Are Australian property prices going to crash?

[Deltaberry]

sorry... a rather obvious error in my formula. should be:

net yield - interest + (debt x CPI) + (cap gain - (asset value x CPI)) = net profit

Or you simply find your net return on equity and then adjust it for inflation to get a real return on equity.

To complicate things your D&A and tax would be off a non-CPI indexed asset base.

Also brings up the question of how do you value your investment. Cashflow-basis since that's essentially how a project at development level is valued?

 

[Deltaberry]

AP, if you attribute so much of an IP's net profit to inflation, then you are saying property growth at the rate of inflation is a sound investment. And remember, the RBA aims to keep inflation between 2 and 3% via rates.

In focusing on inflation, you are erring in believing cash flows and growth have a linear positive correlation with it. This isn't so. When inflation is up, rates go up, and growth is restricted.

Are you mistaking property growth to be solely an effect of inflation?

It is true, inflation fuels a portion of growth, but remember higher rates try to offset that......

The growth that makes an investment a good one, is the portion of growth above the inflation rate.....and that is provided by

Loose Credit

...and loose credit tends to occur moreso in low inflationary environments....though credit has been loose for the last 12 years, which I'll address below.


Where you are right in your thinking, is in the effect of inflation on cash flows:

- Holding costs normally escalate at the rate of inflation.

- Rents escalate at a rate somewhere between inflation and property growth, as rent has to strike a balance between maintaining yield on current value, and inflation's effect on wages.

- Interest is a function of inflation.
If inflation goes up, interest goes up.
BUT, importantly, and in support of your views, when inflation goes down, interest goes down.


These effects are better appreciated when cash flows and net worth are charted. When you do so, sensitivity analysis shows net returns are most influenced by that portion of property growth above the inflation rate. And growth above the inflation rate is possible how?????

BY LOOSE CREDIT

Admittedly, over the last 10 years, growth has been strong. IMO, that is very much due to loose credit via looser DSRs and LVRs. One has to ask whether these can be loosened further in the future.

The argument that undersupply and population growth are the prime drivers of property growth, is shot down when credit it tightened. No matter how many people want houses, if they can't pay cash, the houses don't get built.

Below is property performance over 2 economic cycles.
Average cpi, property and rent growth are 4%.
Rental yield begins as 5%, and retains that on average.
Interest rate averages 3% above cpi.

Hopefully it is evident this investment has weak returns, and most likely underperforms cash in (term deposits or bonds)

To summarize and simplify,

property performance is dependent on the degree combined cash flow and growth outperform inflation.

In the real world, this reduces to how much the combination of rent (and initial rent yield) and growth outperforms cpi.

Growth is obviously a combination of several factors. Can't be pin-pointed down to just loose credit, though I have no doubt that if credit was tightened dramatically the market would die. That said, surely if we had a diminishing population, the market would die too? Food for thought my friend...

But again, it's a case-by-case investment. I wonder how it'd look if you charted the average dividend yield and share price growth of the S&P / ASX 200 or even the S&P 500. You need to be able to pick outperformers even in the market.

And yes loose credit has many connotations to it. One would be that you don't get 'margin called' on your loans (which is a form of looser credit than margin loans), where as even if shares displayed superior returns you'd be margin called and bankrupted before you had a chance to recover.

 

[WinstonWolfe]

Hmm yes..

Term deposits must be the best investment of all.

Hey if you believe there's no advantage in timing the market, there's heaps of -CF sub cpi growth property out there right now.

Go knock yourself out dollar cost averaging into it and shares.

 

[WinstonWolfe]

Growth is obviously a combination of several factors. Can't be pin-pointed down to just loose credit, though I have no doubt that if credit was tightened dramatically the market would die.

That said, surely if we had a diminishing population, the market would die too? Food for thought my friend...

Yes a declining population would counter loose credit's effect on property growth.....as would abolishing IP negative gearing. But I'll stick to dealing with the plausible

But again, it's a case-by-case investment. I wonder how it'd look if you charted the average dividend yield and share price growth of the S&P / ASX 200 or even the S&P 500. You need to be able to pick outperformers even in the market.

Well, the 200 and 500 are a constantly moving target. The ones that underperform (die) get replaced.

