Is there a property bubble in Australia?

The Australian banking system has not had to cope with falling property values, unlike its counterparts in most developed nations. Have we just been lucky? Robert Keavney believes we have, and points to evidence suggesting there is a housing bubble in Australia.

The evidence suggests that residential property prices in Australian capital cities are in a bubble – and we all know how bubbles end.

However, before assessing this evidence, let us consider the importance of residential property prices.

Obviously, many Australians own their homes, which usually represents a large proportion of their net worth.

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There is also a considerable stock of residential property which is investor owned, and generally rented to tenants.

However, changes in the value of residential property can have far-reaching consequences on the whole economy, affecting even those who don’t own property.

It is widely accepted that the collapse in the bubble of US and European house prices was a significant cause of the global financial crisis (GFC).

The foundations of the world banking system were shaken by the extent to which banks were exposed to unrecoverable loans on property, either directly or through conduits like collateralised debt obligations.

(The second stage of the GFC is focussed on the extent to which banks have lent unrecoverable loans to governments, but that lies outside our subject.)

Australia has, to date, come through the global crisis relatively unscathed. Various explanations for this have been offered, including:

• Self-congratulatory claims by politicians that they managed the economy well (which claims rest on the dubious idea that the economy is under the control of politicians); 
• The suggestion that our banks were better managed (though recent exposures about the extent of no and low doc sub-prime lending in Australia undermines this view); and
• We were saved by China and the mining boom. 

Insufficient attention has been given to another factor which has greatly contributed to Australia’s relatively benign experience through the global crisis: only in Australia has the bubble in the price of residential property remained unburst. 

Loans against residential property represent something in the order of 50 per cent of the value of the assets of our banks.

The value of residential property is the most significant factor underpinning the asset quality of the Australian banking system. (Note: any references to property or real estate in this article refer specifically and solely to residential property.)

Almost alone among economically advanced nations, our banking system has not had to cope with falling property values. Why? We have been lucky.

The evidence

Graph 1 represents an index of Australian capital city houses prices from 1880 to 2011, adjusted for inflation.

Below, we explore in detail the not inconsiderable difficulties in creating a meaningful index of house prices, but for the moment, let’s assume this graph is a meaningful representation of real property prices.

The data source is a thesis by Nigel Stapleton, whose work we will explore later.

In the late 1990s, the Capital City Index (the blue line) began a steep and sustained assent, to a point far above the long-term trend line (the black line).

Graph 2 shows real rolling 15-year changes in house prices.

The dates at the bottom of the graph represent the start of each 15-year period – eg, the return showing above 1994 is for the 15-year period 1994-2009. The increase in real house prices over the past decade and a half is unprecedented.

This is the bubble in house prices.

My basis for claiming this to be a bubble is a principle I have used for many years: if it looks like a bubble, it is a bubble – failing manifest evidence to the contrary.

This principle is as an antidote to the ‘this time it’s different’ claims, which emerge in every asset bubble. As a current example of these claims, there are those who argue that the current level of property prices is justified by Australia’s alleged “housing shortage”.

The average number of persons per house is currently lower than at almost any period in our history – that is, the number of properties per person is unprecedentedly high. It escapes me how this can be reconciled with a view that there is a housing shortage.

Should house prices grow at all?

It is worth exploring whether house prices should grow at all, in real terms. This may seem a silly question as property is generally classified as a growth asset, and it has produced strong real growth for the last quarter century.

However, Graph 1 shows that house prices fell in real terms for more than 65 years from 1880. By contrast, over the past 65 years, house prices have consistently increased. Over the whole period, Australian housing has grown at a mere 1.1 per cent per annum.

It is interesting to compare this with Graph 3, which shows the Case Shiller Index of US house prices. US property also fell for more than half a century, beginning in 1890.

Strikingly, with the bubble in US housing having burst in 2007, house prices in real terms today are at approximately the same level as 1890.

Over more than a century, there has been negligible real growth in property values in the USA of 0.12 per cent per annum.

Over the long-term, American housing is not a growth asset in real terms.

There might seem to be little difference between 0.12 per cent per annum and 1.1 per cent per annum, but over such a long period it does make a difference.

Real house prices in Sydney are nearly four times their level of 1880, whereas house prices in the USA are only 16 per cent above their level of 1890.
 

Real house prices in Sydney are nearly four times their level of 1880, whereas house prices in the USA are only 16 per cent above their level of 1890.

Stapleton also refers to a multi-century study of house prices in Amsterdam, which suggests that over almost 350 years there was no rising trend in real house prices in that city. 

These long-term studies suggest that the trend to rising real house prices through much of the developed world over the past three or four decades has been atypical.

This may be a shock to the many individuals who have geared into property as a home or an investment, confident that strong growth in house prices will make their investment profitable. 

Many other countries also experienced a bubble in house prices around the same time as the United States. It is well known that Spain, Ireland, and indeed much of Europe did likewise.

In most of these cases the bubble has burst and prices have fallen back towards their trend line.

Australian property also grew strongly during this period, but prices have not since fallen materially. Is our market different? Or are we due for a fall?

Australian data

In this article, all Australian housing data up to 2007 is drawn from the Capital Cities Index presented in “Long Term Housing Prices in Australia and Some Economic Principles”, by Nigel Stapleton.

Since 2007, the Australian Bureau of Statistics data has been used – adjusted to be consistent with Stapleton’s data. Annual data is to 30 June of each year.

It must be noted that the Capital Cities Index is, in fact, a Sydney/Melbourne index. This needs to be remembered in considering how the comments in this article apply to other cities.

There are long-term indices for most equity markets of the world, but most property data collection began in the 1970s or 1980s – yet longer term data is essential to form a complete view of a market.

