Dear Property Speculator…
Concentrate. Money has a price. The price of money is the interest rate. Lower the price and demand increases. It’s the same with credit. The price of credit is the interest rate. Credit is money. Lower the price of credit and more people borrow. But there is a problem for central banks who like to use the price of money and credit as a tool for manipulating or fine tuning the economy. That problem is the bluntness of the tool.
What the Reserve Bank of Australia would like to see is low interest rates leading to an improvement in demand for borrowing for business investment. This would lead to employment, and a sustained improvement in the state of the Australian economy. What is actually happening however is that business is not investing and those same low rates, which initially fuelled a migration to higher-yielding shares and property, followed by a mad scramble for yield, is now igniting rampant speculation by those who fear missing out on any further gains in the prices of shares and property. Particularly property.
Consider that in 1991 the value of housing debt divided by disposable income was 35 per cent. Consider that today the same ratio is above 140 per cent – surpassing any other peak. Consider also that there is a record 40 per cent of borrowers who have taken out interest-only loans. Finally, consider that housing loans now make up 61 per cent of total of Australian credit, which compares to 24 per cent before the recession we had to have and 52 per cent just before the GFC.
China is painfully rebalancing its economy. It’s looking like Australia will soon have to contend with its own rebalancing.
According to Lindsay David, author of Australia: Boom to Bust and Print: The Central Bankers Bubble, “Based on median multiples, new home buyers in Sydney will spend the better part of 6.54 years savings (using 30 per cent of their income) for a 20 per cent deposit to buy a median-priced home.
“When it comes to servicing the first 12 months of a 25-year/80 per cent LVR mortgage, it will cost roughly 65 per cent to 70 per cent of household income to service that debt at current record-low mortgage rates. Melbourne is not too far behind.”
Think about the fact that global hedge fund manager, Crispin Odey, has warned that economies dependent on China for income including Australia are headed for recession.
Now consider that David Gonski, Chairman of the ANZ – an institution that benefits from mortgage lending, and arguably conflicted when advising on the subject of whether you should take out a home loan, has actually described markets as “quite scary”.
Add to these observations that of the Reserve Bank of Australia, who in its Financial Stability Review said, “The risk of a large repricing and associated market dislocation in the commercial property sector has increased.” Commercial real estate is dwarfed by the housing market but the RBA noted it poses “a disproportionately large risk” and “has been responsible for a number of episodes of stress in the banking sector.”
We have previously noted the ridiculous premiums of net tangible assets that some Real Estate Investment Trusts (REIT) are trading at. If a building is worth $50 million, why would you pay a premium (the equivalent of $65 million) for a little piece of it?
In the US “Sam Zell gained a reputation for impeccable timing with the $39 billion sale of Equity Office Properties Trust on the eve of the 2007 financial collapse.” It seems the Chicago real estate billionaire wants to head for the exit again, unveiling a plan to liquidate up to $3 billion of office property.
Now imagine the local banks do suffer some losses in commercial real estate. How would they ensure profit growth? Might they increase the rates on the residential mortgages? What would that do for real estate prices in Australia? What would it do for the large number of interest-only borrowers some of whom will inevitably be counted among the rising number of unemployed (thanks to China’s precipitous economic slowdown)?
And let’s not even begin to think about what it all means for record high bank share prices that are trading at over 10 times provision, more than 15 times earnings and over 2.5 time book value.
Finally, remember the recent comments we quoted by Ray Dalio, famed billionaire founder of Bridgewater & Associates. He noted that seven years into a US expansionary cycle (that’s about the average length of a cyclical recovery), any slowdown in the US would be problematic. In past recessions the Federal Reserve Bank of New York has been required to cut rates by an average of 300 and 400 basis points. With rates at zero, there just isn’t that room. At the end of the debt super cycle, Ray Dalio is saying he is sufficiently uncertain about the outcome of this great monetary experiment that he doesn’t want any “concentrated exposures”.
Investors and speculators who have borrowed to the eyeballs to buy a residential property might want to ask why they believe a concentrated bet is a good thing.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery, find out more.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
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.
Owen Ow
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Hi everyone
Very much enjoyed reading Lindsay Davids’ “Australia: Boom to Bust”. Im just wondering if anyone could recommend a recent book that would have an opposite opinion/argument to this book.
Thanks!
Joe Rich
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Hi Roger,
Thanks for the great article.
While I agree that housing is overvalued, and have been trumpeting this horn for years to my friends (who all point out that I have continued to be wrong as prices trend ever upwards), I do wonder about what potential catalyst will lift rates in the future.
