’ market. Their website explains:

The Commonwealth Bank - RP Data Home Buyers Index estimates effective supply levels based on the number of properties being advertised for sale within the region.

...On the demand side of the equation, Australia's largest home loan lender, the Commonwealth Bank, provides a summary of the number of home loans that have been funded across Australia. Once we factor the Commonwealth Banks share of market into the equation, the number of home loans funded provides one of the timeliest estimates of housing demand in the market place.

This indicator may signal which direction prices are moving at any point in time, and is therefore a useful tool for market analysts. However, I was wondering if there is a rule of thumb that residential property investors could use to time their entry and exit from the market to maximise returns?

To answer that question I propose Murray’s Retrospective Indicator for Buying and Selling.

Sunday, June 26, 2011

Myth: Tight rental market boosts home prices

A common housing market myth is that low vacancy rates lead to rent increases, which lead to price increases (or at the very least, put a limit on any loss in home values). For example -

...this market imbalance will at some points cause an acceleration in rentals growth and a tightening in rental vacancies, so setting the stage for a recovery in prices through 2012.

Unfortunately, if history is anything to go by, this argument fails in real world conditions.

The two graphs below make the point clearly. In the early 1990s, vacancy rates soared and prices remained flat. But in the early 2000s, rental vacancies matched these highs during the strongest period of price growth observed in 25 years. How can these two opposing relationships been reconciled?

(Images from here and here)

I have a hypothesis.  During boom times overbuilding results in a slight glut in homes entering the rental market (eg 2000-2005). As the construction boom subsides, these homes are slowly absorbed by rental demand. When the market begins to fall (bringing much of the economy with it) potential sellers become reluctant landlords, boosting rental supply (eg 1990-1995). Additionally, nervous householders reign in spending on housing, resulting in an increased occupancy rate and lower rental demand.

There are many ways the occupancy rate increases, which don’t necessarily imply a shortage of homes. Downsizing leads to more efficient use of existing homes -

For example, the parents of a family whose adult children have moved out with friends or partners might find that the upkeep of a large house conflicts with their ‘grey nomad’ retirement plans. They can sell their 5-bedroom house and move into a new 2-bedroom unit, pocketing the price difference for their retirement.

In this scenario the construction of a 2-bedroom apartment resulted in a 5-bedroom home being available to meet the housing needs of population growth.

Other ways include university students moving home with their parents, and grandparents moving in with their children’s families.

If my hypothesis holds, then the ‘rental market cycle’ has two periods for each economic cycle, and tight markets are a signal of a price boom only if the previous trough was prior to a price fall. Therefore our next 'rental market cycle' will be one accompanied by falling prices, or flat at best.  The evidence in Brisbane seems to suggest that this pattern is beginning to occur (although prices have already fallen 10%).

(I also have a suspicion that auction results show a similar cycle - increasing in booms and busts, with low clearance rates at turning points.)

Wednesday, June 15, 2011

Real estate commission madness

The Queensland government is set to remove the maximum commission that residential real estate agents can charge from the Property Agents and Motor Dealers Regulation 2001. Currently the regulation prescribes in Schedule 1A that

The maximum commission payable on the purchase or sale of residential property is—

(a) if the purchase or sale price is not more than $18000—5% of the price; or

(b) if the purchase or sale price is more than $18000—

(i) $900; and

(ii) 2.5% of 


The common practice since the introduction of the regulation has been for all agents to charge this maximum.

The Deputy Premir Paul Lucas is spinning that dergulation will somehow benefit home sellers. Yeah. Right.

Admittedly, NSW, Vic and the ACT don’t have regulated commissions for real estate agents, and the common practice in these states is to charge 2.5% for homes in urban areas, and between 2.5% and 4% for homes in outer and remote areas. It appears from this comparison that Queensland’s regulation mostly benefits those in outer areas and rural and remote areas - those with the lowest value homes.

The question you must ask, is whether the regulation is disrupting functioning markets such that there is an efficieny gain from removing it? I have yet to hear of a real estate agent refusing a listing because the commission is too low. There are always other agents willing to try their luck.

