29 March 2011

Definition of a bubble (part 1)

The first step in defining a bubble is to identify that price rises are not driven by “fundamental” reasons.

Property bulls and spruikers claim that Aussie house prices are not in a bubble and are, therefore, not going to burst. They argue that high prices are justified due to fundamentals such as population growth, a “chronic” housing shortage, the mining boom, low unemployment, dual-household incomes etc. etc.

The problem with these arguments is that, if they were the factors that pushed up house prices, they should have also pushed up rents by an equivalent percentage.

As Adam Schwab over at Crikey explained:

“Given that renting is a reasonable substitute for owning a home, the cost of purchasing a property should reasonably resemble that of renting a dwelling. There are various reasons for disparities (for example, government interference in the housing market or lax bank lending standards) but overall, one would expect the cost of buying a property to roughly track rental costs over the long-term. For example, even if buying a property attaches a slight premium (due to tax and lifestyle advantages) in 1995, that premium should remain relatively constant over time.”

Source: http://www.crikey.com.au/2010/07/28/housing-shortage-no-its-a-debt-fuelled-bubble/

Earlier this month, The Economist explained it another way:

“In theory, the price of a home should reflect the value of the services it provides. People who choose to rent their homes buy those services on a monthly basis. Home prices should therefore reflect the rents that tenants pay.”

Yet house prices have dramatically escaped rents over the last 15 years. As The Economist went on to say:

“Our index calculates the ratio of prices to rents in 20 economies. Hong Kong’s price rises are the steepest in our index but it is not the most overvalued housing market. That honour remains with Australia, which is overvalued by about 56%.”

Interestingly, if house prices are overvalued by 56%, it is wrong to assume that they need to fall by 56% to get back to fair value. Due to a maths quirk, the percentage up is always larger than the percentage down. For example, if something goes up by 100%, it only needs to fall 50% to get back to where it’s started.

Therefore, The Economist’s estimate that house prices are 56% overvalued means that they would need to fall 35% to get back to fair value. Of course, markets have a habit of over reacting and therefore over correcting. Let’s say the market over corrects by 20%, it would need to fall 55% in total.  However, if rents continue rising during the course of the crash, this would do some of the leg work in reducing the price-to-rent ratio.  Taking all this into account, I am predicting an average 40% fall over a 7-8 year period.

But back to the point ... a quick look at the ratio of house prices to rents (when compared to Australia’s long-term average and to 19 other countries) confirms the first step in defining a bubble; that house-price rises were not driven by fundamentals. So if we can agree on this (which I’m guessing not all of us can) the question arises; what did cause the over valuation?

I’ll attempt to answer that next time.

Comments welcome.



  1. millionaire in training29/3/11 9:20 AM

    Andy I sure hope you're right! By the time your 7-8 year prediction comes to fruition my partner and I will be ready to buy again...and given that we've obviously paid too much for our first home, paying off the second should be a breeze! Good times ahead :)

  2. As much as we would like to own our own home, the Scottish blood in me just can't buy something if I know I can get a better deal at another time! Especially when you think about how the decision to buy now or buy later will play out over time in terms of money lost / saved and where else you could be putting your money and what you could be making on it.
    I still feel that owning your own house is really a bit of a non-asset anyway when you consider Robert Kiyosaki's definition of an asset as something that puts money in your pocket. Not that this means that you should never buy a house or course as there are many other reasons for wanting your own spot other than just making money.
    If this means renting for another few years yet then so be it. We will keep saving and put our money into other more productive asset classes. It will also mean a much smaller mortgage when we do buy. Determined to approach this with the head and not the heart. xx

  3. csacker, we're doing the same.
    Renting vs. buying is an interesting discussion from a financial perspective, but also from an emotional perspective.
    It's often said that buying trumps renting when acting from the heart. But that's not the case for me.
    As much as we want security, and would like to have a garden we could actually put long-term effort into and all the other things you can do in your own home that you can't do in a rented property, the most important emotional factor for me is that I don't want to be stressed by money.
    None of the things we could do in our own home would give us any joy at all if we were stressed about making our obscene mortgage repayments or had no money to enjoy our lives. Therefore for us, renting is an emotional no-brainer (pardon the pun).

    A question to Andy, though - Andy, there seem to be a lot of out there who are watching and waiting for prices to fall. Might this mean that when they start falling there will be lots of people ready to buy, therefore negating - or slowing - the decline in prices?