And yes loose credit has many connotations to it. One would be that you don't get 'margin called' on your loans (which is a form of looser credit than margin loans), where as even if shares displayed superior returns you'd be margin called and bankrupted before you had a chance to recover.

I will gladly take the other side of a trade by anyone who uses leverage without mitigating downside risk. Hedge funds can only dream of evermore such clients.

 

[Sunfish]

Hmm yes..
The taxed return from a Term deposit has beaten:

An index fund of the US share market bought 10 years ago
Virtually any property in Japan bought 20 years ago
Gold that was bought 40 years ago
Almost all blue chips in the Aussie sharemarket purchased 5 years ago
Almost all Western Sydney properties purchased 5 years ago
and much much more.

Term deposits must be the best investment of all.

Wealthy Americans invest massive amounts of their funds in bonds. Should we write them a letter to inform them of their poor judgement?

 

[WinstonWolfe]

Here's one formula to calculate net gain anytime in the future, ignoring tax.

Here's a challenge: Try and improve performance by increasing inflation rate.


=Vo*((Yo*(1-(1+rentgrowth)^per)/(1-(1+rentgrowth)))
-Ho*(1-(1+cpi)^per)/(1-(1+cpi))
-incost
-avrate*per
+(1+cg)^per
-1)

Vo = Initial Value
Yo = Initial Gross Yield as % of Initial Value
rentgrowth = Rent Escalation
per = No. of years
Ho = Initial Hold Cost % of Initial Value
cpi = annual cpi
incost = In cost as % of Initial Value
avrate = Average Interest Rate
cg = Annual Property growth rate

Oh, ok here's the xls

 

[WinstonWolfe]

Wealthy Americans invest massive amounts of their funds in bonds. Should we write them a letter to inform them of their poor judgement?

And they'll be buying more bonds shortly methinks....


An urgent 'sell' warning

Richard Russell, author of the famous Dow Theory Letters, is “insisting, demanding, begging” his subscribers to “get out of stocks”.
In his latest letter, published last night, he says the stockmarket has lost its mind. “Finally it’s happening. The poor thing is falling apart.” Russell is referring to the fact that the market is falling in the face of persistent optimism about the US economy. He says you should believe the market, not the economists.
“It’s been hard, and it’s hard to tell my subscribers that this market is topping out and that you should be out of stocks. So, if you are still in the market, sell your common stocks (not the golds) and get out. I don’t care how good or how blue-chip your stocks are, when the bear takes over, he sinks his claws into the throats of all the boys and girls. Declining price/earnings in the bear market alone will cost you, and P/E ratios are now dangerously over 20.”

 

[Sunfish]

And they'll be buying more bonds shortly methinks....

There is such fear out there that the 3 month treasuries are yielding 0.01%.

I reckon our market is overpriced at a PE of 14. What are the Yanks thinking, bidding theirs up to 20?

 

[Ausprop]

There is such fear out there that the 3 month treasuries are yielding 0.01%.

doesnt this contradict your theory that lenders require a return above CPI?

 

[WinstonWolfe]

doesnt this contradict your theory that lenders require a return above CPI?

Well, the theory in its entirety is, get all of your capital back with the >cpi return.

 

[Sunfish]

doesnt this contradict your theory that lenders require a return above CPI?

It is above CPI if they fear deflation. (In this case probably asset deflation, particularly in stocks, which is what WW warned about).

It definitely confirms something I've said here often: Return of capital is more important than return on capital.

 

[Deltaberry]

Here's one formula to calculate net gain anytime in the future, ignoring tax.

Here's a challenge: Try and improve performance by increasing inflation rate.


=Vo*((Yo*(1-(1+rentgrowth)^per)/(1-(1+rentgrowth)))
-Ho*(1-(1+cpi)^per)/(1-(1+cpi))
-incost
-avrate*per
+(1+cg)^per
-1)

Vo = Initial Value
Yo = Initial Gross Yield as % of Initial Value
rentgrowth = Rent Escalation
per = No. of years
Ho = Initial Hold Cost % of Initial Value
cpi = annual cpi
incost = In cost as % of Initial Value
avrate = Average Interest Rate
cg = Annual Property growth rate

Oh, ok here's the xls

I ran a quick IRR return and cross-checked it with your formula. Obviously a few things to note. Perhaps the biggest one is you've used nominal CG of 3%. Yesterday there was an excerpt in the AFR about post-tax growth averaging between 8.5% to 10.5% in the last decade.

