I have a friend who is mildly wealthy but not gainfully employed. He has been a customer of the same bank for the past 40 years. Like me, he doesn’t own a house. Unlike me, he has been thinking about it.
So he rolled into his local bank branch recently and asked to have a chat with someone about a potential mortgage. The staff member pulls up his details, sees a bit of cash in the account and tells him he’s in the wrong place. “You, my friend, should be talking to our High Net Worth division.”
A couple of quick phone calls later and my friend is heading to a swish HNW setup in Sydney’s Barangaroo towers. Do you need a parking place, sir?. It’s ok thanks mate, I’ll be getting the train.
Apart from a fancy coffee, he didn’t leave with much. The conversation went something like this:
Bank employee: So I hear you are after a mortgage loan?
My friend: Well, maybe.
Bank employee: How much did you earn last year?
My friend: As salary, not much. I don’t have a full time job. But if I bought something I would only be looking for a small loan relative to the value of the house.
Bank employee: But you must have a tax return or something?
My friend: Yes, I’m sure I can find one of those.
He digs around on his laptop for a while and finds last year’s tax return showing total income of roughly $26,000. Here you go Mr HNW manager, $26,000!
Bank employee: But we can’t lend you anything against that?
My friend: Well I’m not expecting you to. I’m only planning on borrowing 20-30% of the value of the house. You will have plenty of security.
Bank employee: I’m really sorry, but that’s not the way things operate. Without income, we can’t lend you money. Ciao for now.
That was the end of the meeting.
Credit the only thing that matters
It is not surprising that income is important. Obviously someone who earns a lot should be able to borrow more than someone who doesn’t. What is surprising (to me at least) is that it is the only thing the banks care about.
Ten years ago, my (naive) understanding was that a potential home buyer’s first step was to find a house they wanted to buy. Let’s say it was worth $1m and they had saved a $200,000 deposit. Then they would go to the bank, the bank works out whether they can afford to repay an $800,000 loan and respond yay or nay.
I had the process completely the wrong way around. The starting place is a bank (or mortgage broker). The bank assesses the customer’s income, decides how much they can lend against that income, then the borrower goes out and buys whatever they can with that amount of credit.
While banks tell their shareholders all about loan to value ratios and how much security they have, they don’t lend against the value of houses. They lend against people’s incomes. And the amount that they lend is the sole determinant of the “value” of Australia’s housing stock.
On a recent call, UBS analyst Jonathan Mott summarised the situation perfectly:
“House prices are not driven by the demand and supply of housing and population growth. Maybe on a 20-year time frame they are. House prices are determined by the demand and supply of credit availability. When you take your hand down at the auction is when you run out of money. And if the banks aren’t lending you as much as they did 12 months ago, well your hand comes down a couple of hundred grand lower”.
If credit is the sole determinant of house prices, what drives the provision of credit?
Income and interest rates
First, incomes. If incomes grow, banks can lend more money. But there hasn’t been much of that for the past decade. So it can’t have been the main factor driving more debt.
Second, most importantly, interest rates. Here is a chart we’ve put together using data from the RBA. It shows Australia’s house prices, measured as a multiple of disposable incomes, plotted against average mortgage costs over the previous four years:
Statistically, you can explain 81% of the change in house price multiples over the past 20 years by changes in the average cost of borrowing. They are almost the only game in town.
Important exogenous lending factors
The final factor is any exogenous impact on the multiple banks are willing to apply to a person’s income at any given interest rate. Interest rates aren’t rising, incomes aren’t falling. But house prices do seem to be going down. And the reason is that these exogenous factors are very prominent at the moment.
Regulatory pressure and a royal commission into the banking sector has curtailed the amount the banks are willing to lend at low interest rates.
No doubt there are many individual outliers but the chart below shows interest costs as a percentage of disposable incomes across the entire country. As you can see, there is nothing here suggesting a problem. Servicing our debt is costing roughly the same percentage of income as it was 20 years ago.
But the regulators (rightly, in my opinion) are worried about banks assuming interest rates will stay lower forever. For several years they have had to stress test a borrower’s capacity to service their mortgage at a 7% interest rate, more than 2% higher than today’s levels.
It’s hard to fudge the 7%. It’s not hard to fudge the income. The royal commission has uncovered countless examples of absurdly low estimates of living expenses artificially inflating the capacity to service a loan at much higher interest rates.
