Reply: 1
From: Jas
Hey all,
What's your ideas?
Jas
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Residential Property
Is it a bubble?
I suppose I have never been seen as a great fan of residential property.
Having said that I wrote an article for the AFR in 1997, which tried to
point a more balanced picture on residential property investment at a
time when financial planners were slamming it relentlessly. I even
received a congratulatory letter from one of the real estate bodies in
response at the time.
Nevertheless, now on any objective analysis it is a time to be extremely
cautious about residential property investment. For the reasons I point
out in this paper I believe the broad property market is as vulnerable
to poor returns and capital losses as any time in recent decades.
Characteristics of a bubble
One approach is to simply think about the characteristics of financial
asset bubbles and ask oneself whether the residential market currently
has these. Such characteristics are:
1. Strong increases in prices irrespective of the underlying
investment fundamentals (particularly the current and future income
generation potential of the investment)
2. Very heavy use of debt by buyers of the asset and easy
availability of finance.
3. Widespread participation in the boom amongst the general
population
4. A belief that prices can only go up, not down (or at least that
if not up they can only go sideways)
5. Government policy that facilitates, accentuates or at least
provides a fertile ground for the bubble to develop
All of these elements were present in the technology boom that peaked in
early 2000. Today they are all present in the residential property
market. It looks like a bubble, sounds like a bubble and acts like a
bubble.
Of course all that we know about bubbles is that they eventually
collapse and cause significant losses, particularly for those that buy
in the "frothy" stages. Of course even bubbles in the frothy stage are
inclined to inflate further than people expect.
While no two bubbles are identical, it seems likely that a bubble has
developed in residential property (in cities at least) and like all
bubbles in investment markets, it will burst with the current (and
heavily geared) entrants the most badly burnt.
Is home ownership different?
Of course many of today's buyers of residential property are not
investors but potential homeowners. Surely, this cannot be speculative?
you might ask.
It is true that owning one's own house makes sense for most (but not
all) people and most (but not all) of the time and for sound investment
not just emotional reasons.
In owning a house you are effectively receiving the implicit rent
tax-free plus you have the benefits of capital gains tax free growth.
These benefits however, only accrue most effectively:
1. When you have paid off the property and own the property
outright (i.e. you have no borrowings, the interest on which is paid
from after tax dollars)
2. When the per annum rent that you would otherwise be paying for
an equivalent rental property is high relative to the value of the
property (i.e. it has a high rental yield)
Effectively, someone who has no mortgage is receiving the rent they
would otherwise pay tax-free. If and when net rental yields are 5-6% or
above this represents a sound after tax return for the funds employed,
even without any capital gain. This is particularly the case if rents
are expected to increase in the future.
The problem today is:
1. Those buying property today are doing so primarily with debt and
with more debt than probably at any time in history. Thus the rental
advantage is offset by the ongoing interest cost of 6-7% per annum on a
large mortgage and they have to pay this interest cost out of pre-tax
income.
2. With price rises outstripping rental increases, rental yields
have fallen significantly in recent years and the implied rent advantage
has become smaller. (Net rental yields on some highly sought after
areas have dropped below 3%)
3. With rental vacancies high in many areas and inflation low the
outlook for increases in rent in the next few years is muted.
Therefore while owning your own home makes sense, gearing to the
eyeballs to invest in something where the rent on such a property would
earn represents a small ratio to the price you pay does not.
Today the combination of these factors means that the benefit of taking
out a large mortgage to buy a residential home may be less than in the
past. A very heavily geared homeowner is losing on a cash basis
because they are paying 6-7% interest (which is likely to rise in the
short term) compared to the 3-4% rental yield they would pay to rent a
similar place. It is true that through the 1970s and 1980s high interest
rates were also above rental yields however those renters generally
experienced significant rent increases time. Such rent increases seem
less likely today. Of course buyers still receive the capital gains
tax free but the question must be asked, will the capital gain be there?
All investment is about cash flow
Property investors and home buyers seem to be forgetting that the
fundamental value of an investment always comes down to its ability to
generate cash flow and the discounted value of this cash flow compared
to the cost of borrowings and other investment alternatives. They seem
to be ignoring the mediocre (in some cases poor) investment fundamentals
on many properties and buying with a simplistic notion that recent
capital gains will continue. They just have to get in, is the common
mentality.
Any asset's long-term performance is driven primarily by its ability to
generate income. Of course, markets are also driven by sentiment in the
shortmedium term meaning that the valuation of that income flow may
temporarily be a less significant factor impacting prices. However,
there is a tendency for valuations relative to underlying cash flow to
eventually revert towards longer-term averages.
One way to look at the valuation of property is the multiple of average
prices to average rentals. This is akin to price earnings ratios in the
stockmarket. The PE ratio for residential property (average property
prices over average rent) is now at about 23 or close to the highest
level ever. This implies an average gross yield of around 4.5%. It is
lower in Sydney and Melbourne. History shows that Price earnings ratios
for property have generally tended to be around 12-15 over the longer
term (implying a 6-8% gross yield)
Of course the big argument for lower yields and higher PE's (in both the
sharemarket and property market) is that inflation and interest rates
are lower today than in the 1970s and 1980s. This makes sense at first
but there is an element of "money illusion" in such an argument. The
true fundamental value of an asset is based on the discounted value of
future net rental income flows. If inflation is lower, rental growth is
also likely to be lower reducing the value of future rental income.