  4. Jo – your first point is a good one. It is said that money is the leading cause of relationship break downs. So whichever way you go, it’s important to avoid over-extending yourselves and always have a financial buffer (and appropriate insurance) for the bad times.

    Regarding your question, I’d say it won’t mean that. That’s not how bubbles tend to work. Keep an eye out for Part 3 where I’ll cover the forces that will push prices down as the bubble deflates – which will far outweigh any opposing force of those waiting to pounce.

  5. Vancouver Guy29/3/11 1:49 PM

    Might this mean that when they start falling there will be lots of people ready to buy, therefore negating - or slowing - the decline in prices?


    What you are describing is a classic 'negative feedback loop'. In control theory, this is what stabilizes a dynamic system.

    In the case of falling prices in a bubbly market I think a POSITIVE feedback loop is more likely. If prices generally fell by, say, 5% in a month (after rising for years) wouldn't you be inclined to wait another month to see if the drop would continue? Wouldn't everybody else? Nobody wants to catch a falling knife. That apprehensive delay would in turn drive prices lower... and lower... and the race to the bottom would be on.

  6. Vancouver Guy, you're right - I definitely would wait!

    Looking forward to Part 3, Andy. Your blog is very informative, clear and well-written. I'm loving the myth-busting. Keep up the good work!

  7. I like the Analysis but I think it is missing one factor. House prices vs rent have a symbiotic relationship, They do not move independantly. As there has been a massive and unsustainable upward pressure on house prices over the last 15 years it has had an impact on rents as well. As the prices drop in housing we are likely to see some upward pressure on rents for a while as more people will rent as they see the house prices going down and dont want to risk buying in a falling market.

    This is likely to be only a short term factor; once the rent to price ratio stabilises somewhat we will see a return to purchasing but it will still be subdued. This will in turn allow rents to move down again.

    My personal view is that rents currently are probably 15 to 30% over priced due to the high purchase price pulling them up. Once property price drops start to gain momentum and the initial inertia in rental markets lets go we will see a return to a more realistic figure.

    Of course I realise that if the property values are over stated by 56% as the economist claims and my own valuation of rents being 15 to 30% over priced all are correct then a return to realistic rent and property prices will see about a 50% price reduction if not more.

    I think if my rental estimates are acurate ( and they are only gut feelings ) then property is actually between 80% and 100% overvalued.
    This would be inline with the current 8 * median income to 4 * median income which most people consider affordable long term.

  8. Jo,
    actually you are correct. THe first leg down in price will end when some of those on the sidelines rush in because they are impatient and think a 10% drop means they are getting a bargain. So, they will help to stabilise or maybe even slightly increase prices for a while. But a 10% fall is not enough to bring the market anywhere near back to equilibrium so the price falls will kick off again. You'll see two or three downlegs, each punctuated by flat spots. Then, you'll see the capitulation which signifies the bottom. Prices will then have fallen below any reasonable definition of a fair value. The whole process could take 5 years. everyone

    Read Shiller's "Irrational Exhuberance" if you really want to understand the process a bit more.

  9. LongTermBuyer29/3/11 5:15 PM

    There's one big difference between buying and renting; with a mortgage, at some point your outgo stops. With what do we compare a 25 year mortgage? A 25 year rent period? Nope. Renters will keep paying their landlord when they are old a decrepit; what a scary thought! Now one might suggest that a long-term renter will simply put aside the difference between their rent and an imputed mortgage payment, and at the end of 25 years, they'll have a nice nest egg. Only problem is, this NEVER happens.

  10. Hiya Andy,

    I remember 5 years ago, people were saying exactly the same thing, that prices can't keep going up and they will crash, and it would be crazy to buy at those prices, etc, etc. Imagine if you had been ready to buy then, but waited. House prices jumped massively in that time. Many people who waited would have put that money into the stock market instead - and just look what happened to that over the same period. So at this point in time, almost anyone who bought in the last 5-10 years or so has done well. Extremely well if you compare to those who decided to put their money in the stock market instead, and watched it crash.