Forcing them to use 7% and actual living expenses is going to seriously curtail the amount someone can borrow.
And just because you can service the interest doesn’t mean you can repay the principal. A newer, more restrictive regulatory restriction is that banks can now only lend up to six times their gross income. That removes removes living expenses from the equation. And it provides a cap irrespective of how low interest rates go. It will be particularly restrictive for multiple property owners who have been parlaying their equity into more and more properties.
Implications for house prices
It is clear that today’s marginal buyer has less access to credit than they did 12 months ago. That arm at the auction is coming down earlier and you are already seeing it in the official house prices. It explains why Sydney is suffering more than anywhere else. Six times your income won’t buy you much in the harbour city, whereas it still gets you a house in Hobart.
UBS anticipates a 5-15% fall in the short term and I don’t see any reason to argue with it.
For more dramatic falls, though, you would need to see interest rates rise, incomes fall via rising unemployment or a change in the Australian psyche.
While I don’t see any of those as imminent, the days of house prices rising faster than incomes are over. Interest rates are not the binding constraint at the moment, so further cuts won’t make any difference. If six times income is the cap on lending, six times income will be the cap on prices.
That, for much of the country, is going to take a lot of getting used to.
If you are interested in receiving the Forager monthly and quarterly reports, please register here
Starting Forager Funds in 2009, Steve has grown the business to over $370m of funds under management. Offering an Australia and Global equity Fund, Steve focuses on long-term value investing of unloved and undervalued companies.
Excellent article Steve......love the story re your mate
And what they count as income is interesting as well. I owned my house outright. At the time I had 400,000 in shares and an annual dividend of 20,000 from these shares. I work 4 days a week. When I went to inquire about getting an investment loan to buy an investment property the bank did the calculations and I found to my surprise that the amount was so low I basically couldn't buy anything. I was so surprised I asked the bank manager why couldn't I get more. Her reply was we don't count shares or dividends from shares. So based on your 4 day income and the value of your house this is all we will lend. I now have no property but a million dollar share portfolio and substantial dividends. I wouldn't even qualify for a 500 dollar investment loan now (I was told I don't have any property to act as security for an investment loan so the bank couldn't give me an investment loan).
So the Australian property market is the highest (?) globally, with owner occupier down from ~75% to ~50% because our banks lend too much? More for the royal commission ...
O'h, and let's not forget the RBAs fast growing aversion to interest only loans. Many marginal cases get their loan across the line of serviceability with IO for the first year or two. When they (as per a new RBA directive) are required to revert to P&I reducing, that adds about $7,000pa to the average annual mortgage repayment. This will drain around $4 billion of elective spending out of the economy in the next three years.Baton down the hatches!
Fantastic work Steve - greatly appreciate the analytical insights.
Excellent article. The property "market" is obviously a heavily nuanced animal, subject to all sorts of input variables. As shown above, credit availability and income are a big chunk of those inputs. However, Western Australia's property market has not shown growth in over 10 years. Nil - and for many property owners, their home/investment property is worth less than it was 10 years ago. So there are other inputs that loom large. Arguably, the huge drop in incomes and employment uncertainty post the mining boom would have accounted for a large proportion of the post-boom falls. However, there is still more to it than that. Good ol' Economics 101 tells us the marginal transaction determines the price, and in a low turnover market like property, changes in population can drive that marginal price far more than expected. The Bureau of Statistics Dec 2017 population figures make fascinating reading. Much like the income/price chart in the article, the state-by-state immigration patterns are highly correlated to house prices. Sydney and Melbourne taking ~80% of new immigration, and recent falls in total immigration are possibly having an extended marginal impact on house prices in those areas. Perth's house prices strongly follow (on a chicken-or-the-egg basis) the inflow and post-boom outflow of population moves. I have no statistical veracity to this thought - but it appears to me that immigration/population demographics have a much larger role in determining house prices at cyclical peaks and troughs. At its core though, there is no doubt that higher incomes, double incomes, and low interest rates are the long term drivers of house prices.
