The Australian property market just broke a record - but that isn't a good thing

James Marlay

Livewire Markets

As interest rates begin their gradual ascent in Australia, there are a lot of nerves in the domestic property market. Dr Philipp Hofflin from Lazard Asset Management believes these concerns are well-founded, singling out a couple of eyebrow-raising metrics.

  • During the period preceding the GFC in the US, property prices over there rose by the equivalent of 60% of the national GDP. Australia has done a lazy 100%-plus over the past three years.
  • During the Japanese property bubble, Japan set the record for the ratio of the value of its residential land to GDP, which was more than 330%. Australia has just beaten that record. 
  • A 200 basis point rise in interest rates could translate into a 16% hit to property values - this is near that point where you risk a loss of faith in the market.

In 2019, Dr Hofflin wrote that forecasting the "timing of any (real estate) downturn would be difficult, if not impossible, to predict." Since then, interest rates have continued to bottom, boosting domestic property prices. Based on the metrics above, it looks like a residential property decline could be coming sooner rather than later

Residential Property Declines – The Lessons of History

In this episode of Expert Insights, Dr Hofflin discussed his research on global property busts and compares that to the domestic market. He also discusses the implications of declining residential property values for equity market investors.  

Main topics discussed:

  1. The risk that the Lazard Australian Equity team sees in property prices
  2. How Australia's market compares to the Japanese property bubble
  3. Changing interest rates and their impact on property values
  4. The affect of market conditions on equity investors.

Edited Transcript

Do you have a base case on the outlook for residential property prices?

Look, we don't try to forecast property prices. We really see that as a risk. It's a risk that was off the table for a little while because rates were very low and the environment was very favourable, but it's a risk that has returned. It's returned because of three factors if you will.

The first one is that we've had another very significant rise in prices. In fact, during the period preceding the GFC in the US, property prices rose by the equivalent there of 60% of US GDP. Well, we've just done a lazy 100% plus in three years. Residential values rose by two and a half trillion dollars over the last three years, they hit over 10 trillion at the start of this year. And you can see this dwarfs really any other asset price in the country.

A slightly more positive angle is that during the last three years, debt levels didn't increase an awful lot compared to household incomes, but they did remain almost double US level. They didn't get any worse, but they didn't improve either. And lastly, of course, there's the question of rates finally rising. And the question is, of course, all about how far will they have to rise and how much pain will be inflicted on that market. That combination of a starting point is really obviously where the risks arise from.

Are there parallels between the Japanese property bubble and the current Australian market?

The Japanese residential bubble was of course probably the most famous residential bubble in the 20th century. It was of extraordinary size and it, of course, changed the Japanese economy very dramatically from pre-bubble in the '80s to post-bubble in the '90s. 

The concern is that we have just either equaled or beaten probably, the record that Japan set for the ratio of all the value of residential land in Japan to a GDP, which was over 330%, and the price to income ratio in Japan in 1990. We've just beaten that record in Australia, which is not a great starting point.

It certainly didn't work out well in Japan. And importantly, it didn't work out well in Japan, despite the fact that they have fully recourse mortgages, despite the fact that there were really no underwriting problems, the way they actually had been in the US pre-GFC. And despite the fact that really, there were very few actual defaults of people with mortgages.

The effect it had was on the Japanese economy and people now talk about the lost decade or decades following that. That is really the risk. The risk is that, like in Japan, if house prices start to fall, people want to repay their mortgage. They want to reduce debt. And debt really is the driver here. There have been, over many years, a lot of debates about why do we have such expensive property values? And there have been sort of three schools of thought if you will. And they're not exclusive necessarily.

One is obviously just rates and availability of debt. The other one is demand and supply of housing. And the third one was, is it just foreigners, foreign capital coming in, driving the market up? And to a significant degree, we conducted what an economist calls a natural experiment. We kept people out, so no more population growth, but we kept on building. There was no more capital coming in and we cut rates to zero. And I think the results speak for themselves. 

It's pretty clear that yes, interest rates and availability of debt, your borrowing ability is what drives Australian property prices.

And I've included here a chart, which come from Gerard Minack, a wonderful chart because it covers 110 years of history, and shows how tightly linked have been the ratio of property price to GDP and credit to GDP. As again, Gerard likes to say, the price of Australian housing is not determined by the demand and supply of housing. It's driven by the demand and supply of debt.

What are the flow-on effects of falling property values for equity investors?

It is certainly a risk that we have in the back of our minds when we think of the interest rate sensitive parts of the economy consumer discretionary spending and the like. And it does have an impact on how we see the banks. We bought into the banks in a fairly significant way in the last quarter of 2020. And a lot of them, or three of the major banks certainly, traded at book or even NTA. But we are now selling them, despite the fact that there's no doubt that interest rate rises will help the net interest margin of the banks.

But the market is now quite focused on the benefits that come there. And they're mean-reverting, if you will, normalising the NIM in the bank sector. What they're not doing is normalising any credit cost. People have a consensus that has that at astonishingly low levels, despite the fact that there are clearly some challenges ahead. And we don't know how far rates will in fact rise. We always normalise all the drivers in the P&L and that's why we are a little bit more negative again on these banks. And why have been net-sellers.

There are a couple of other flow on effects. I mean, perhaps the most dramatic one is just that we differ from the current futures of where interest rates are headed. I think last time I checked, a futures market had Australian cash rates at well over 3% by the middle of next year. And we're very sceptical that our property market can sustain this. 

And there's a very simple calculation you can do. If you go to mortgage calculator websites, there's also a government one, you can see that for every 100 basis point increase in the SVR, the borrowing ability of a customer drops by about 10%. For a fixed income and other details, the borrowing ability drops by about 10%.

By the time you include a 20% deposit, that lowers your ability to pay by let's say 8%. 200 basis points will translate into a 16% hit to property values. And it is roundabout at that level where things can become very uncomfortable because you're near that place where you risk a loss of faith in the market.

If you do get to that point where the public loses faith in the housing market, they will change their behaviour. They will want to de-gear, they will want to sell, they will want to save more, they will reduce their spending because they've changed their view of the future. That's the big risk. We think that if you start getting a house price drops, yes, perhaps if it goes past 10, 15%, I think the RBA would be wise to hold off because I think rates, as they're currently forecast of over 3%, to us at least, seem unrealistic given where property prices are.

More insights from Lazard Asset Management

You can access more insights from Dr Philipp Hofflin by clicking on the wires below:

Hofflin: An update on the thesis for ASX energy stocks
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