In fact, recent competition suggests that more agents are negotiating below this maximum. I wrote earlier how lower commissions could be a massive competitive advantage for new agencies.  

Indeed, when the regulation came in home prices across Queensland were less than half of their current levels. So for every sale, an agent now makes double from charging the same commission. If this regulation was a problem we should have felt it years ago, not now.

Poor REIQ Chairman Pamela Bennet reckons “the regulation of commission rates for residential property transactions has not kept pace with the changing market resulting in consumers not receiving the benefits originally intended” What now?

For the maximum to have kept pace with the changing market it should have been reduced over time so that the inflation adjusted average commission was constant – theoretically providing the same benefits as originally intended.

The only logic I can see is that the government thinka this change will stimulate sales and hand them back some stamp duty revenue? Sorry. That's not going to happen.

Population and housing all muddled up (and now corrected)

RBA governor Glenn Stevens needed to say something about house prices in his recent speech. What he said was a little muddled, but if it is meaningful, does not bode well for home prices.  The analysis however got quite a bit of support from one property commentator.

First to the governor’s housing commentary –

It surely is no coincidence that the two state capitals that have had the clearest evidence of declining house prices over the past couple of years – Brisbane and Perth – are the two that previously had the highest rate of population growth and that have since had the biggest decline in population growth. Moreover, it is hard to avoid the conclusion that changes in relative housing costs between states, while certainly not the only factor at work, have played an important role. Relative costs are affected by interstate population flows, but those costs then in turn have a feed-back effect on population flows. This is particularly so for Queensland.

Historically, Queensland has had faster population growth than the southern states, as it has seen a slightly higher natural increase, a rate of net international migration on par with other states and a very substantial net positive flow of interstate migrants. Net interstate migration to Queensland peaked around 2003 – not long after Sydney dwelling prices had reached a new high relative to other cities. Interstate migration at that time was contributing a full percentage point a year to Queensland's population growth. By 2008 this flow had slowed a bit, but international migration had picked up and Queensland's population growth increased, peaking at nearly 3 per cent. Western Australia's population growth was even higher, peaking at almost 3½ per cent.

Meanwhile, at least up to 2007, people were confident and finance was readily available. Brisbane housing prices, which had been a bit over half of the average level of Sydney and Melbourne prices in 2002, had risen to be almost the same by 2008, which was unusually high.

The rate of interstate migration to Queensland then slowed further, to be at its lowest in at least a decade. The effects of that on state population growth were compounded by a decline in international migration, something seen in all states. At the same time, finance became more difficult to obtain and lenders and borrowers alike became more risk averse. This happened everywhere, but its effects in Queensland seem to have been more pronounced. Since then, Brisbane housing prices have been declining relative to those in the southern capitals and the construction sector here has found it tough going.

I decided to check the facts. Below is a graph derived from the ABS Sept 2010 demographic statistics on State populations. The figures show that WA did in fact have a population growth spurt during 2008, but that WA and QLD still retain their claim to the highest population growth rates in the country. In fact, Vic also recorded declines in growth rates of a similar magnitude to QLD in 2009-2010, but home prices have been far better maintained there. 

The only conclusion, to draw, if we believe the RBAs population explanation of home prices, is that with national population growth rates now down the gurgler, home prices nationwide can expect significant falls.


Tuesday, June 7, 2011

Dwelling finance springs back

The ABS released their April dwelling finance data today, and there was quite a bounce for owner occupiers across all States, but investor finance continues to fall.

Taking a look at the big picture it is hard to know whether this one month's data is particularly meaningful.

Monday, May 30, 2011

Brisbane and Perth housing slide continues

RP Data-Rismark released their dwelling price data for April today (here).  Brisbane and Perth are leading the price slide with Sydney and Canberra showing small gains.  This follows a stream of poor economic data recently.

I March 2010 I suggested that the next interest rate move by the RBA would be down.  I was wrong.  They increased another 75 basis points in total in their April, May and November decisions. 

My reason for suggesting they must move down is that the economy was much weaker than they anticipated, and the outlook far less bouyant.  Given this recent data one must think that their optimism is slowly fading.

2011 will be a very interesting year indeed. 