Stapleton makes an attempt to create an index for housing back to 1880, but explores in considerable detail the difficulties in this.

These include: 

• Depreciation – any building owned in 1880 would have depreciated materially. In fact, every piece of timber and every nail in the property would have worn or rusted away. If the house still stood, it must have had ongoing funds spent on it merely to maintain its condition. Depreciation reduces the average value of properties. Thus, an estimate of the rate of depreciation needs to be allowed for in calculating the rate of growth of property;
• Changes in quality – according to the 1861 Victorian census, the average house had 2.8 rooms. It would not have had electricity, sewerage or running water – never mind air conditioning or broadband. The average house today is far larger, with many more services. If we were to compare median house prices in 1861 with median house prices today, it would be far from a like-for-like comparison. Some of the difference in median prices would reflect changes in the quality of properties. This needs to be allowed for in calculating the historical growth rate for property; 
• Capital spending – large sums are spent each year on renovations and extensions to the stock of existing properties, which increases the value of properties. The cost of these needs also to be allowed for in calculating the return on property.
• Geographic changes – capital cities are expanding. New areas are being opened up. In Sydney, for example, the population centre of the city is moving steadily westward. In comparing median house prices at different periods of time, an adjustment needs to be made to reflect the fact that we are not comparing like-for-like – ie, the stock of houses at different times is spread over different areas.

These factors make it very difficult to create a meaningful index of median property prices. Stapleton made estimates of the impact of each of these factors, which he applied to the raw price data in order to determine the rate of capital return achieved by property owners.

He concluded that the net effect of the above factors was 0.6 per cent per annum.

Thus, if median property prices grew by 2 per cent in a given year, he calculated that 1.4 per cent of this was capital profit and that 0.6 per cent reflected the net effect of depreciation, changes in the average quality of properties, the cost of renovation and extensions and changes in geographic sample.

It is impossible to know how realistic this adjustment is, though his method seems as reasonable as any other which could be determined. It must be understood that all Australian data referred to in this article is in real terms, and after allowing for this 0.6 per cent per annum adjustment.

Historical perspective

Graph 1 shows a sharp jump in prices in 1950. This followed a period of price control. As a war measure, rents were fixed in 1939 and house values were fixed in 1942.

This interference with the market led to predictable distortions. Stapleton reports that “price controls were circumvented in a number of ways. Firstly, low prices for houses were offset by excessive payments for furniture …

When this loophole was closed, the market switched to vendors requiring ‘key money’”.

As inflation was considerable through the 1940s, price controls forced a real loss on home owners. Once price controls were removed, values quickly rose to more realistic levels.

These events explain the dip in prices in the late 1940s, followed by an explosive rise. 

The period from 1880 to today fits the old football cliché of a game in two halves. From 1880 to 1949, prices fell in real terms. As we have discussed, the last decade of this period was subject to the distortion of price controls.

However, excluding this decade, prices to the end of 1930s were still down compared to the previous century.

Since 1950, prices have risen – especially over the past 15 years.

Prima facie, it seems reasonable that over the long-term property prices should grow broadly in line with inflation – ie, nil real growth. One would expect rents to grow broadly in line with inflation, so failing any structural shift in rental yields, values should do more or less likewise. 

As it happens, the strong real growth in recent times has been accompanied by a fall in rental yields. Clearly, the trend for prices to rise more than rents cannot be sustained indefinitely. 

Many commentators assess the relative value of the housing market as a multiple of average family incomes. Stapleton found no sustained relationship between property prices and wages.

From 1955 to 2011, mean house prices on average were more than twice as expensive – as a multiple of average income – compared to the 1901 to 1955 period. In fact, in 2011 median prices were more than four times the 1901-55 average.

Many factors could have contributed to the sustained trend to property selling at higher multiples of average income, including the increase in double income families.

Conversely, there are fewer people living in each dwelling than in earlier periods, which suggests more single income families through divorce, later marriage, etc.

Although Stapleton found no sustained relationship between income and property prices, the current level of four times average income is further prima facie evidence of a bubble.

Worse than America

With hindsight, everyone realises that American housing was hugely overblown in 2007. How does our bubble compare with that in the US pre the GFC?

Graph 4 compares American property with Australia since 1980, and suggests that we may be far more overvalued than the USA at its peak.

One must offer qualifications to a graph like this: Case Shiller uses different methodology to Stapleton; selecting 1980 as a start date is random, etc.

Nonetheless, only those with their heads most firmly buried in the sand could fail to feel some degree of caution at the extent to which the boom in domestic residential property seems to have exceeded that in the USA, at its worst. 

Conclusion

History suggests that, locally and internationally, residential property produces little real long-term growth.

However, during the 1990s and the early part of this century, property prices grew strongly in many parts of the developed world.

In many countries this resulted in a bubble, which has since burst. However, prices remain elevated in Australia.

It is seems reasonable to expect that the market in Australia will normalise.

This could take the form of a fall in property values, or under a more optimistic scenario, prices could cease to grow from here for an extended period.

The widespread expectations that residential property generates real long-term growth would be disappointed.
 

Under either of these possibilities, the widespread expectations that residential property generates real long-term growth would be disappointed.

Under a worst-case scenario, bank balance sheets could be threatened by losses on their loan portfolio, which could contribute to a weakening of the economy.

As it happens, prices have reduced slightly in several Australian cities over the past year. It is not yet clear whether this is the beginning of a marked decline – only time will tell.

One can often identify bubbles with a high degree of confidence – but this provides no guarantee that they won’t inflate further before their ultimate popping.

Robert Keavney is an industry commentator.