For all the talk of ‘tapering’, central banks will *never* voluntarily lift rates substantially (i.e. back to historical averages). This is because the level of debt in developed countries is now so large that any substantial hike would cause massive issues for indebted governments and economies around the world. Nobody wants to be the Reserve Bank Governor who presided when the party ends, much less the one blamed for causing GFC 2.
Banks will not raise rates to lift profits, if they believe that doing so could spark a high level of mortgage stress. Doing so would hurt their competitive position, give them bad press (imagine the Herald Sun battler articles), and could cost them more in bad loans than increased profits on the rest of the book. Remember, people running banks are very risk-averse.
The only situation I could see that would increase rates is if there was a currency crisis with 1 or more currencies being rapidly devalued due to a loss of confidence in that currency. Faced with a huge spike in inflation, politicians and central bankers would be forced kicking and screaming to raise rates to protect the currency. The choice would essentially be – do nothing and hyperinflate, or protect the currency and see stock and property prices collapse.
I certainly hope I’m wrong and that a situation like this will not play out…
Roger Montgomery
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Previous bubbles have popped without the conventional rate rise catalyst. House prices can stop rising even if rates were to fall. Banks may have to raise rates as compensation under the new CET1 requirements spelled out under the Murray review.
Andrew Legget
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One thing i have noticed is just how little noise has been made in news etc regarding the RBA interest rate decision. This used to be a chief story every month and would be disected in great detail.
Now those stories about battlers doing it tough to keep there home have been replaced by stories of tiny sheds going at auction for millions. It wasn’t even that long ago (or even basis point ago) that those stories about mortgage stress existed.
All of a sudden it seems, the level of interest rates isn’t important to the average aussie.
I think there is a large “irrational premium” to property prices, at least in Sydney. I beleive many who have recently purchased property would have overextended themselves and this will come back to bite the owners as well as the banks. This will exacerbate declining property prices and result in bank prices falling back to more normal levels if not at cheap prices for a little bit.
I just think many people would have said “i know we were looking at that $350k unit, but with interest rates where they are we can afford to borrow much more and purchase that $800k 4 bedroom house on a 30 year mortgage”. This obviously ignores the point that interest rates now will not be the same as those in 30 years time.
Roger Montgomery
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Irrational premiums indeed!
Bruce Gleeson
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G’day Roger – I think the other point worth noting in Sydney [as it doesn’t seem as widespread in other capital cities across Oz] is simply the large amounts of cash reserves sitting in places like China that is fuelling the development property market. As a 40 something Sydneysider I have never seen the market so white hot. Sydney based property developers [notably the ones that have ridden cycles and don’t have such a short memory] will tell you they are sitting on the sidelines at the moment because they can’t make the numbers work on the prices currently being paid. Cycles are cycles after all, it’s just the numbers and names of people that change.
Roger Montgomery
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I think you’re spot on Bruce
John E
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Another Sydney weekend and another record auction clearance. Cheerleaders out in mainstream media are urging on this boom to greater and greater heights. Of course many of them have vested interests with their stakes in online property listing companies.
Luckily property prices never fall !!! Well there’s a generation who’s never experienced a fall – at least in many parts of Sydney.
And what about valuing residential property? It’s generally valued on what other ‘similar’ properties sold for – not the income that can be generated from the asset. A greater fool theory in that there will always be someone in future to offload the property to at a higher price.
Once confidence changes to the other side, then we’ll see a lot of pain across many areas – not just borrowers and banks. A lot of employment has been created in other areas from this housing boom in construction/development, trades, retail. So once it turns, the economy will take another hit. And what about the state finances depending on all this stamp duty and land tax??
At least we don’t have ‘jingle’ mail like in the US where the ultimate liability lies with the lender in the case of negative equity. This really exacerbated the GFC over there.
michael west
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If we are heading into what could be a prolonged recession then some current market darlings could drop heavily in value. What price SEEK when job vacancies dry up? To name just one of many.
Roger Montgomery
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Hi Michael, We don’t know if it will be prolonged or not. And we can’t really say, with 100% certainty, that we will have a technical recession either. All we can say is that the ducks appear to be lining up. Its vital to invest based on value, quality and prospects. These will be different for every company. For Seek a recession may dent the share price, but it may not dent the company’s business performance nearly as much. It will depend on how prolonged/deep any recession is.
Peter Harris
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A little more on the conflict of interest inherent in Bank mortgage lending from Positive Money..
http://www.positivemoney.org/issues/house-prices/
Roger Montgomery
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Thanks Peter