Sunday, May 29, 2011

Getting my head examined - a Chris Joye rebuttal

Don't get me wrong. I agree with Chris Joye on some things - lowering the inflation target (perhaps not right at the moment), pushing for a more streamlined NBN, and supporting Malcolm Turnbull's political ambitions.

But when it comes to the housing market the guy with all the numbers is happy to overlook the strikingly obvious and adores a verbal stouch with his foes - the group he calls 'housing nutters'. In fact he just recently recommended the following 

At the same time, anyone who claims that a 1% year-on-year retracement in dwelling values is a major asset-class event (cf. the share market frequently falling more than 5% on a given day) needs their head examined, with the greatest of respect. And I sincerely meant that latter caveat: you genuinely should seek medical advice if you are convinced that house prices are plummeting. 

Let's take his advice and examine what is in my head (noting that I don't believe a 1% year-on-year fall in national home prices in isolation is a concern). 

Joye often likes to draw attention to the low volatility of the housing market compared to the share market (eg here and here). But he neglects a few important differences. 

1. The housing market has at best monthly data only. Moreover each month's price data point is essentially an average. The share market would be far less volatile if you measured it that way and averaged away each month's price extremes. Not that volatility represent risk in any case. 

2. The share market is an equity market. If you want to compare like with like you need to compare the change in home equity to the change in share prices. If there is $1.7trillion in housing debt outstanding against $3.5trillion worth of housing, you can double any housing price change to calculate the change in equity of homeowners on average. Of course prices are set at the margins so perhaps for the price setting buyers and sellers the leverage, and importance of small price movements, is even greater. 

3. The negatively geared investor sets the market price (apart from the recent burst of FHBs). This means they are losing money every year. Any small decline in value decreases their equity substantially in addition to losses already incurred. 

4. The marginal homebuyer is heavily leveraged - 80% plus. This is not the case in the share market. Remember, leverage works to improve both gains and losses. 

5. The wealth effect is much stronger in the housing market than other markets, particularly due to leveraging and the sheer size of the asset compared to household incomes. 

6. Cost of home ownership is much greater than simply the interest cost. For most homes around 25% of the gross rent is spent on annual costs (refer to 3.) 

7. Housing market crashes, while they feel almost spontaneous, actually take some years to eventuate.

Irish housing - 5 years to fall 28%, or 0.41%/month

US housing - 6 years to fall 31%, or 0.38%/month

UK - 2 years to fall 21%, or 0.8%/month (and still 18% down from their peak 4 years later) 

8. Lastly, I feel sorry for anyone who shared Joye's property optimism and bought into the Brisbane or Perth property markets in the past two years.  While the share market hasn't been crash hot, 6% returns on cash has been pretty flash.

Anyway, if these notes are a sign of a mad man, well so be it ;-)

Wednesday, May 25, 2011

Wealth effect driven by the housing market

Leith van Onselen over at Macrobusiness has written a couple of very important and timely articles on the wealth effect. Put simply, the wealth effect is an increase in spending that accompanies and increase in perceived wealth.

In relation to housing, this paper suggests the wealth effect increases our propensity to consume by 9c per dollar of increased housing value (which is further supported here). So if the housing stock of Australia is valued at $3trillion (some say between 3.5 and 4 trillion), and market values increase 10% in a year, then we will spend on average 9% of the $300billion of new 'wealth', or $27 billion - with $6 billion of spending occurring prior to the end of the next quarter.

Importantly, this money is spent before it is earned by selling the asset. The easy access to home equity lending has been a contributing factor to the size of this effect, enabling households to spend their capital gains before they have been realised which increases their financial risk.

There are few readily available studies about the size of this effect in reverse, but if the same values hold in both directions we can look at some interesting scenarios.

If prices fall 2.5% nationally over a quarter then we lose $75billion of perceived wealth, with an immediate reduction in spending in the following quarter/half year of about $1.5billion and ongoing reductions in spending totalling $7billion

With about $1.7trillion of bank loans outstanding, that is about the same effect on spending as an increase in interest rates of 0.25% and keeping them there for two years (which will mean $4billion extra is spent on interest repayments per year). This of course assumes that house prices are not dramatically affected.  Indeed, if we consider that interest rate moves are likely to also bring down home prices, we can expect a much greater effect from the monetary lever.

