Popping a housing bubble fantasy

In one corner we have journalists at The Economist newspaper, who in a recent survey made the extraordinary claim that Australian house prices are overvalued by 55 per cent using their preferred benchmark. In the other corner we have a crowd of the most respected economic minds in Australia, including the Reserve Bank of Australia, the Commonwealth Treasury, almost all market economists, and leading house price index providers, such as RP Data and Rismark.

This latter cohort essentially contends that The Economist does not know what it is talking about. They argue that Australian house prices are not materially overvalued, and there is no reason to believe that they must suffer precipitous price falls in order to obtain some more desirable valuation benchmark.

This group has also produced vast reams of analysis showing that robust demand and supply-side fundamentals underpin Australian housing valuations while dwelling-price-to-income ratios remain unexceptional by international standards. In fact, recent research by Rismark has demonstrated that house price growth in Australia’s capital cities and our regional areas has not kept pace with disposable household income growth since the end of the last cycle in 2003.

It was only a few months ago in The Economist’s backyard, the city of London, that RBA governor Glenn Stevens was tossed a question about whether he was worried about Australian housing valuations. In the past – most notably in 2002 and 2003 – the central bank has not hesitated to express reservations. Yet Stevens responded:

“Well, let’s establish a few facts… For the past year or two, house prices haven’t done anything much at all… We continue to see arrears rates on mortgages very low by global standards ...We don’t have a gearing up going on now… I don’t think we have huge rises going on... that’s probably not top of my list of worries…

“The other thing I’ll say is that it’s quite often quoted very high ratios of price to income for Australia, but if you get the broadest measures, a country-wide price and a country-wide measure of income, the ratio it about 4 ½ and it hasn’t moved much either way for 10 years. And that is higher than it used to be, but it’s actually not exceptional by a global standard as far as I can see.”

While the typically conservative RBA thinks Australia’s housing market is sitting pretty, The Economist’s survey suggests it is massively overvalued. In order to decipher who is right or wrong here, one has to dive into the detail.

The Economist arrives at its 56 per cent estimate by taking the ratio of median house prices to median rents, and then comparing current levels with their “long-run average”. There are many technical problems with this approach. One obvious issue is that we do not observe rents for more than two-thirds of the entire housing stock, which is ‘owner-occupied’. So The Economist is actually comparing the yields on rental properties with the prices of owner-occupied homes. Imputed owner-occupied rents are likely to be different to those deriving from investment properties given the far greater control rights associated with the former.

But this is a trivial error in the scheme of things. There is a much deeper problem with The Economist’s logic, which both the RBA and we here at Rismark have repeatedly highlighted. Let me explain.

Anyone can compare the current observed values of a range of economic indicators, such as interest rates or inflation, with their ‘long-term’ averages. But we need to ask ourselves whether this is an informative exercise, or potentially misleading.

For example, applying The Economist’s way of thinking to Australian interest rates would lead one to conclude that current rates are much too low. Indeed, the analysis implies that Australian government bonds are massively overvalued since today's 10-year yields of 5.5 per cent are more than a third lower than the 30-year average of 9 per cent.

Yet the body that sets interest rates – the RBA – has repeatedly told us that present-day lending rates are, in fact, “a little higher” than their long-term averages. So what is going on?