Thanks for publishing these thoughts Steve, they have been a refreshing dose of common sense. Interest rates have been falling since the early 1980s. They are now at record lows. Everybody that purchased early in this move has had a 35+ year tail wind as interest rates have fallen and property prices have appreciated. The release of "equity" has allowed further purchases at lower rates and higher valuations. It's not rocket surgery. Mathematically, Australian banks operate in a recursive relationship. The importance of this recursive relationship can not be stressed enough. Soros dedicated an entire book to the importance of recursive relationships in finance. It's as easy as: 1. Bank lends money 2. Demand drives property prices up 3. Banks lend more money against paper based equity 4. Demand drives property prices up... 5. Banks lend more money against paper based equity 6. .... Releasing equity based on valuations is a recursive relationship against the balance sheet. Falling interest rates are like the release of equity in cash flow terms, and leads to recursion in the current account. Everyone wants you to believe that the description above is naive, and I agree many details have been omitted. However, I like to remind them that we got to the moon by strapping a pocket calculator to a billion litres of rocket fuel. Yes, the details mattered, but once you ignited the fuel it was only ever going up. The obvious question is to ask what happens when the rocket fuel is spent? Apollo 11 eventually escaped Earths gravity and no longer needed it's fuel source. In our case, we're still firmly planted on Earth and our runway of appreciating valuations, and depreciating interest rates is coming to an end.
From one analyst to another... Map M3 money growth vs. combined house growth over all capital cities. Something I did many moons ago. Would make a great update to this piece.
Hi Steve, out of curiosity, why would you not consider purchasing a home?
Consider an example: Joe Blogs decides to buy a $500,000 investment property in the outer suburbs of Brisbane using a $100,000 deposit and $400,000 interest only loan at 5%. Loan repayment circa $20,000 p.a. Assume an equivalent opportunity cost on the equity (deposit). This adds $5000 to arrive at an initial investment cost of $25,000 p.a. not including transaction costs and thereafter rates, property insurance, management fees, upkeep, land tax, etc. Lets assume the property rents at $480.77 per week. Sounds silly, but $480.77 x 52 weeks = $25,000 p.a. In other words, using these assumptions the return on investment (ROI) is zero. The outcome is much the same for the owner occupier, perhaps worse from a tax perspective. So why would anyone do it? We all know the answer: 30 years of relentless capital gains. But what happens when the cheap money is taken away? The optimist says no growth for a while; the other demand factors will prop things up. That equates to the zero ROI scenario outlined above. The realist considers the implications of an almost perfect correlation between Australian house price growth and ballooning household debt during the post GFC period of record low interest rates. They recognise these factors must normalise at some point. The pessimist has already sold, happy to assume the role of a pathetic renter- me among them. RBA Chart: Household Prices vs Household Debt https://www.rba.gov.au/chart-pack/household-sector.html
Hi Spiro, I wrote a piece on home ownership a while ago: https://foragerfunds.com/news/retire-happy-comfortable-property-free/ The short answer is that there is a large gap between the 2% net yield on a residential property and the return I think I can earn on equities.
@Alex, you are right there are many nuances but your analysis sums up the crux of it. It's not just resi property of course, any long duration asset has benefited from the same.
So the Australian economy needs wages growth as a greater priority to income tax cuts.
Good article. Regulators stress testing interest rates at 7% is a tad optimistic. I recall my home loan interest rate at 17% (seventeen percent) circa 1985, until John Howard as Treasurer put a ceiling in. From memory that year home loan rates went from 11% to 17% in about six months. In one particular month rates went by up by 100 basis points, twice, for a total rise of 200 basis pts for the month. I was 27 at the time and rates headed south and have stayed down ever since (courtesy only of central banks, who have rigged the price of money - unsustainable by definition)- so pretty much anyone under my age 60 does not recall double digit home loan rates. It can and will happen again. House price formula is (long term as you rightly pointed out, 81%) a straight capitalisation: HV = AM/LR where HV = home value AM = cash available for mortgage payment LR = mortgage rate. When LR goes up, HV goes down, in proportion. The only big change in my life has been two household incomes now support the mortgage, courtesy of women entering the workforce. This has massively boosted AM and HV.
5 years ago my son returned from working overseas for ten years he wanted to buy a house in a good area .he found the right one 520,000. he had 420,000 in cash but no institution would lend him the 100,000 because he didnt have employment at the time so he cashed his investments and bought it any how
@Peter Brown made a curious claim that no investment loans can consider shares. The lending market is not so opaque. Most lenders will use 50% of investment income. Peter was earning about $20k per year from dividends, definitely sufficient for a $500 investment, perhaps even an additional $50k investment. For such a matter, consult a mortgage broker, not a bank, because each lender uses different criteria.