Warren Buffett’s quote (our title to this View) may identify some of the underlying forces at work with residential prices in Sydney and Melbourne. The quote reflects Buffett’s observation of the role of “envy” in propelling equity prices sharply higher towards the end of a speculative price bubble. People (let’s not call them investors) envious of their neighbours, friends or associates, dive into the market so they can claim to have not missed out. In such cases people don’t really care if they ultimately lose capital – as long as everyone else they know lost out as well!
“Greed” is a different human frailty, but it too is often observed in markets. It sometimes explains the inability of a person to take profits on overpriced assets or the aggressive use of leverage to purchase an asset to maximise gains. Greed swamps logic, the analysis of value and the understanding of risk. It contrasts with envy which drags people into asset markets through fear of missing out. However, whatever the cause, raging asset price markets are great for early buyers and tremendous for those disciplined enough to take profits. They are highly dangerous for late-comers and particularly those that buy with excessive leverage.
In recent months, the media has been swamped with opinion pieces questioning the sustainability and highlighting the inequality of high residential property prices. The 40% lift in average Sydney residential prices over the last 3 years has become a significant political issue for State and Commonwealth Governments. If residential prices are left unchecked to market forces, this could ultimately threaten the financial stability of the economy. Should residential property prices fall sharply, Australia could experience similar effects to those of the residential property crashes that hammered the US, Ireland and parts of Europe during the early years of the GFC. The flow-on effect for banks was devastating in those economies and therefore the positioning of Australian banks needs to be carefully monitored.
The following chart shows the makeup of Australian bank loan books. Interest only loans now represent about 40% of total housing and property investment loans. Arguably this level reflects both the high level of property speculation (targeting capital gain only) and affordability (interest but no capital repayments of debt). It also suggests that investors are buying their second and third investment properties through interest only loans.
Figure 1. Australia HL book composition
Source. Morgan Stanley
IPL is investor property lending, OOL is owner occupied lending, P+I is principal and interest repayments.
The above chart suggests a growing need to regulate the expansion of credit to the household sector. Our review of Commonwealth Bank’s recent results shows that interest only loans have grown from 37% of residential assets to 40% in the last year.
Could the above trend be a means of hiding a growing credit problem? If principle and interest loans are being rolled into interest only loans, perhaps arrears are not growing whilst improving “Loan to Value Ratios” are totally dependent on price rises rather than loan repayments.
No one should be deluded. Excessive residential property prices, driven by greed, envy or excessive debt, will not create a good outcome for Australia. High residential property prices may be maintained for long periods when governments and regulators support them, but eventually either affordability and/ or intrinsic value will bring prices down. The intrinsic value of residential property, understood through the interaction of yield, interest rates and leverage capacity, has become an important issue in Sydney and Melbourne because investors have driven prices higher rather than occupiers. That factor makes this cycle very different from previous cycles.
It also means that cross international comparisons of housing prices to incomes is fraught with difficulty. At the recent “Australasian Housing Researchers Conference,” Reserve Bank Assistant Governor Luci Ellis produced the following table to show that on a simplistic comparison, Australian residential property was not overly expensive.
Figure 2. Dwelling Price-to-income Ratios*
Source. BIS; Bloomberg; Canadian Real Estate Association; CoreLogic; Halifax; national source; OECD; Quotable Value; Realkreditraadet, Thomson Reuters; United Nations
The problem with the above chart, apart from the fact that it reflects different mortgage rates, incomes and taxation arrangements, is that it is both out of date and incredulous. It exposes the folly of economic analysis when undertaken by economists.
Let’s look at Australia. The latest average yearly earnings disclosed by the ABS for November 2016 is $76k per annum.
Figure 3. Average weekly earnings, key figures, Australia, November 2016
The table above seemingly assumes that there are two full time wage earners in a household ($152k gross income) that pay tax and have about $130k in household disposable income. If we multiple this by 4.7 times, we have a $600k average dwelling price in Australia. While that doesn’t sound so bad, the comparisons with offshore falls to pieces when we note:
- A dual income family probably has children, and child care in Australia consumes most of the second salary;
- The aveage house price in Sydney now exceeds $1 million and in Melbourne $800k; and
- The cost of essentials covering education, energy, healthcare and public transport has grown faster than average earnings for the last decade.
The price of housing along Australia’s south east coast has risen because a multitude of factors: envy, greed, the poor regulation of debt, excessive taxation breaks for property investment, the lack of restrictions governing non-resident investment, population growth and high immigration, poor infrastructure development, poor urban planning and uncoordinated land release. The lack of foresight and planning in urban and regional development must be addressed. While we do not want to go anywhere near the draconian centralised administration of China, we can learn from their long term vision, planning and five year reviews (see below).
The recent GDP report for 2016 calendar year showed an unhealthy focus in Australia on housing investment over virtually all other sectors. Indeed only exports, buoyed by the extraordinary rise in coal and iron ore prices, outpaced dwelling investment in the last year while business investment collapsed in a hole.
Figure 4. GDP (E) by component
The connection is clear. Australia is producing more part-time jobs so that people can buy homes with “interest only loans”. The dream of owning your own home is being repaced by the hope of merely living in your own home. This transition mostly affects the growing “Y” generation.
There should be little doubt that housing affordability in Australia’s two largest cities will be a major issue in the 2019 Federal Election. The “Y” generation are fast becoming a political force and the older generation, pandered to over the last decade, should realise that their influence will slowly wane.
Also, the years of elevated immigration (2006 to 2014) without a serious housing and infrastructure plan, is now coming home to roost. High levels of immigration, which has received very little critical analysis, has added to the housing demand at a time when supply was not adjusted.
Figure 5. Net in-bound migration
Whatever scheme politicians promote to alleviate the lack of housing affordability is doomed to fail. Affordability is governed by the interconnection of price, interest rates and wages. Given that the world economy is at the bottom of the interest rate cycle, either wages must massively rise (therefore inflation surges) or property prices must fall, to bring the market back to long term equilibrium. We think that a surge in wages is unlikely, and therefore that residential prices must fall – despite every effort by government to hold them up.
For those that invested driven by envy, this will not be an issue as everyone will suffer similarly. For those driven by greed, they have been warned but greed will ensure that they ignore it.