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Last Friday we received the below email from Crikey reader Stuart:

“I do not profess to be an economist or property expert but any chance Crikey could explain what a property bubble is in plain English for dummies? Is it that prices are way too high considering returns?

What is an asset bubble?

Asset bubbles have been a familiar occurrence throughout financial history. In basic terms, a bubble occurs when the price of an asset class rises well beyond its intrinsic value. This happens when a mass of speculators believe that the price of an asset will continue to rise with little regard being given to the actual earnings or cash flows being generated. As Trevor Sykes explained in the Financial Review, during a bubble “enthusiasm for the commodity drives prices to unreal levels [and] few investors have mental strength to stand aside while a bull market is going into overdrive. In the words of Chuck Prince, former chief executive of Citigroup: ‘As long as the music is playing, you’ve got to get up and dance’.”

The key ingredient of a bubble is that rational players make irrational decisions — fantasy, temporarily, becomes reality. Until the bubble pops.

Famous bubbles include the Dutch Tulip Bubble, which saw the price of tulips in Holland rise to 10 times the annual wage of a skilled craftsman. Tulips, which provided little utility other than being a status symbol, quickly returned to their pre-boom prices, causing financial ruin for many speculators.

Almost a century later, France was gripped by the Mississippi Bubble, with Scottish financier John Law promising riches to speculators hoping to profit from trade with Louisiana. The company would soon collapse and Law would be exiled to Belgium. Around the same time, England witnessed the South Sea Bubble, which promised riches to investors seeking to profit from trade with Spanish South America. Sir Isaac Newton, who in today’s dollars, lost millions of pounds in the bubble, would observe, “I can calculate the movement of the stars, but not the madness of men.”

More recent asset bubbles include the Dot-Com Bubble, which saw the value of the technology rich NASDAQ exchange in the United States rise from 1000 in 1995 to peak at 5132 in 2000 before falling back to 1000 three years later. The collapse flowed across to “old economy” companies as well, with more than $US5 trillion being wiped off the market capitalisation of US stocks.

Following the dot-com bubble (and the terror attacks on September 11, 2001), the Alan Greenspan-led Federal Reserve undertook a prolonged period of monetary easing in which US interest rates were reduced from 6.25% to only 1%. This had the unfortunate effect of creating the US Property Bubble. That bubble was exacerbated by complex financing structures and mortgage securitisation (which saw banks “sell” mortgages to investors). Because interest rates were low, people bid up the prices of residential properties with little regard to the income those assets could generate or their ability to repay the borrowings. In 2007, US property prices started to fall as it came to light that many home buyers could not afford to service the debt on their borrowings. This led to a general economic downturn, increase in unemployment and further drop in house prices.

Why haven’t Australian house prices fallen?

Even during the global financial crisis, Australian house prices have continued to rise — the median house price in Australia, according to RP Data, is $457,000, a record. The median house price in Australia is about six times household disposable income — double the historical ratio in Australia and more that double the ratio of the US. (Case in point — last weekend, an apartment in Melbourne’s fashionable Brighton sold for $680,000 having last sold for $235,000 in 1998. In 12 years, the property appreciated by 11.2% annually, over that time, the All Ordinaries index rose by only 5.2% per annum while economic growth averaged about 3% each year. Traditionally, house prices should rise at a similar level to economic growth).

However, just because the price of an asset rises, that doesn’t necessarily mean that there is a bubble. So long as the intrinsic value of an asset is rising, it is rational for its price to rise as well.

That, however, has not been that case for Australian residential property.

That is because property prices have increased at a far lower rate than rental income. According to Australian Property Monitors, the gross rental yield enjoyed by Melbourne house owners has fallen by almost 9% in the past year.

In simple terms, the net return that someone can get currently from buying a residential property is about 2%. This is a far lower return than you can get by putting your money in a relatively risk-free savings account. If someone borrows money to invest in property, they will almost certainly make a cash flow loss each year.

Most of the time, the prices of assets are a reasonable reflection of their value. That means often (but certainly not always), asset markets are “efficient”. However, when a bubble forms, people confuse price and value and assume simply because the price of an asset rises, so to has its value.

The price of residential property has risen for the wrong reasons. The main driver of higher property prices since 1997 has been the willingness of Australians to use more debt to buy residential homes. The ratio of mortgage debt to GDP has tripled in past decade. Remember the US housing bubble occurred because the Federal Reserve kept interest rates too low for too long? A similar thing has happened in Australia.

The bubble has been further exacerbated by very foolish government policies (supported by both sides of politics). Negative gearing encourages investors to make a loss on property investments to reduce the amount of tax they pay while the first home owner’s grant, combined with easy credit, caused the price of lower-end homes to increase substantially.

And there’s also the madness of crowds, as Newton observed, a key ingredient in any bubble. The fear of missing out on joining the “housing ladder” leads otherwise rational people to behave irrationally. Such madness is often encouraged by a naïve media and self-interested groups who peddle myths such as a housing shortage (basic microeconomics suggest that a shortage would lead to increased rental costs and yields, rather than falling yields).

Several expert commentators, including Morgan Stanley’s Gerard Minack, GMO’s Jeremy Grantham, Professor Steve Keen and the highly respected Economist magazine have indicated that Australian property is in a price bubble (the Economist deemed Australian property to be 63% over-priced, relatively the most expensive residential property in the world). Based on rental yields, income-price and price-GDP ratios, property appears to be about 35%- 50% over-priced.

What’s wrong with a bubble?

Many people think a rising property market is a good thing, everyone who owns a residential property is richer, right? Wrong. When the price of property increases (without any corresponding increase in income derived from property) it is no better than a rise in the price of bananas or petrol. In fact, it is far worse.

When property prices deviate from their intrinsic value, that leads to a misallocation of capital. That is, savings that should be going towards building Australia’s productive capacity (for example, increased spending on research and development) is instead used to speculate on higher assets (in this case, property) prices.

As Morgan Stanley’s Minack noted, “there is no value to society from rising house prices. It is simply a wealth transfer to existing owners from potential buyers. Pumping up house prices creates not more wealth than the RBA printing an extra six zeroes on every piece of currency. Worse, by increasing the leverage in the household sector and financial system, it increases the risks in the economy.”