Leverage
Interesting to see the comments this week from ASIC chairman Greg Medcraft in relation to house prices, and the swift rebuttal from the Housing Industry Association (HIA). For those who came in late, the HIA position seems to be that there is currently no cause for alarm, although we could be in shaky territory in 12 months’ time if recent growth rates continue. ASIC, which presumably has no vested interest in continuing strong house prices, seems to be concerned that we may already be in bubble territory.
Bubbles are notoriously difficult to identify until after they pop, so trying to definitively judge whether we are in one may be fruitless. However, one thing seems clear: If we’re having a discussion about whether or not house prices are in a bubble (as we have been for some time now), house prices do not represent good value at the current level. The debate is about whether they are expensive, or seriously expensive.
While the distinction may be interesting from a media standpoint, from an investment standpoint you get to the same conclusion either way: now is not the best time to be leveraging heavily into residential property.
Tim Kelley is Montgomery’s Head of Research and the Portfolio Manager of The Montgomery Fund. To learn more about our funds please click here.
Tim joined Montgomery in July 2012 and is a senior member of the investment team. Prior to this, Tim was an Executive Director in the corporate advisory division of Gresham Partners, where he worked for 17 years. Tim focuses on quant investing and market-neutral strategies.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Aaron Somner
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The common theme here seems to be that low interest rates are driving house prices higher. If low interest rates raise house prices then Japan should have a massive housing bubble due to 20+ years of zero interest rates. And yet they are still struggling with deflation. House prices would be rising all across the country not just Sydney. It is allways the difference between the nominal interest rate and peoples expected rate of return that drives investment. In 1988 during one of Australias biggest housing booms interest rates were rising well above 10%. People were still borrowing because the expected rate of return was far higher than that. If Australian housing was in a bubble then the $A would be rising from all the foriegn capital looking for opportunity. We are in a normal cyclycal bull market in real estate. The cycle will peak and then prices will fall for a normal period of time. When interest rates start to rise then a broader section of investers will start to buy as the fear of higher rates will stimulate demand. The whole idea of the effect of interest rates has been turned on it’s head. It works the opposite of what is being discussed here. Every boom goes hand in hand with rising interest rates.
Dario Petkovic
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You can’t ‘move’ property, you can’t hide it from the government who some (Martin Armstrong) say will tax the he11 out of it when its desperate. Next crisis is indebted governments and the bondarket crash is due in October 2015 and that spells lack of liquidity, coupled with increased land taxes – who wants to gues what happens then?
John E
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An observation that I’ve come across with a few people recently who were suspicious of rising Sydney property prices in recent history, are now starting to waver and now believe migration and overseas investment will keep the property higher for longer. Others think it won’t crash or fall heavily, just go sideways for a number of years – like 2003-2010.
In terms of trying to identify a bubble, obviously the general public mindset towards the asset is a key factor. Everyone’s starting to take notice and property is a regular conversation piece.
Residential property is generally priced in comparison to what the house sold down the road last week and why this house is better than that one and hence worth more!! There isn’t much discussion of the earning potential of the asset or opportunity cost of making such a large non diversified investment.
Tim, you’re correct. You generally can’t tell a bubble for sure until after the implosion of the asset – like the internet bubble and US housing bubble. But there are usually plenty of clues along the way.
When people believe property doesn’t go down, they need to do something with their money as it pays nothing in the bank and there is general jubilation due to the wealth effect, then seeds are sown for a possible bubble. Especially when Sydney prices are so out of kilter with the rest of the country and indeed much of the world.
All the ingredients are there. Sure, prices can go up another 20% or more, who knows, but you’d have to think the longer prices go higher from here, the harder the landing.
It won’t necessarily take higher interest to make property go backwards. Simply buyer exhaustion and a loss of confidence for whatever reason can also lead to this.
david.keel.3597
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This is the second article I’ve seen here hinting at a sense of impending doom for housing. I’m not sure why you guys are so negative on an asset class in its’ entirety.
As with the stockmarket, there is not one Australian housing market, referring to it in this way is like lumping CSL in with Qantas.
The RBA Governor himself has said that there is too much focus on the 20% of the market that has clearly run ahead of fair value (Sydney), but this does not mean that there aren’t attractive opportunities in other areas of the housing market. However, much like the ASX, the lower interest rates go the harder it is to find quality assets at a fair value.
I see the Australian housing market as a great way to take advantage of the population boom that will occur in Australia over the next few decades. We have one of the highest population growth rates in the OECD at 1.7% and net migration will ensure that this remains at a high level.
In areas of the market (inner city suburbs), there is absolutely fixed supply and demand growing consistently and predictably.
Regarding current prices, I don’t see it as a bubble at all given that 70% of the market are owners (not investors or speculators), the average mortgage-payer is 18 months ahead in repayments and affordability of those payments are at very comfortable levels due to the low interest rates. Granted, if interest rates increase rapidly the asset class will be affected, but this could be said about other asset classes also.
I think both asset classes have their merits and it shouldn’t be a case of one over the other.
Tim Kelley
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Valid points, David. However, I’m always cautious about valuation arguments that aren’t anchored to some underlying denominator. For example, if prices were double their current level, we might still have population growth, net migration, growing demand and 70% of the market as owners, but would we still conclude that prices were good value? Is there a price level at which these factors no longer lead us to conclude all’s well?
david.keel.3597
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I would say that household mortgage repayments as a % of income is a fair indicator of the relative valuation of housing, I don’t think it’s unreasonable to anchor prices to this measure.
Households have been willing to pay between 33% and 55% of their income on housing for decades in Australia, right now in Sydney the number is right on 55% (not my research, I spoke to a buyer’s agent about this last week). Obviously if prices were to double from this level in the next twelve months it would be unaffordable and definitely in bubble territory.
Joe Rich
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I have long argued that housing is overvalued, and that high prices are primarily driven by extremely low interest rates rather than supply/demand imbalances (as evidenced by price growth outstripping rents).
However, I am finally started to question my position. Could I be wrong? Could housing actually be cheap?
My view over-valuation has always been based on the notion that excessively low interest rates would have to normalise at some point. But what is this assumption is wrong? What if governments and people around the word are so indebted that central banks are essentially trapped – unable (or unwilling) to raise interest rates until inflation spirals out of control?
If you accept that central banks will never *voluntarily* raise interest rates due to a combination of economic and political factors, then could saddling up with debt actually be a good idea? In a world where central banks print every more money to keep up with each other, savers are the ultimate losers, and people in debt the winners.
I’m not saying that there will never be higher interest rates again. But the idea of an ‘orderly’ exit seems implausible. Indebted governments will do everything they can to suppress interest rates. Even a small upward fluctuation would have seriously negative consequences on deficits, budgets, mortgaged voters and ultimately re-election hopes.
A few years ago there was an article on this blog that discussed a beautifully simple valuation model for housing. ( c / (rrr – g)). Where c = cash flow from investment after costs, rrr = required rate of return, and g = estimated long-term growth in rents.
If the risk-free rate goes 0 or negative, or inflation sparks rental growth, the denominator in the equation can be driven very low, and thus give a very high valuation.
Just my 2 cents…
Joe
Tim Kelley
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Your point is a good one, Joe. Value is calculated by reference to a discount rate, and if you believe low discount rates are here to stay that implies a higher valuation. Our analysis leads us to think that low interest rates tend to be followed by higher interest rates, but we are in uncharted waters as far as rates go, and the future trajectory is very uncertain.