The ‘housing bubble’: a tale of two markets

Lindsay David and Philip Soos from LF Economics have heavily criticised the government for not doing more to prevent what they anticipate to be a ‘bloodbath’, particularly in relation to Sydney and Melbourne property prices. Meanwhile, the chief economists of HSBC and ANZ – Paul Bloxham and Warren Hogan – say there is no housing bubble. They assert that there can be no bubble unless it affects properties nationally. The government tends to agree – Joe Hockey says property prices are still affordable (provided you get a good job that pays well) and asserts that talk of a bubble is the result of “lazy analysis”. He says it is simply a limited supply issue. Unfortunately for Mr Hockey, any statement on housing affordability seems to underscore the fact that there’s not an undamaged window pane in his political glass house at present.

So what is a bubble, does it exist and are we going to see it burst any time soon?

According to Investopedia, a housing bubble exists when “housing prices increase, fueled by demand and speculation and a belief that recent history is an infallible forecast of the future”. Excuse me, but this seems far too esoteric. How about this: an overheated housing market exists when property prices exceed the historic mean distortion for property values and where those values continue to rise above the rate of increase in national incomes and GDP, and where the cost of borrowing on an average mortgage grows disproportionate to household net disposable incomes. By these measurements, there can be no doubt that the property market is overheated. A ‘bubble’ however is a very emotive term evoking expectations it will burst violently.

Other factors one must add to the mix of considerations is supply and demand (on a per-location basis) , the cost and availability of credit, and the inexorable link between commodity prices, currency fluctuation and their impact on general economic stability.

Mr David and Mr Soos also argue that net rental incomes are another indicator of impending doom in places such as Melbourne because they are historically low as a percentage of value. But this ignores the elephant in the room – negative gearing. So long as investors are able to offset the cost of borrowings (over and above rental income) against their total taxable income, then property investment shall remain attractive irrespective of rent-to-value ratios, within reason. Also ignored is the fact that Australia is one of the most liquid capital markets in the world because of its compulsory superannuation and that, since 2007, self-managed super funds (SMSFs) have been able to gain access to bank loans to gear-up investment in property, thereby adding further capital inflows to the market.

So what does this mean? By my measurement it means that residential properties in prime metro Sydney and Melbourne areas are overheated, fueled by an abundance of low-cost debt, an increase in investor capital (both domestic and migrating) and relative economic stability. Outside of state capitals and economically vibrant cities and towns, there have already been corrections. There have been contractions in Brisbane and the Gold Coast (which are now stabilising) and a softening of the non-prime markets in Western Australia and South Australia. All mining areas which enjoyed value increases due to pressures of demand over supply, such as Gladstone, the Surat Basin and outlying townships in WA have seen a softening of values as supply has caught up with and now exceeds current demand.

Questions as to whether or not there is an impending bubble about to burst will depend principally on whether there will be a mismatch in supply and demand and an increase in cost of borrowings. Supply and demand is geographically relevant. But there is no current indication of excess supply in Sydney or Melbourne, as attested to by auction clearance rates which remain incredibly high at 83 per cent for Sydney and 81 per cent for Melbourne. When this trends down, we might consider supply to exceed demand. In terms of interest rates, there is no indication that the RBA will affect an upward trend in this regard in 2015 – it being more likely to trend further downward caused by a weakening economy and unemployment. But we can’t ignore the fact that property prices in some suburbs have increased beyond local levels of owner-occupier affordability – Schofield in Sydney has seen upwards of 40 per cent annual growth, with many others exceeding 25 per cent in the last year. The picture is similar in Melbourne, with Middle Park at 31 per cent and four other suburbs exceeding 25 per cent growth.

With such increases, the government has come under increasing pressure to act. Of course, in absence of an increase in interest rates the most efficient way to dampen market speculation would be to remove negative gearing. This would disincentivise investors and take heat out of the market but it would have to be phased out over a decade to avoid impacting every single home owner. We doubt this can be achieved because it would require bilateral cooperation in parliament, and since neither party has addressed the issue as incumbents despite hypocritical pressure from each other in opposition, we can’t see it happening any time soon.

The only response on the subject has come from APRA – the prudential regulator responsible for maintaining the integrity of the financial sector which is dominated by the big four banks. Its role therefore also protects the financial integrity of the Australian economy as far as it would be negatively affected by bank failures or significant losses. APRA has introduced measures to restrict increases in bank lending for investment loans, and it is also considering whether investment loans should carry a 25 basis-point loading over home loans. As these measures are unlikely to have any meaningful impact in further protecting bank exposures to what is a fairly low-geared investment market, they will also have virtually no effect on property speculation or prices, particularly in the short-term.

APRA is a regulator, so it is quite normal for it to express opinions publicly on the importance of protecting banks from over-exposure to the market, but quite another to hear it speak in terms of taking measures to dampen the market itself. This smacks of pressure from Treasury and the RBA to provide soothing political soundbites to a public eager for action. This tells us the federal government has no intention of adressing the issue more meaningfully itself, which proves there is no current political will to take actions that hand influence over the property market back to owner-occupiers.

However, Australia has no history of meaningful property market calamities. Downturns in values have recovered relatively quickly, giving a mean distortion that has seen municipal properties in key cities doubling on average every 10 or so years. The rest of the property market has always been fairly volatile. In short, I don’t think property prices in prime locations will suffer significantly even when interest rates rise or if the market is affected by any other economic forces. If anything, prices may stabilise and hold firm until corrected to mean distortion. But if interest rates do rise to cost levels that further households’ net disposable income, and if these increases remain in line with or exceed current levels of household debt, you can be sure there will be an increase in stock through forced sales in suburbs where latest gains have been disproportionately high. There may also be a release of discretionary investment property which will exacerbate the problem by increasing property stocks. Under such circumstances, we could certainly see depreciations close to the predictions of Mr David and Mr Soos, but the major impacts will likely remain localised.

I will make a final observation: historically, so-called property bubbles have lasted decades until a perfect storm of factors have colluded to cause downturns. As far as property in Australia is concerned, it is and always has been a tale of two markets.