Jonathan Rochford

Summary - Australian residential property is overpriced relative to most other countries, but that doesn’t guarantee it will fall. Seven factors have been a substantial tailwind for property prices in the last 20 years. Of the seven factors, only one is expected to remain positive in the next five years with four likely to be negative.

There’s nothing like discussions about Australian residential property to bring out the opinions and biases of investors. Everybody seems to have a view on where prices are going and why housing is or isn’t overpriced. Many have predicted a downturn, but like those betting on rising yields on Japanese government bonds it has become something of a “widowmaker” trade. Where many have been caught out is relying on simple logic such as “Australian housing is overpriced relative to other countries therefore it must fall”. It’s the second level thinking that distinguishes great investors, which in this case starts by asking the question, “why have residential property prices risen so much”?

Commentary that seeks to answer this question often ends up picking one factor and arguing that it alone has been the issue. For instance, it has often been argued that the supply of appropriately zoned land needs to increase and that doing this alone will fix the affordability issues. It is correct that land restrictions have contributed to high prices but I think this is one of seven factors that have contributed to high prices. I will run through each of these factors shortly, but first I should provide some basic evidence that Australian house prices are high by global standards.

The best tool I’ve seen for assessing the relative performance of house prices is from The Economist. It compares 26 countries with data starting from 1970, using prices against average income and prices against rent as the main measures of value. You can pick your preferred measure and preferred time frame. They’ve also prepared a table of the results using 2008 as a starting year.

What can be said with confidence is that regardless of the measure or timeframe used Australia is at or near the top of the list for real price growth and for being overpriced. This won’t be much of a surprise for those who have migrated to Australia or who have returned after an expat stint overseas and have suffered a case of real estate sticker shock.

Younger and middle aged Australians who haven’t lived overseas and who don’t read widely can easily fall into the trap of thinking that the “onward and upward” experience with Australian property in the last 20 years is normal. What the data shows is that Australia isn’t normal and that many of the other countries that saw the largest increases in prices saw some pullback in prices thereafter. So with the case made that Australian housing is overpriced on at least a relative basis, here’s the seven factors that have contributed.

Tax system

If someone set out to design a tax system that would push up property prices Australia’s tax system would contain many of the elements they would want to use. Tax systems are built on three main components, income taxes (which includes income earnt from work and income from investments), consumption taxes (GST/VAT) and wealth taxes. Australia over-taxes income earnt from work (high marginal tax rates that cut in at lower levels), gives special treatment to income earnt from investments (reduced capital gains tax and allowing negative gearing) and with the exception of the ACT there’s no land tax. The main negative for property is stamp duty charged on property purchases.

Approvals to build

For many years it has been common for property researchers to note that Australia is not building sufficient new properties to keep up with new household formations. Australia is a very large continent so there isn’t a lack of land, it is simply a lack of land that has been approved for residential dwellings around the capital cities. Local governments and state governments bear responsibility for this issue.

Local governments have often been slow to approve new developments and have often demanded developers make large “contributions” in order to obtain approval for high density dwellings. Timing delays are simply about inefficiency, with bureaucrats often requiring substantial consultation periods and then taking long periods of time to consider all submissions, with appeals processes creating further delays. The cost of approvals stems from councils failing to properly balance their budgets. Developers are asked to pay for pet projects rather than charging ratepayers for cost of building and maintaining new amenities. This situation has improved somewhat in recent years with many state governments introducing “call-in” powers in order to fast track much needed large developments.

The second issue with approvals to build comes at the state government level. Australia has often been slow in allowing the release of new land for housing developments, which increases competition for existing land and forces up its price. State governments have been slow to build new infrastructure such as roads and public transport that new suburbs will need. The overlap of responsibility for these costs with the federal government as a result of the vertical fiscal imbalance is another part of the problem.

Population growth

Population growth in Australia is double or triple that of most other developed nations. As well having a fairly healthy level of natural growth (births minus deaths) as a result of being a reasonably young nation, Australia has a substantial intake of migrants each year. There’s two impacts in this – more infrastructure is required to support a larger population and then there are more buyers for goods and services. High growth means there’s a lot of construction required (houses, schools, transport, hospitals etc.) and that becomes demand for white goods as people fill the new houses. Big business strongly supports migration as it benefits from the extra demand for goods and services that comes with a growing population, but sees little of the personal cost of overcrowded cities.