Most commentators like Shane Oliver all believe growth will moderate in the next decade but will still see gains of 5%-6%. Who knows if he's right or not? But on most accounts 3% does seem low. That's 33% over 10 years compounded. 5-6% makes a significant difference to your assumption (ie more than doubles your numbers) and in the quick and dirty model I built in 10 mins, it drives IRR from some 3-4% at 60-70% gearing to easily 15-16% IRR over a 5-year exit horizon. Most of your other assumptions I kept the same.

Also another thing to note is that in your formula you multiplied the nominal interset rate by 10 years. If you gear at 80%, your actual interest rate is 0.8 x 0.07 x 10, I would imagine. Not a significant difference to go crazy over, but still a hefty 1.4% additional returns.

Obviously I didn't model it like an LBO using excess cash to pay down debt since based on your holding costs/incosts and low yield there is no excess cash, but if I did have excess cash (eg 6-8% yields and lower holding costs) it'd be a lot stronger (provided you can get 6%+ yields). I did not factor in taxes though. So perhaps that pulls it back down obviously.

And isn't it funny how suddenly people get so opinionated about property investments and everyone seems to have a view and is an expert. Even the AFR found it warranted to make a 6-page special report on Property vs Shares yesterday. I don't see anyone talking about that in 2007 or 2008. The way people are all so opinionated reminds me of 2008 when all the experts who suddenly became very intersted in equities said 'it's all different now', 'there'll be no more liquidity' and 'conglomerate banks like Citi' are not going to survive'. I still remember sitting through meetings with high level people telling me how the world's no longer the same and it could spell the end for my industry. A year on, equity raisings in Australia have never seen so buoyant a deal year (eg Wesfarmers, Rio, Santos, Westfield, Woodside, ANZ, Myer, NAB, CBA, TLS all $2bn plus) and M&A is on the loose now (Healthscope, AXA, Lihir, Sigma, WesTrac, Macarthur, Felix, Arrow all again $1bn+).

At the end, a model is a model and you can twig your assumptions whichever way you want. Not long ago I valued a company at $10 and that's 10x its current value. A degree of conservatism is good, but at the same time being too hung up on numbers could equally blind you. You just take a calculated risk. That's all. Always happy to critically analyse formulae and models, but that said also need to be a realist.

 

[Bill.L]

Hi all,

I want to tackle the inflation aspect once again, using the real example of the house we owned in Mulgrave.

In 1981, when purchased for $44,000 the rental return on it was $65-70 pw. Interest rates were 14.5% due to high inflation. A second year out teachers wage (my wife's) was ~$13,000 pa.

Fast forward to 2010. A second year out teachers wage is ~$54,000, because of inflation it has gone up by a factor of 4. Rents in the area for the same type of house are ~$280-300, they have gone up by a factor of 4 again because of inflation.

The house that had an initial yield of ~8% on the $44,000 loan would have a current yield of ~33% on the same loan. Also the wages of the purchaser have gone up greatly so that if they really wanted to pay off the loan of $44,000, it would be very easy with just the rent over a few years.

The above is just the effect of inflation and is totally irrespective of what the property is currently worth (which by the way is over $400,000).

Over those 29 years inflation has averaged about 5.3% pa.

bye

 

[WinstonWolfe]

I ran a quick IRR return and cross-checked it with your formula. Obviously a few things to note. Perhaps the biggest one is you've used nominal CG of 3%. Yesterday there was an excerpt in the AFR about post-tax growth averaging between 8.5% to 10.5% in the last decade.

The formula ignores tax DB. It was developed to elaborate the effect of inflation on investment performance. I set cg at the rate of inflation to show the inflation component of cg alone, results in poor investment performance.

It is the component of capital gain in excess of cpi, that determines investment strength.....as the cg rate the AFR refers to, confirms.


Most commentators like Shane Oliver all believe growth will moderate in the next decade but will still see gains of 5%-6%. Who knows if he's right or not? But on most accounts 3% does seem low. That's 33% over 10 years compounded. 5-6% makes a significant difference to your assumption (ie more than doubles your numbers) and in the quick and dirty model I built in 10 mins, it drives IRR from some 3-4% at 60-70% gearing to easily 15-16% IRR over a 5-year exit horizon. Most of your other assumptions I kept the same.

