If you were trying to sell your 1987 Commodore VL, and someone offered you $30,000 for it, would all 1987 Commodore VLs be worth $30,000? No. They wouldn’t. Because the intrinsic value of a VL is nothing like the price paid by the single irrational car lover. But for a just a minute (until the next person purchased one), you could argue that the price of Commodore VLs would be $30,000.
The property market is a little bit like that, although on quite as extreme and no where near as homogenous.
This is because only a relatively small number of properties actually change hands annually — of the nine million dwellings in Australia, about 10% of them are sold each year. That means even if the vast majority of people believe that property is overpriced, property prices could maintain current levels, or even increase. How? Because that small percentage of buyers (often funded by large amounts of debt) are enough to create the illusion of a buoyant market.
Last week, The Economist found that Australian property prices were “overvalued” by 56%. The Economist determined this by comparing prices to rents (using a base year of 1975). It didn’t take long for housing bulls, or poorly informed columnists to criticise The Economist’s logic — quickly falling back on simplistic arguments such as the make-believe housing shortage or Australia’s miracle economy or our tax structure.
The problem with those arguments is that they are answered by the rent-to-price calculation (other than perhaps the tax argument). As The Economist noted:
One of the virtues [using the] price-to-rent ratio is that it takes them into account. If immigration is putting upward pressure on house prices, it should put upward pressure on rents too. And if developers can’t build homes, they can’t build rental homes either. Those factors may justify high prices. They don’t justify high price-to-rent ratios.
As this column has noted on occasion, if there really were a housing shortage, it would be very quickly borne out in higher rental costs. If someone has the choice between renting a property (for more money) and living on the street, most rational people would pay slightly more rent. This, of course, has not happened, with rents in cities such as Melbourne remaining constant in 2010, while property prices rocketed by almost 20%. Similarly, Australia’s miracle economy is not only dependant on housing prices, but also, has for some reason not translated to higher rental amounts.
But remember — for property prices to rise, it only needs a small proportion of people to pay an amount that is above the intrinsic value. These buyers are often using a large amount of debt to fund their purchase (last week the CBA announced that it would allow first-time customers to borrow up to 95% of the purchase price), so their rationality is diminished by the fact that they are not even using their own money. Moreover, at the end of a decade-long boom, purchasing an asset is as much of a status symbol as anything else. Keeping up with the Joneses is, in many cases, far more important to some Australians than paying the right price for a home.
Eventually though, even the small pool of laggards will dry up (as has happened in the US, Ireland and Spain), leaving a rump of buyers who have no interest in paying exorbitant prices for dwellings and leading to a rapid correction.
There remains are two major reasons why people continue to purchase property in Australia — the fear that property prices will “never go down” and the “status symbol” value attached to housing. These reasons will eventually evaporate when the correction begins, and people realise they are better off being solvent and renting a property, than being foreclosed from their dream home.
As Benjamin Graham famously observed (in relation to a different kind of market), “in the short run, the market is like a voting machine — tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine.”
It seems that at almost every turn these days we are subjected to another ludicrous report. The latest is from The Economist, which last week issued a report purporting to demonstrate that Australian house prices are the most overvalued in the world. The proposition is based on a prices-to-rent formula developed for overseas markets.
It should be noted that The Economist has been getting it wrong on Australian house prices since their global house price index started in 2002; but dismissing their claim based on this bias, whilst fast and easy, doesn’t really cut the mustard. There is little doubt that Australian housing is expensive, affordability is low and current values are high when compared to household income. But that doesn’t equate to a housing crash; nor does it mean we have the most overvalued homes in the world. In the world!
Why? Because The Economist’s ratio of average house prices to average rents model is seriously flawed. According to The Economist our houses – based on their price-to-rent ratio – are overvalued by 56%, followed by Hong Kong by 54% and 48% in France. According to the journal, Australian house prices have risen by 215% since 1997.
This raises some interesting points.
Firstly, and somewhat obviously, rents have not risen anywhere near as fast as end prices. This supports our thesis that Australia’s residential market, when measured correctly, is not as undersupplied as most believe. Hence rental growth remains subdued. Why, then, have prices risen so much when compared to rents?
There are several logical reasons why this has occurred, the sum of which dismisses The Economist’s claim.
Close to 70% of Australia’s dwellings are held by owner-residents, of which half are owned outright. A third of Australia’s dwellings are held by investors and are rented out.
We can sell our principal place of residence tax free. Investment property is subject to capital gains tax.
Two thirds of the Australian housing dollar is spent on renovations, a trend which has accelerated since the introduction of GST on new dwellings about a decade ago. Close to 80% of this renovation money is spent on owner-occupied homes. Very little is spent on improving investment dwellings. Improvements to Australian investment property are done to increase the rental return, not necessarily the sales price. Given the current tax laws, it makes good economic sense for owner-residents to improve their homes. Hence there is a large difference between the price of owner-occupied homes and investment property across Australia.
Whilst gross rental yields are on the slide, they still are in the mid-to-high 4% range – depending on dwelling type and location – across Australia. The median weekly rent Downunder is about $425 per week, suggesting that many rental properties sell for prices in the mid-to-high $400,000s. Most owner-occupied properties sell for much more, with close to 70% selling for prices over $500,000 and near to 40% selling for in excess of $600,000.
A quick survey of twelve suburbs across Brisbane found the following results. Within the inner city (5km from the GPO) dwellings sold by owner-residents in 2010 attracted a 20% to 25% premium over investment property sold in the same location and during the same year. This ratio was between 15% and 18% for middle-ring locations (around 10km from the CBD) and 8% to 10% for the outlying suburbs (about 20 km from the Queen Street Mall).
Owner-residents generally prefer detached houses over attached stock. The reverse is true for investors. Attached stock is, more often than not, cheaper than detached housing. More renters live in attached stock than detached product. This further exacerbates the reason why end prices – when pooled together – far exceed rents in this country.
So there is little wonder that the average price of Australian houses is much more than the average rent. Our rental stock is inferior – for the most part – to the dwelling stock held by owner-residents. A simple drive around any of our cities will illustrate such.
We cannot continue with the flawed system as it is. If we want a true level playing field, then abolish negative gearing. Let the market decide the proper price. Simple. But who has the guts to do it?
“….of the nine million dwellings in Australia, about 10% of them are sold each year. That means even if the vast majority of people believe that property is overpriced, property prices could maintain current levels, or even increase. How? Because that small percentage of buyers (often funded by large amounts of debt) are enough to create the illusion of a buoyant market.”
Based on your figures, are you really saying that 900,000 property sales a year is too small a sample to identify the true market trends of real estate in Australia?
What is the basis for your implication this situation is unique to Australia ?
Economist? Not in the real world. To say that people would pay more rent rather than live on the streets is an ill conceived notion as it assumes that renters have infinite resources. Try and get $600 per week rent from someone earning $500 per week. Get the point? As I live in the real world and see adequate housing as a fundamental need I would like it to be affordable. If your words convince investors to buy rental properties they cannot rent out with overpriced rents then that will serve proponents of affordable adequate housing well as there will soon be an oversupply of such properties on the market. I disagree with the accuracy of the economists as reported but nonetheless relish such reports for having a positive unintended consequence, should such advice is followed, of an oversupply leading to lower prices as those that paid heed to the ‘unlimited rental’ advice are forced to sell after relying on the said advice.