    Perhaps prices will crash now, but I think you said that it's more likely that they will slowly decline over the next 8 years. Perhaps some other global event will occur that will cause them to jump again - perhaps a nuclear incident somewhere and massive jump in the influx of immigrants. Perhaps another world war. Who knows. People have been saying that the prices in Manhattan simply cannot keep going up - and yet they do, against all the odds. If you had suggested 10 years ago that a Manhattan apartment could cost over $25 million, people would have had you locked up. If you compare Australia's biggest cities to America's biggest cities (NewYork/San Fran for example), we are WAY underpriced on a bang for your buck basis. Try calculating the multiple of average US income to house prices in those areas and see how many times more it is than here. Try buy a 4/5 bedroom house on it's own block 20 minutes from downtown New York or San Francisco for the same as you'd pay here. I could be completely wrong (can't find the links I had before), but I'm not sure how much luck you'd have. And all this while the US is in a severe recession. Can you imagine if it wasn't?

    Also, one thing you're haven't considered is that very few people have the discipline required to manage their money properly if it's NOT being forced into their house. Even if the value does go down, they will still own something of value at the end of the day. For the vast majority of Australians, not having a house means that money would have been blown on flatscreen TVs, overseas holidays and new cars otherwise, and they would have absolutely nothing to show for it at the end of the day. This forced saving has been going on for many decades, and in general it has worked out pretty darn well for most.

    All that said, I do agree with you - if house prices are going to go down, it probably doesn't make a lot of sense to buy now. But really that's only half the equation. The question is, what should people do instead? Keep their money in savings? Invest in the stock market? The bank? What happens if there is another crash? Also, the other thing you can do with a house is ADD VALUE. Who says you have to buy a brand new one? Many people buy one that needs work, and add value that way. Pretty hard to do that when your money is in the bank.

    Ultimately, the question is what is your town personal target? To protect your net wealth? To increase it? To have a house to call your own so that you can use your income for other things and not have to worry about mortgage payments and interest rates? To live in someone else's house and make money by investing? To keep saving to get more money, and hope that prices do come down over the next 7 or 8 years?

    Just things to think about too.

    What is your recommendation?

  11. LongTermBuyer

    That was a pretty poor attempt at trying to convince people to buy now at these putrid price levels lol

  12. Marky

    I believe you're wrong when you say that Australian capital cities are cheaper than New York or San Francisco.
    Singling out Manhatten proves nothing - it does not represent American cities.

  13. Marky Mark – You said:
    “If you compare Australia's biggest cities to America's biggest cities (NewYork/San Fran for example), we are WAY underpriced on a bang for your buck basis. Try calculating the multiple of average US income to house prices in those areas and see how many times more it is than here.”

    Demographia has already done that and they found that Sydney, Melbourne, Adelaide, Brisbane and Perth are all less affordable than New York, which is itself classified as “severely unaffordable”.
    (see www.demographia.com/dhi.pdf).

    Your last series of questions (about what to do if sitting on the property sidelines) are good ones, but are well beyond the scope of this blog (and my expertise). Personally, I’m saving hard and have all cash in U-Bank earning 6.51% but I’m by no means suggesting this is the right/best thing to do. Anyone else have any thoughts?

  14. LongTermBuyer – paying a landlord for life is not scary if you have assets that produce enough income to the cover the rent. I know you claim this NEVER happens but I doubt that’s true. Either way, I for one have never recommended renting for life.

  15. JB: Why are you saying you can't compare the most expensive parts of Australia with the most expensive parts of the US? Last time I checked, Manhattan was in America just like Point Piper, Toorak or Peppermint Grove are in Australia. :-) I haven't seen too many $25 million apartments in Australia... happy to be convinced that NY/SanFran are cheaper than Sydney/Melbourne.. (probably need to compare the cost per square metre or something like that...)

  16. Andy: While I agree some people do have assets that pay the rent, I'd argue it's a tiny proportion of the population. To pay rent of, say, $800 a week, you'd need to have capital/assets of about $850,000 returning 5% a year (not including tax, which would drive it up to about $1,000,000 depending on your tax bracket). Just to pay the rent! I don't know too many millionaires who rent. So while it obviously happens sometimes, it ALMOST never happens. Just a thought.

  17. Marky Mark – my guess is that it’s more common than you think – especially in countries where they’ve realised that house prices don’t always go up. But as I said to LongTermBuyer , I have never suggested that anyone rents for life.

  18. 6.5% interest in savings.

    Average tax rate in Australia = 30%

    After tax, interest rate = 4.55%

    Assuming 3% inflation (more than likely, a lot higher).


    If you are on a higher income, the real return is negative (higher marginal tax rate).

    If interest rates drop further, the maths looks even worse.

  19. Thanks Anonymous – I do realise that money in the bank is a low risk / low reward proposition and I don’t intend to use it for wealth creation. An advantage of having cash, however, is that it allows you to take advantage of opportunities as they arise.

