Figuring out the intrinsic value of an asset is fraught with many variables. That is largely why most people are unable to correctly value shares and property and why so often asset markets are prone to wild bouts of optimism (booms) and pessimism (busts). The situation is further exacerbated by the use of debt to fund those asset purchases. Some of the variables which affect the residential property sector have been revealed in recent weeks and should give even more cause for concern for property bulls.

Arguably the most important ingredient in the recent boom (which commenced back in 1997 and has seen property prices rise by almost 200% in real terms) has been the increasing use of debt to fund dwelling purchases. Since 1997, the ratio of mortgage debt to GDP has risen from 35% to almost 90%. A critical factor in this increase has been the relaxing of lenders’ deposit requirements — this is also referred to as the loan-to-valuation ratio.

Historically, property buyers required a 30% deposit when buying a property and could use a mortgage to fund the rest. For example, if someone had saved up $50,000, they could go out and borrow another $116,000 and buy a property which costs about $166,000. However, with the advent of mortgage insurance and competition from non-bank lenders, the deposit required in recent times has been sharply reduced.

Prior to the global financial crisis, non-bank lenders were even willing to lend to buyers 105% of the property value — that is, buyers not only wouldn’t need to have saved up a deposit, but the lender would even cover associated costs like stamp duty. Banks would require the borrower to take out insurance if the LVR rose above 80%.

In many instances, purchasers, especially first home buyers or investors seeking negative gearing, would borrow using an LVR of upwards of 95%. Going back to the previous example, that means someone who had managed to save $50,000 (and had an income of say, $100,000) would have been able to purchase a property for $1 million. It is not difficult to tell that such lending practices are highly inflationary and contributed substantially to the resulting price boom. (The increased prices then flow through to higher priced properties as the vendor is then able to purchase a more expensive property with the proceeds.)

However, after the global financial crisis, banks started to tighten back on their lending practices. For example, Westpac reduced its minimum LVR to 87%, still historically high, but below a drop from the boom time levels. Importantly, most banks also required first home buyers to prove that they had a genuine saving history, rather than relying solely on the government’s first home owner’s grant.

However, it appears the banks’ (and non-bank lenders’) prudence has been cast aside in recent weeks as banks try to arrest an alarming drop-off in first home buyer activity. As a share of borrowing, first home-owners had slumped from around 27% last year to only 10% as interest rates rose and the first home owner’s grant was lowered.

Westpac, which is the second largest residential lender after CBA announced that it would increase loan-to-valuation ratios from 87% to 92% for new customers — for existing customers, the ratio is 97 percent. Yellow Brick Road, the finance company owned by Australian Apprentice host Mark Bouris, further cast aside prudence and will no longer consider the origin of a buyer’s deposit in assessing their suitability for a loan.

These measures have the direct effect of allowing buyers to pay more for a property. The problem is, the measures don’t change the intrinsic value of the dwelling (which is based upon its future cash flows, not the amount of leverage a bank is willing to provide). As a result, the price of dwellings will continue to diverge from their true value.

But while banks are allowing buyers to continue to lever up to purchase a property, the economic fundamentals are becoming less attractive. Part of the rationale for buyers to use further leverage was the so-called ‘housing shortage’. It was this alleged shortage which has helped real estate agents convince buyers to pay on average six times their household disposable income for the median property (historically, buyers paid around three times disposable income).

The alleged shortage has been used to tell buyers that property values will keep on rising (presumably on the basis that rental yields will increase as people scramble to find shelter). The only problem is, there doesn’t really seem to be a genuine shortage and rental yields are not rising.

What did occur was that between 2007 and 2009 immigration temporarily spiked and dwelling construction encountered a short-term drop-off — this led to a squeeze in the rental market (especially in Melbourne and Sydney). This squeeze, coupled with relatively benign rents for the past decade in most of Australia, led to a sharp increase in rentals and the appearance of a property shortage.

But since 2009, the rental market has shown remarkable steadiness — while property prices increased by more than 11% in Australia last year, rental prices rose by only 2.9%. If there were a real shortage of dwellings, we would witness a sharp increase in rental costs, which has not occurred.

The reason for stable rentals has been a reduction in the number of temporary visitors to Australia, especially from India. Fairfax reported today:

  • In 2008-09, 65,503 Indian passport holders applied for Australian student visas across all education sectors. But in 2009-10, the number of applications fell to just 29,721.
  • Overall, 50,540 fewer international students were granted visas to study in Australia in 2009-10 compared with 2008-09.

The rapid drop-off in students has led to a remarkable turnaround in the rental market. Instead of automatic increases, landlords have had to settle for minimal rent rises. One real estate told Crikey that a reasonably priced property in Melbourne’s desirable St Kilda area had been vacant for more than two months and the landlord had dropped his asking rent by more than 10%.

Ben Graham once famously said (talking of the share market) that “in the short term the market behaves like a voting machine, but in the long term it acts like a weighing machine”. Buyers of residential property should start looking closely at their scales.