That’s why house price falls of just a few percent can cascade into a crash so easily.

I would suggest the reason the wealth effect in relation to housing is much higher than found elsewhere is that many people who benefit/lose from house price changes are highly geared, which increases/decreases their equity more quickly for a given price change.

On this note I would add that you can’t directly compare share market volatility to house price volatility, since the share market is an equity market. To make a direct comparison you need to compare the volatility of the equity component of the housing market with share market, or the volatility of the share market value plus the value of debts held by those listed businesses to the housing market.

Sunday, May 8, 2011

1980s Texas Housing Bubble Myth - A Reply

Recently the debate on the price impacts of planning regulations has been a hot topic here and elsewhere. Leith van Onselen at Macrobusiness is one of the more sophisticated proponents of supply side impacts on home prices and recently responded to a comment of mine about Houston Texas. My comment was that if Houston is an example of how responsive supply can help cities avoid house price volatility, why did Houston experience a house price bubble in the 1980s?

Leith argued that Houston's apparent price bubble was a mere blip on the grounds of price to income multiples. In his typically evenhanded fashion Leith also notes many of the demand side factors at play during that time— the oil boom, liberalisation of loan standards, and population growth. He brings together these points with the following conclusion.
What makes Texas’ home price performance in the early 1980s particularly impressive is that prices managed to remain relatively stable in the face of significant demand-side influences that should have caused home prices to rise significantly and then crash.
An additional point is made that Houston has managed to avoid the 2000s property bubble infecting most of the US and much of the world.

My reply.

Houston prices declined around 40% in real terms following the 1982 market peak—that is indeed volatile—and it took 15 years for prices to recover in nominal terms.  The Case-Shiller 10 city index has dropped by a similar amount since the US peak in 2006 (30.5% nominally). So much for the volatility aspect.

But why do prices in Houston still appear so dramatically affordable when compared to incomes?

One major reason is the relatively high property tax rate.

Property tax rates in Houston more that doubled from 1984 to 2007 becoming one of the highest rates in the US. Depending on your area you can pay between 2-3% of your properties improved market value in annual State taxes, while the US National average is 1.04%.

One would expect areas with higher property taxes to have structurally lower prices, reduced price volatility, and much lower price to income ratios.

An illustrative example is shown below. The three comparisons are intended to roughly represent the early 1980s, the early 2000s, and today. The Houston property tax rates increase from two to three percent, while the comparison taxes increase from half to one percent. Interest rates also represent mortgage rates at the time.


From these examples we can see that from just this single factor, the property tax differential, we should expect prices in Houston to currently be structurally around 30% lower than national averages (more on the impact of the property tax differential here).

An important factor at play in this example is that at lower interest rates a fixed percentage property tax leads to greater price differences. Therefore, over time, we would expect Houston to home prices to be a smaller fraction of comparable homes elsewhere as the property tax differential has a greater price impact at lower interest rates. Remember that in the table above, rents and returns are the same for each comparison - only the tax rate is different.

Of course, this does not mean that housing is lower cost. It just means that the cost of housing is borne by annual tax obligations rather than capitalised in the price. A far better comparison of whether housing is structurally cheaper in Houston would be to compare quality-adjusted rents to incomes over time and across cities.

Perhaps once the property tax differential and other demand-side factors are properly considered we will see Houston's supply-side impact on housing prices diminish to zero.

Lastly, I would add that the memory of such a deep and prolonged property price slump would be motivation enough to dampen speculative housing demand in Houston. Who in their right mind would bid up prices in Houston knowing that increased tax liability and the history of dramatic losses on the property market?

Evidence of supply-side effects on home prices remains elusive.  

Thursday, May 5, 2011

A sign of desperate times?

Saw this advertisement today in the Financial Review.  I haven't seen anything like it before but it reeks of desperation.  Is it some kind of joke?

I like the first part of the fine print "Real Estate agents tell me I can get $2.1million for my luxury home but..."