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.”
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.