One common refrain is that there is a skill shortage and that migration can fill the gap. The notion that businesses have responsibility for hiring and training from the existing population, which has a substantial pool of unemployed and underemployed, is rarely mentioned. The number of overqualified taxi drivers in Australia is another marker of the faulty logic. Universities and other education providers want an open migration system as their biggest carrot in attracting international students is the possibility of work and permanent residency after a course is completed.

Interest rates

Since the property boom and bust in the late 1980’s and early 1990’s when standard home loan rates peaked at 17% interest rates have been on a long downward trend. The RBA cash rate is now at its lowest ever levels. The RBA has lowered the cash rate in recent years primarily to push down the Australian dollar and encourage non-mining investment. Managing the level of the currency, as well as unemployment levels, economic growth, inflation and whilst trying to discourage excessive credit growth all at the same time is an impossible mix. The decision ultimately has been made to ignore credit growth and house price growth and to focus on the other targets.

The RBA can’t be criticised too much for lowering rates in a world where an unofficial currency war is taking place. What it can be criticised for, like virtually every other central bank, is taking so long to realise that lower rates do little to stimulate real economy demand, commonly referred to as “animal spirits”. It was only in June this year that the RBA confessed that it had figured out that low rates boosted asset prices but not investment. In effect, there was a lot of credit growth and growth in house prices but not much of a bump in GDP growth from lower cash rates.

The second component of lower interest rates is the decline in the margin charged for residential borrowing over the cash rate. The introduction of securitisation in the 1990’s allowed brands such Aussie, Rams and Wizard to undercut the big banks. The current crop of competitors like FirstMac and Resimac, as well as no frills bank brands like UBank continue to offer very sharp pricing. RBA data points to a drop in net interest margins of approximately 2.5% over the last two decades as a result of these competitive pressures.

With both of the components being lower, borrowers are now paying a much lower all-in interest rate on their home loans. This means that the same monthly repayment goes much further allowing for a much larger loan. As a guide, monthly repayments of $2500 over 25 years imply a loan of $448,000 at a 4.5% interest rate, $352,000 at 7% and $297,000 at 9%. If all borrowers experience a similar increase in the amount they can borrow it is natural consequence that property prices will be bid higher.

Availability of credit

It’s not just the drop in interest rates that increases the amount that can be borrowed, it is also the looser terms that lenders are offering. The most obvious is the decline in the percentage of savings required to obtain a loan. As a guide to the power of this change a borrower with $50,000 of savings with an 80% loan to value ratio (LVR) has $250,000 available to buy a property but this increases to $500,000 if the LVR is increased to 90%.

Less obvious is the impact of the easing of other credit conditions. Recent ASIC and APRA investigations have found that lenders haven’t been applying appropriate stresses for a potential increase in interest rates or for forecast rental income on investment properties. This has resulted in over-inflated income calculations and under estimation of the cost of servicing loans at some lenders. The risk adverse culture of banks after the 1990’s property collapse has faded, with sales targets on all frontline staff. Healthy bonuses are paid to those who exceed targets and there’s remedial training and redundancy for those who don’t.

International demand

The number of international investors and the impact they have had on Australian property prices is very much an unknown. Anecdotes abound of wealthy overseas investors paying crazy prizes at auctions, bidding up development sites and paying deposits for properties in physical cash. Much of the high rise development along the East Coast wouldn’t have happened without international investors with some buildings over half owned by non-residents. In the long term the extra supply will help, but in the short term international demand pushes up prices.

Momentum/sentiment

After twenty years of solid gains many local investors have lost long term perspective. Phrases such as “safe as houses” and “they’re not making any more land” are used to reassure potential buyers that what looks like a very high price isn’t and that it can’t fall. Those with bad experiences with property investing are typically the ones who have sat on the sidelines, whilst a generation of buyers (often the parents of those now looking to enter the market) have seen their investments grow strongly. In such an environment it is very difficult for most people to consider the experience of other countries or to reflect on that of the early 1990’s. Many now believe that “this time is different”.

In hindsight, it is easy to see that with seven key factors all having a positive impact on house prices in the last 20 years strong price growth was inevitable. However, as the table below shows it is not realistic to expect that this can continue, with the next five years looking like a mixed picture. The reasons for each view are detailed below.