Rebuild your model using 100% gearing. That will account for the opportunity cost of your initial capital.

Also another thing to note is that in your formula you multiplied the nominal interset rate by 10 years. If you gear at 80%, your actual interest rate is 0.8 x 0.07 x 10, I would imagine. Not a significant difference to go crazy over, but still a hefty 1.4% additional returns.

You've obviously had a good look at the formula, which I appreciate. But I wrote it that way because I always presumed 100% gearing for the reason mentioned above.

Obviously I didn't model it like an LBO using excess cash to pay down debt since based on your holding costs/incosts and low yield there is no excess cash, but if I did have excess cash (eg 6-8% yields and lower holding costs) it'd be a lot stronger (provided you can get 6%+ yields). I did not factor in taxes though. So perhaps that pulls it back down obviously.

It took me a good fresh minded hour (which I don't have a lot of) to put that formula together. I wouldn't dare try to write one formula that includes tax and paying down debt or attracting interest. To restate, the formula is purely to analyse the effect of inflation. I have more accurate xls models.

You have escalate rent based on the terms of the lease. i.e. a 12 month lease with no change in rent cannot have doesn't go up during t

This point I am aware of, and can be overcome by putting in average rent for the first year.

And isn't it funny how suddenly people get so opinionated about property investments and everyone seems to have a view and is an expert. Even the AFR found it warranted to make a 6-page special report on Property vs Shares yesterday. I don't see anyone talking about that in 2007 or 2008. The way people are all so opinionated reminds me of 2008 when all the experts who suddenly became very intersted in equities said 'it's all different now', 'there'll be no more liquidity' and 'conglomerate banks like Citi' are not going to survive'. I still remember sitting through meetings with high level people telling me how the world's no longer the same and it could spell the end for my industry. A year on, equity raisings in Australia have never seen so buoyant a deal year (eg Wesfarmers, Rio, Santos, Westfield, Woodside, ANZ, Myer, NAB, CBA, TLS all $2bn plus) and M&A is on the loose now (Healthscope, AXA, Lihir, Sigma, WesTrac, Macarthur, Felix, Arrow all again $1bn+).

I'd suggest reading some of Pimco's stuff. Bond analysts have sharper pencils and more PhD's than cowboys in equities and hedge funds. Most believe global credit has to and will contract, and no one is going to escape that, including Chinese gdp. The economists' Martin Feldstein, Paul Volcker (ex US Fed Chairman), and John Taylor can also elaborate the perils of excessive global credit.

At the end, a model is a model and you can twig your assumptions whichever way you want. Not long ago I valued a company at $10 and that's 10x its current value. A degree of conservatism is good, but at the same time being too hung up on numbers could equally blind you. You just take a calculated risk. That's all. Always happy to critically analyse formulae and models, but that said also need to be a realist.

I appreciate you spent the time analysing the formula. But please appreciate its intended use. The formula was part of an ongoing discussion between Ausprop, Hi Equity, and myself regarding the importance of inflation to leveraged investment performance. We had been discussing things ignoring tax.

Happy to discuss modeling with you anytime though. I enjoy the challenge and think a good model is actually quite difficult to build. Shortcuts always have unintended consequences. In fact, the most accurate way to model something is on a monthly basis, so as to appropriate escalations and tax effects to cash flows more accurately. But then, forecast assumptions can easily negate attempts at more rigorous treatment of cash flows.

 

[Deltaberry]

Very good. Love your responses. Much better than the 'Werribee is the best' or 'never buy in inner city' discussions I've been having with some other members previously.

I absolutely agree that capital on top of inflation is what counts. I think if you build a detailed model and discounted your cashflow and resell value back, arguably your discount rate would capture that. But that requires perhaps too many lofty assumptions (such as betas, market risk premium etc) for my liking, so I prefer to look at it from a debt-amortisation modelling perspective (as said, provided your cashflow allows for debt amortisation) and look at IRRs.

