There has been a lot of talk over the last few months about the Australian residential property bubble. Most recently with overseas hedge funds telling us that our market is so overpriced (25%-40%) we need to be shorting Australian banks as mortgage holders.
Conversely other industry commentators, often promoters, argue the market is reasonably priced because of low interest rates.
Is the Australian residential property market so overpriced that we should be shorting our banks? Not in my opinion, but only because our major banks are high quality businesses, delivering good returns on equity and operating in a limited competitive environment. They are not solely exposed to residential mortgages. A business that does directly reflect the residential property market is McGrath Real Estate whose share price has fallen 30% from its IPO in December 2015.
I also don't agree with those industry participants (often mortgage brokers and estate agents) who use the following graph to argue that residential prices are reasonable.
When I hear this argument it feels like the proponents are saying that whilst alcohol is cheap the best way to avoid a hangover is to stay drunk. With interest rates at historic lows, what this graph demonstrates to me is the potential problem when interest rates eventually rise. The only way to avoid a hangover is don't over consume.
The following graph demonstrates the increasing indebtedness of homeowners particularly in the ages approaching retirement. The argument that interest rates were much higher back in 1990 and so household incomes today can comfortably service loans that are larger relative to household income maybe true but it ignores the reason for requiring higher debt in the first place and the enormous problem waiting to materialise when interest rates eventually increase.
Percentage Home Owners With A Mortgage
Source: ABS Surveys of Income and Housing
IS RESIDENTIAL PROPERTY OVERPRICED?
I’m not in the business of predicting markets; I simply try to assess what I believe to be fundamental worth relative to market price in order to identify the potential for value.
In attempting to assess residential property’s fundamental worth we need to recognise that residential property has two very different functions.
- A home - somewhere to safely cook, eat and sleep whilst sheltering from the elements.
- An investment - where an investor realises an acceptable return on their capital.
1. Residential Homes
The worth of the home depends on the criteria one adopts, which is obviously different for everyone. To try and assess the financial worth of the broader residential market, in terms of the residence being a home, probably the best metric to consider is affordability.
There are many different measures for housing affordability, some of which are.
- 30 per cent rule where housing is considered to be affordable when it takes up less than 30 per cent of a household's gross income before tax;
- 30/40 rule where housing is considered to be affordable when a household spends less than 30 per cent of its gross income on housing and when it has disposable household income in the bottom 40 per cent of the income range;
- Comparing house prices to growth in the overall consumer price index (CPI) and when house price growth exceeds CPI growth, housing is considered to be increasingly unaffordable;
- Comparing house prices to incomes where housing is considered to be affordable if it costs less than three times household income;
In the above graph 'HAR' is the 'Housing Affordability Ratio', measured by dividing the median house price by the median income of the house purchaser. A ratio of 5 or less (below the green line) is considered affordable. A ratio of 7 or more (above the purple line) is considered severely unaffordable. Source: Master Builders Australia
Mean Mortgage Debt To Income Ratio
The chart below illustrates that average mortgage debt has soared relative to the average household incomes of mortgagors in all age groups in the last 20 years.
Of 360 international housing markets assessed for housing affordability across nine countries, Australia has 25 severely unaffordable localities. Hong Kong is the least affordable city followed by Vancouver and San Francisco. Sydney was the fourth least affordable and Melbourne ranked sixth. Source: Demographia International Housing Affordability Survey Q3 2016.
Whilst there is no formally agreed measure of housing affordability, in consideration of all the available measures it is evident that home ownership is becoming less affordable. The Senate Economics Reference Committee’s inquiry into affordable housing reported to the Senate in May 2015 the following.
“The overwhelming weight of evidence received by the committee demonstrates that Australia has a housing affordability problem. As Mr. Eslake (Chief Economist Bank of America Merrill Lynch) put it in his submission, while most Australians are 'physically well housed, it can no longer be said that we are, in general, affordably housed'. Sustained growth in median housing costs above the rate of median household income growth in recent decades has made it increasingly difficult for a growing proportion of Australians to afford housing that is safe, secure and appropriate to their needs.”
2. Residential Investment
The Property Council of Australia estimates that almost 60% of Australian's who own an investment property utilise negative gearing. Another way of looking at this is that nearly 60% of residential investment properties are cashflow negative with investors speculating on a capital increase to justify the investment.
The following from CBA's Property Insights Summer Edition 2015 best sums up the Australian residential investment market.
"The development cycle is in full swing, with an estimated 80,000 apartments under construction. Local market impacts will vary enormously — depending on the concentration of completions, along with the level of demand for these properties from buyers and occupiers.
Inner Melbourne and inner Brisbane will experience the highest concentration of apartment completions in absolute terms, in the next two years. As a result, these two locations are likely to be subject to rising vacancy and reduced rents, leading to downward pressure on values and a heightened settlement risk.
In Sydney, the broader geographic spread of completions across a large number of suburbs, together with a greater depth to the buyer and occupier market, is likely to mitigate these risks.
While the supply-side in Perth is heavily concentrated, no Perth suburbs appear on the top 20 completions lists. However, the recent fall in population growth and the already high vacancy rate appears to be a more important driver in future vacancy and prices. Already, Perth is the only metropolitan area where the median apartment price is falling (-2.6% year-on-year) and vacancy is above the equilibrium (3.8%). Completion of the 2,700 apartments currently under construction in inner Perth is likely to exacerbate this situation.
Adelaide and Canberra have much smaller supply pipelines so market demand for apartments is likely to be reached sooner in the cycle. When this happens, supply is likely to adjust to a more sustainable level.
High rise and high density apartment living offers greater housing diversity in response to changing household structures. But the large number of apartments being developed in high concentrations, over a short period of time, cannot be quickly absorbed by the occupier market.
It’s likely to be a number of years after the 2017 peak of completions before population growth can absorb these new apartments, so vacancies can return to acceptable levels and allow positive growth in prices and value."
Uh oh! No wonder APRA and the banks are tightening lending criteria.
Residential property is definitely over priced, perhaps by as much as 20%. Will it crash? I don't know. What I do know is that affordability is a serious social issue for Australian families that will get worse when interest rates rise. As an investment the fundamentals in terms of cash flow and capital growth are not looking good. There are better investment sectors.