  20. Marky

    I'm not saying you cant compare the most expensive parts of US with those of Ozz... because of course you can.
    but thats not what you were doing. you were comparing Manhatten with AU capital cities as a whole - hardly a fair comparison.

    If you want to compare apples with apples, i.e. cities in their entirety with each other - have a look at the latest Demographia report:


  21. re: cash

    a) You also miss opportunities by not being invested.

    b) I would call missing opportunities "high risk"

    What would you use for wealth creation?

    Then we can use that to compare against property, in the past, and in the future?


  22. JB - I agree with you, Sydney should not be compared to Manhattan.

    Try San Francisco which has a median of $590,000 which is fairly close to Sydney at $605,000.

    So if SF is $590,000 after a crash, does that mean that Sydney needs to crash by $15,000

    Ref - http://www.trulia.com/real_estate/San_Francisco-California/

  23. Anonymous, I think you’re confusing high risk with opportunity cost.

    Yes, you miss the opportunity for profit while in cash – but you also reduce your risk of loss – hence low risk/low return.

    And remember, being fully invested can also come with an opportunity cost – if a better opportunity comes along and you can’t participate.

    Past performance of different asset classes is readily available on the internet for you to compare. As for the future, we’ll just have to wait and see.

  24. Peter Fraser31/3/11 7:18 PM

    A present for you Andy -


  25. Thanks PF - and it's not even my birthday!

  26. PF - San Francisco has fallen by 30%. But who's to say its finished its slide?

  27. Peter Fraser31/3/11 9:24 PM

    Andy - yes it will fall a little more, and then bounce up again. markets always over correct.

    But still you can see that Sydney in a bouyant economy is not overpriced in comparison with SF in a faltering economy.

  28. Andy - Analysis paralysis?

  29. Anonymous - possibly.

  30. Anon:

    Brain paralysis?

  31. Commentators can choose to include what data they like to represent one point or the other, but if you dig deaper than just the data then you can find what is really happening and thus make your decision on whether to buy or sell.

    You have used the idea that rents have not kept up with property prices and thus property prices are overvalued. I have been renting out properties for the past 12 years and more, and I can personally tell you that especially in the last 3 to 4 years that I have increased the rents on my properties (in line with market rents in the areas) more than the values of those properties has gone up. We have even been offered at times 10% to 20% more than our asking rents by prospective tenant at times. (No we didn’t take up the offers because the applicants did not meet our criteria in terms of rental history). And I know both other renters and landlords in other areas that have been experiencing the same thing.

    Now I do expect prices to fall over the coming year and over 2012 as interest rates increase further, some areas more than others, and some areas maybe even increasing. However, I do not see falls of 35% to over 50%. Any falls will be between 10 to 15%, and possibly in some areas as a worst case about 20% (this does not include regional areas by the way). This is part of the normal cycle of peaks and troughts. This is precisely the reason we won’t have a crash. As soon as property prices fall 10 to 15%, interest rates will start to fall again and both investors and home owners will come back into the market. As the property prices fall there will be less properties available for rent (with less investors buying) and more people looking to rent (with less home owners buying and thus looking to rent), putting further stress on the rental market and causing rents to increase further. The reduced interest rates and higher rental returns will thus be the fuel for property prices to start their next rise up to the next peak.

    The whole point is not to take the data and comments reported by both sides of the spectrum at face value, do your own research and make your own decision to either buy or sell. Different areas of the property market experience differnt cycles at different times, so the objective is to pick the location and then research it, take your time and buy or sell when you feel comfortable and are ready.

  32. I feel very comfortable selling now.
    I would have felt much more comfortable selling 18 months ago though - when there were many more suckers ready to pay too much for property.
    Unfortunately many people have already cottoned on to the fact that property in Australia is way overpriced and its better to wait for prices to collapse before buying.

    am hoping for some uninformed idiot to buy my place still though - although there's fewer of them every day

  33. Peter Fraser4/4/11 7:35 AM

    JB - I'm looking for some cheap property.

    How does $75,000 sound ?????

    Cash of course....

  34. PF
    So you're not willing to pay fair market price then? ;)
    What if everybody started to be greedy and think like you do???

    OOPS! i think we'd have a market collapse... ;)

  35. Peter Fraser4/4/11 3:50 PM

    But JB I will pay in Silver, and you TOLD me that it will increase ten fold. that's $750,000 smackers, and that will be double what it is worth in todays market.