Building a model using 100% leverage would more or less defeat this LBO modelling which I've adopted (as it essentially relies on IRR). Since there's no initial outlay, there is no IRR because any profit would command an infinite amount of returns. Also 100% leverage is only used for theoretical purposes. But in short, what I can say is (and you would know), as long as my net return on asset (ie net yield) is greater than my cost of debt, increasing leverage will increase my IRR. Otherwise, reducing leverage is the way to increase IRR and the investment becomes extremely capital intensive. What's important to note in proper modelling also is that the rent grows by inflation (hence yield grows by inflation) where as your cost of debt remains flat (assumming you haven't amortised your debt and there comes a point hopefully where rent or a reduction in cost of debt allows for some form of debt amortisation

I take your point that the real purpose of that formula is to look at inflation and that's also the only use I can see for it. It's just a question then of whether:

a) you think you can outgrow inflation
b) how close can your yield get to your cost of debt or even outperform it

 

[WinstonWolfe]

The house that had an initial yield of ~8% on the $44,000 loan would have a current yield of ~33% on the same loan. Also the wages of the purchaser have gone up greatly so that if they really wanted to pay off the loan of $44,000, it would be very easy with just the rent over a few years.bye

Bill,

According to ABS cpi index series640101, the 20 years
1971-1990 averaged a cpi of 10.42%pa
1991-2010 has 2.43%.


And my comments re inflation refer to ABS cpi.

Considering the RBA targets a lower rate of inflation, what's the probability we get double digit cpi reported anytime soon. And granted, I don't believe cpi in the real world has averaged 2.43%....more like 4-5%.

Many of the goods we consume have for 20 years, been increasingly imported from cheap labor economies. This has helped keep official cpi low.

However, the price inflation of local services and local fruit and veges correlate very strongly with bank credit/money supply. And it is my view it is the same for property prices.

 

[Deltaberry]

Cost of most things have probably inflated by 4-5% pa. The only thing not inflating is salaries, which is dragging down the average inflation.

Obviously at the end of the day governments need to maintain some sort of ruler over liquidity, credit policies and so forth. Things could go wrong. But at some stage you just take an educated guess/calculated risk.

 

[BayView]

If we are allowed to cherrypick examples, I have 1,800% gain in shares in 7 years. (In the last 10 years the results of my property investing has been disappointing.)

I may never repeat that, and it is unlikely you would be able to repeat your experience, starting today either.

It is not only probable, but more than likely - especially for someone who has some knowledge and experience (in property). 10 years ago I had not much, but had a crack at it.

Shares? Well, we all saw the GFC affect the markets, and unless you had enormous knowledge of how to do well during the downturn (not after) and saw to get out just in time, the majority were creamed I suspect. I know my super fund went backwards; and this is supposedly managed by the experts in the industry..

But the Aus property market was relatively unaffected - and not all markets were affected anyway.

Why was your last 10 years investing in property disappointing? The last 10 years has seen some good increases in many areas.

 

[BayView]

Mark, my workings above ignored tax and deductions just to simplify things.

I thought this was the case.

But many times people trot out the "cash is king" statement and it's not that simple. Hence my attempt to illustrate what is actually involved.

Same with the shares versus property statement.

If you ignore all the various goodies, then yes; cash would be possibly better. It is certainly easier.

But this is why property is better, and shares are better; the various "perks" make them attractive, otherwise no-one would call them an investment.

By the time you incorporate all the various negs and pos of each class, it is apparent that cash is the worst investment of all for pure return on your capital invested. And that's allowing for compund growth from re-invested interest.

It may be safe (but is it?).

 

[WinstonWolfe]

By the time you incorporate all the various negs and pos of each class, it is apparent that cash is the worst investment of all for pure return on your capital invested. And that's allowing for compund growth from re-invested interest.

It may be safe (but is it?).

My interest in inflation and investment performance is leading me down another path for the time being. What I believe is official inflation rate seriously underestimates inflation, hence why the ABS is looking at a major review of it and the RBA are looking at asset price inflation in addition to general price inflation.

My argument is that property that grows at general price inflation, as recorded by cpi, performs poorly. In fact, when general price inflation goes up, performance is worse. It is growth above inflation rate that makes a property investment a strong performer. However, all this is contingent on cpi actually representing general price inflation accurately, and I am doubting it does.

Bill's IP example obviously has performed well in the long term, but how much of that performance is due to growth attributable to cpi, depends on how much inflation cpi represents.