Therefore while there is no doubt that low interest rates have
encouraged buyers (and lenders to provide funds) to pay higher prices
for property, the case for rationally doing so is not as strong. This
is particularly the case if, as seems likely, rents are likely to be
flat or may even fall because of high rental vacancies.
One barometer I have measured casually over the last 15 years or so have
been the number of pages of units and houses for rent in Saturday's
Sydney Morning Herald. In most market environments up until the last
few years' units for rent have averaged less than 2-3 pages. Recently
there have been over 7 pages. The official rental vacancy has been put
at 4-5% in Sydney. This is several times the level experienced in the
late 1980s boom when vacancies were 1-1.5% and inflation was also
higher. Rents are unlikely to rise and may even fall in this
environment. These are not good fundamentals for today's property
buyer.
Many home buyers seem to be operating under the premise that rental
property and home ownership are not interchangeable; i.e. they have no
choice but to buy. In practice though, renting is always an option and
at times when rental yields are low and rental vacancies high it can be
an attractive option compared with buying. Of course there is the
uncertainty of living under a short-term lease, but the reality is that
for almost any type or location for a house or unit you wished to buy
there is likely to be a similar one that could be rented
In such an environment potential homeowners should consider abandoning
the perception that they "have to buy" based on the premise that "prices
always rise in the capital cities". This statement is simply not true.
There is no asset price throughout history that always rose or was
guaranteed not to fall. The fact that most people have experienced price
rises over the last 20-30 years should not hide the real truth. In fact
the more people who believe in this fallacy, the less likely housing
prices will rise or be immune from falls (since by then almost everyone
has already bought and there are fewer buyers to take prices higher or
prevent falls). Just ask the Japanese who have been through a 10 years
period where residential property prices have falls at least 60%.
The property investor
Of course property investors are the other drivers of the market and
have become particularly active in the unit market in recent years.
Seminars promoting negative gearing into properties as the sure way to
wealth are being aggressively promoted. Perhaps a more difficult
sharemarket environment encouraged investors to consider property as a
"safe" alternative.
Property investors are in a different position to homeowners, but they
too are hostage to market fundamentals. While they receive a tax
deduction on interest, they require a capital gain because with net
rentals at 3%, an additional 3-4% is needed just to break even given
interest and other costs. Even if they are not borrowing these net
yields are below what they could get in safe bank deposit. Again the
scope for increases in rents in many areas is limited.
If the net rental yield is below 3% what can investors really expect?
The problem is with rental vacancies high there is a good chance that
rents will be flat and may even fall over the next few years. Where do
investors expect capital gains to come from if not ultimately from the
growth in rental income? Interest rates are not going lower. Further
price rises in this environment is more likely to be the components of a
bubble that will not be sustained.
Interest rates and household debt
While interest rates have fallen the interest burden has not because
borrowers have taken on more debt. Household debt has more than doubled
in the last 5 years. Thus while home affordability should have
increased with lower interest rates, this has been largely offset by
rising house prices and the resultant greater debt required to purchase
property. Today only a small increase in interest rates would have a
significant adverse impact on the ability of homeowners and property
investors to service their mortgages.
Of course, the increase in household debt may have been at least partly
soundly based (apart from lower interest rates). For example, the
Australian economy has been remarkably resilient. The resultant high
job security has encouraged people to take on greater debt. Even the
Australian sharemarket has been less volatile than other markets and
compared to history, and this has encouraged some investors to gear into
the market. However, the problem is that these conditions are
historical and there is no guarantee that such benign conditions will
continues into the future. There is little margin for error in many
highly geared households today.
Two possible threats to this benign environment are:
1. Rises in interest rates (and with debt so high these do not have
to be significant).
2. An increase in unemployment perhaps as a response to a renewed
recession in the US economy.
Either of these factors could be the catalyst for the unwinding of the
property market bubble.
Another factor impacting property market prices is its correlation (with
a lag) to the sharemarket). The property market tends to rise after the
sharemarket has begun a bull market and continue to rise even once the
sharemarket begins falling. Typically, however though, the property
market has peaked 1-2 years after the sharemarket and is followed by a
decline.
Conclusions
The cynics will say you could have been negative on property 2-3 years
ago and missed out on the recent gains. This is true to a point, but it
has only been in the last 12 months that the market has showed the
excesses that typify a bubble. Moreover, identifying a bubble does not
mean prices cannot go higher. The nature of bubbles is that they tend
to go higher than people expect, although they also tend to fall further
than people expect when the bubble bursts.
Therefore, when the bubble bursts prices could easily fall markedly,
perhaps even to below levels of 2-3 years ago. Remember also that
similar sorts of argument were also used to justify the technology boom.
If this is a bubble then like all bubbles it will end badly for those
who get in close to the top, who over-gear to get in or who spend their
paper gains. This is not to suggest that some properties cannot do well
or be bought cheaply in a difficult overall property market. The same
is true in a bear market for shares. Some companies and sectors can
still make money for investors although they are few and far between and
more difficult to find. In any case, it seems clear that the easy ride
for property is coming to an end. Housing prices, like any asset
class, are susceptible to speculative excess and can fall. Indeed they
are most likely to fall when the majority believes that they cannot
fall, as seems to be the case now. Is important not to confuse brains
with a bull market.
ENDS
Dominic McCormick is the chairman of the Investment Committee of the
listed financial planning and management company, Snowball Group
Limited, specializing in investment research and portfolio design. He
is a former head of research with Bridges Financial Services.