    It is you who is greedy, not me, I'm really quite generous.

    What happened to that job that Mufti Nick offered DC, he is still unemployed and he still sleeps in until midday. Did he turn out to be unemployable. Surely he could sweep Nicks floors. He can't be that hopeless.

    And how come you don't go back there any more? Did you cotton onto Mufti Nicks real agenda?

  36. PF
    lol - i dont get much spare time nowdays so only post on here now and then.

    I still say that CB and Nick have a great general knowledge and are incredibly knowledgeable in certain areas as well. MM is far poorer without their contributions.

  37. Peter Fraser4/4/11 8:55 PM

    JB - you are wise to stay away from Nick - cb is ok though. Nick actually knows absolutely nothing, and his absence from MM is a huge bonus for us all.

    Be careful around Nick.

  38. PF
    I dont believe you're buying properties anymore.
    Perhaps for around $75K but you may have to wait a good few years yet for that kind of price

  39. Peter Fraser5/4/11 3:36 PM

    JB - believe whatever you like, I don't care. I'm not buying houses though unless one comes up at a price I can't resist, my 1st choice is commercial property.

    But it's not for everyone, you need much more capital to buy commercial property. 65% LVR Max usually.

    Cheers .......

  40. JB = missed the boat, made a big mistake.

    Really, are we going to listen to this chump.


  41. Anon

    Pull your head out of your arse! You're just sore that your RE ponzi empire is crumbling all around you

  42. Peter Fraser9/4/11 10:00 AM

    JB - so you accept that prices are crashing - in that case my offer is $64,000 - still cash though.

    you had better go and talk to cb - he is getting very lonely - dc the unemployed doesn't get up until afternoon now, and Mufti Nick is just going on about all sorts of utter bunkum now to try to keep some volume of posts going.

    Mate they are desperate - they NEED you and others there. please help them they are at desperations door. Any day now your so called "brains trust' will implode.

    BOOM .... too late...

  43. PF

    At the risk of sounding dumber than you usually think i am ... what does Mufti mean???

  44. Peter Fraser9/4/11 9:05 PM

    A Mufti is an Islamic teacher or scholar. Has he converted you to Islam yet?

    $64,000 is my final offer, it drops tomorrow.

  45. PF

    lol - thanks but no thanks. i don't think that property has dropped to 1/6 of its peak value quite just yet...
    In fact i don't expect it will drop that low.
    A drop to 1/2 is far my likely...

  46. Peter Fraser11/4/11 4:02 PM

    Ah, so you would consider $180,000 then.

    We can start negotiations there. Still cash of course.

    Do you throw in a new BMW as well?

    I'm starting to see the advantages in being a bear on property. Of course I have been for a while, but JB you have convinced me that property will be decimated.

    Perhaps $180,000 is excessively generous?

  47. PF
    I promise you that if my property is still not sold by the time the crash troughs out i will offer it to you for $180K.

    How does that sound?

  48. Peter Fraser12/4/11 6:27 AM

    A. You won't know where the trough is until it has passed.

    B. I won't be as generous during any trough as I am now.

  49. Very interesting blog, thanks! I was wondering if what happens is that we see more of a long term flattening of house prices rather than a drop. We are seeing heavy inflation (real world inflation) with food and fuel at the moment which has a good chance of becoming fairly permanent for a large number of reasons (such as climate, peak oil, food security).

    Does anyone think this is a likely scenario rather than a drop?

  50. Peter Fraser13/4/11 9:43 AM

    Andy W - Yes, I'm of that opinion, although I do expect a small drop - maybe 10% nationally depending on local oversupply/demand, followed by a long spell of little or no gains, followed by a period of slow gains.

    I don't expect to see the long bull run of house price gains again in our lifetime, although sharp jumps may occur.


  51. Andy W – I think a flattening of house prices is as close you get to an impossibility in economics. My reasons are here.

  52. The table clearly shows how important population growth is to housing bubbles, or more correctly the perception of ongoing population growth. Australia has had both rapid population growth and a perception (correctly?) it would always be that way.

    The only two clearly undervalued (affordable) markets listed, Germany and Japan, are also the only two countries with strong negative population growth of (-)0.2% pa. More importantly both the German and Japanese governments have projected that population numbers will be about 15% lower by 2050. In effect they are promising not to offset low fertility rates with immigration, which seems to be the opposite to Australian government policy.


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