Key Factor

Impact on last 20 years

Forecast impact on next 5 years

Tax system

Positive

Negative

Approvals to build

Positive

Neutral

Population growth

Positive

Positive

Interest rates

Positive

Neutral

Availability of credit

Positive

Negative

International demand

Positive

Negative

Momentum/sentiment

Positive

Negative

Tax system – Negative

In the next five years it is likely that Australia will implement wholesale tax reform. Twelve months ago most people thought I was crazy when I brought this up, but the national debate has advanced a long way. The tax white paper is due shortly, the reform summit spent most of its time focussing on tax reform and we’ve got a new Prime Minister and Treasurer who have given very positive signals that change is coming and the economy is the priority. With the politics involved it is not a done deal, but with a Prime Minister, two State Premiers, business groups and welfare groups making the case for change the politics might be easier than many currently think.

Decreasing income taxes, removing negative gearing allowances, reducing or removing capital gains tax discounts and land taxes are all in the mix. The removal of stamp duty is being proposed by some, but that is highly likely to be linked to the introduction of land taxes. The vertical fiscal imbalance dictates that state taxes such as GST and land tax must increase whilst federal income taxes must decrease. The momentum behind simpler and fair taxes including removing loopholes leaves the many current tax benefits for property exposed.

Approvals to build – Neutral

Whilst there has been a jump in the amount of building approvals in recent years, there is still solid opposition at both state and local government levels to further easing of the approval process. Governments in Victoria and Queensland that focussed on easing restrictions in order to promote housing affordability have both been replaced this year with governments that are more concerned about amenity and community consultation. In other states where high density construction hasn’t seen the same boom there’s been a mild lift in approvals that should continue if demand warrants.

Population growth – Positive

Natural population growth is slowing as the Australia population ages, as well as some couples deferring having children and others having fewer. The level of migration is also trending down. However, the overall rate remains around the 20 year average and is still well above almost all other developed economies. Whilst the Australian economy is not as strong as it has been, it is still one of the more prosperous and offers amongst the best prospects for those with skills and willing to work hard. Even if a substantial global economic downturn occurs, Australian population growth should remain high, with a better lifestyle continuing to attract migrants from Europe, India and China particularly.

Interest rates – Neutral

The current outlook for Australia interest rates is balanced, with little change predicted by interest rate swaps over the coming five years. There has been a small increase in rates for investment property loans with the possibility of more margin increase for loans that have higher risk characteristics such as high LVRs or interest only periods. The higher capital levels required as part of Basel III reforms is likely to see banks increase their net interest margins to protect their return on equity ratios, with home lending an obvious target for a further 0.10-0.25% rate increase.

Availability of credit – Negative

The recent crackdown by APRA and ASIC on bank lending standards has tightened the availability of credit for the most marginal borrowers. These potential purchasers will need to save more or borrow less. After six years of recovery since the last financial crisis, the next five years is likely to bring another global economic downturn and this would further tighten the availability of credit. Australian banks remain heavy users of overseas capital, which means that in any crisis there is a much greater demand for locally sourced deposits and a need to reduce the amount of lending.

International demand – Negative

The recent report that Sydney’s largest apartment developer, Meriton, has reduced prices and increased commissions in order to meet sales targets is arguably the clearest possible sign that overseas buyers are tougher to find. China has seen a minor run on its currency, which is completely rational as its citizens fear currency devaluation, confiscation of their wealth and are looking for better risk/return opportunities elsewhere. As a result, the Chinese government has been closing down avenues for capital to exit China, with reports that some buyers are struggling to have sufficient capital available by their settlement dates.

Momentum/sentiment – Negative

The massive buzz in Sydney and Melbourne property markets just a few months ago appears to have started to die down. Auction clearance rates have fallen and agents are starting to remark that vendors need to reduce their expectations. The decline in equity markets, slowing migration and the increase in interest rates for investments loans are put forward as reasons for the reduced sentiment. Beyond the two largest cities price growth has been much more subdued with the pullback of mining investment impacting Perth and Darwin.

Conclusion

The solid growth in Australian house prices in the last twenty years has made Australia housing amongst the most expensive in the world. Pushing along this price growth has been a combination of seven key factors. However, only one of these factors is likely to persist as a positive influence on prices in the next five years with two factors expected to be neutral and four factors likely to be a negative influence on prices.


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Patrick Poke

Long, but worthwhile.

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