A plague on Aussie housing

Is Australia's residential property market in a price bubble? This question has been much debated over recent years as housing prices leaped then slowly receded, resulting in entrenched views on both sides. Certainly, mainstream opinion is opposed to the idea that a housing bubble exists, with the government, FIRE sector (finance, insurance and real estate), and much of academia claiming that prices are linked to fundamentals or intrinsic value.

It helps to have a sound fix on what an asset bubble is when exploring this matter. Otherwise, it becomes like pornography: you can't define it exactly, but you know it when you see it. A good starting point is the work of the late US post-Keynesian economist Hyman Minsky. His contrarian work revolved around developing a realistic model of how financial markets interacted with asset prices. This theory was called the 'financial instability hypothesis', arguing that financial markets continually misallocate substantial amounts of credit into asset markets, creating Ponzi (pyramid) schemes.

Minsky defined three phases of finance: hedge, speculative and Ponzi. With hedge financing, income flows from an asset are sufficient to pay down both principal and interest on the debt used to finance the asset purchase, and prices are based upon intrinsic value. Speculative financing results in income flows covering only interest repayments, not principal, requiring debt to be continually rolled over. Investors may experience financial stress, but it is not widespread and fundamentals valuations are kept largely in check.

The terminal phase occurs with Ponzi finance, as income flows cover neither principal nor interest repayments (including running expenses in the case of rental property). Investors rely solely on escalating capital values in order to realise substantial capital gains at sale to pay down the cost of debt and balance their income losses. Asset prices are completely delinked from fundamental valuations at this stage. Investors rely upon 'greater fools' to maintain positive price momentum, resulting in a bubble. Once there are no more investors willing to take upon staggering amounts of debt to finance asset purchases, prices stagnate then collapse, as the market finally realises that prices are based upon a pyramid scheme, not fundamentals.

With Minsky's theory, it is possible to determine whether a housing bubble exists. Unfortunately, there is evidence to suggest that Australia's residential property market is experiencing said bubble. Figure 1 shows the long-term trend in housing prices, adjusted for inflation and quality. The 1996-2010 period is the largest single boom on record, rising by approximately 130 per cent.

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The latest housing boom provides one piece of the puzzle: rising asset prices. The next aspect to consider is whether investors are running current income losses. Figure 2 indicates that this is indeed the case as aggregate net rental returns are negative, with losses escalating from $1 billion in 2000-01 to $5 billion in 2009-10. Losses peaked at $9 billion in 2007-08 when interest rates were relatively high, though rate cuts during and after the GFC relieved some of the pressure.

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There are more than 1.7 million investors with an interest in one or more properties, owning close to two million rental properties. Absolutely and relative to the total housing stock, this is a large sample. If investors are running current income losses of this magnitude, the imputed rents on the stock of owner-occupied housing would bear a similar resemblance, though owner-occupiers treat their properties as security rather than as an investment.

The reason for the sustained net income losses is the combination of rental costs and interest deductions outweighing gross rental income. The ATO does not provide data on principal repayments as they are not deductable against rental income. Accordingly, the rental losses would be larger if these principal repayments were included as they must be funded out of current income. Figure 3 illustrates the growth of aggregate rental costs and interest deductions as a percentage of gross rental income.

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Another indicator is the rising levels of household debt used to speculate on housing prices. Household debt is overwhelmingly composed of mortgage debt, whereas personal debt is a small fraction. Figure 4 shows the recent and considerable increase in the household debt to GDP ratio, peaking at 97 per cent in 2010 when housing prices did the same. The ratio has fallen slightly to 93 per cent, which may explain the falls in property values over the last two years, including the historically-low growth in housing finance data (Housing finance misses expectations in November, January 14).

A troubling fact is that almost 60 per cent of investor loans are interest-only (25 per cent for owner-occupier loans), signifying the speculative motive of property owners.

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Lastly, a classic sign of a bubble is the price to rent ratio. The reason why this metric is often used in housing analysis is because debt speculation affects capital values, not rental incomes (the latter is determined by wages and population growth). Given that the denominator (rents) tends to remain stable over the long term, it is the numerator (housing prices) that comprises the deciding variable. The following figure illustrates the uptick in the ratio commensurate with the boom in housing prices as shown in figure 1. From the trough in 1997 through to 2011, this ratio indicates an overvaluation of 44 per cent, similar to the figures that were recently released by The Economist. The largest surge occurred post-WW2 when the government released price controls on housing, but took until the 1970s to remove all controls on rents.

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Minsky's financial instability hypothesis can help to integrate the occurrences seen in the data. The speculative financing phase likely corresponds to the 1996-2000 period, as housing prices steadily increased but rental income still covered mortgage interest repayments and rental expenses. This relationship, however, broke down from 2000 onwards as housing prices rapidly escalated. Investors were then dependent upon rising capital values in order to realise a profit at sale and to cover the cost of mortgage debt.

This resembles the terminal Ponzi phase, where housing prices and the household debt to GDP ratio have boomed while net income losses have escalated. Accordingly, by these measures, the evidence suggests that the residential property market is currently experiencing a bubble, with prices detached from fundamental valuations. This appears to be the largest bubble on record, orders of magnitude larger than all preceding bubbles. When it does burst, heavily indebted property owners (recent home-buyers, negative gearers) will experience financial trouble, including the economy at large.