Author: Stephen Tunley - CEO Balmain Funds
Nothing ignites more economic passion than a debate about the future direction of
house prices in Australia. This passion fills internet chat rooms, results in
high-profile bets between economists, and employs a host of talking heads and TV
Everyone has a ‘position’ in property. Two-thirds of households own
(outright or mortgaged) their own home - their biggest, and tax-free investment.
One third are renters, some who intend to buy eventually, others who cannot
afford or choose not to buy.
This paper is in two parts. In Part we explore the case for residential
investment. In Part 2 we explore the case against. But firstly, let’s look at
how Australia’s housing market has performed in recent years.
The chart below (presented by the RBA in a speech on 18 May 20101) shows capital
city and ‘rest of Australia’ dwelling prices (houses and units) indexed to 100
and adjusted for inflation. Interestingly, despite a public perception that
capital city prices have streaked ahead of the rest of the country, the chart
FIGURE 1 Real Dwelling Prices* 1993=100
*Deflated by the trimmed mean CPI
What drives property
prices? Simply, it is demand & supply; the cost of funds vs rental
yields/capital appreciation; taxation impacts...and the expectations for all of
Demand comes from population growth,
demographics, household formation trends, expat/foreign investor demand, and
stability of employment. All of these are currently increasing demand. Consider
* Census date interpolated using dwelling completions
The result – a demand/supply imbalance and a
continuing shortage in housing as reflected in tight rental vacancy rates and
rising rents in recent years, particularly in NSW.
Gross rental yields are 5.1% (units in Sydney. RP
Data-Rismark) and after costs of approximately 1.5% results in a net rental
return of 3.6%.
With the cost of borrowing around 6.5%, this results in a minus
2.9% return. For an investor, this equates to an after-tax return of around
minus 2%, due to negative gearing benefits. This can be seen as acceptable if
capital appreciation of around 10.2% -13.7% (in the year to July 2010 in Sydney
and Melbourne ) is repeated in future years.
For a renter, mortgage repayments
would roughly be similar to rent payments. The argument to buy improves when one
adds the benefits of home stability (compared to rental uncertainty in the
current tight rental market). In addition, a stable jobs outlook gives comfort
to most potential buyers regarding their ability to service a mortgage.
owners also benefit from the property’s capital gains being tax free, making it
an attractive after-tax ‘investment.’ In addition, recent stock market
uncertainty and volatility has made equities a less attractive alternative to
Gross rental yields in Australia’s fastest
rising market, Melbourne, have fallen to 3.5% for houses and 4.1% for units,
according to RP Data-Rismark. Which means other cities could see yields falling
to similar levels under ‘boom’ conditions. For example, Sydney yields are 4.1%
and 5.1% respectively. For Sydney to ‘boom’ as much as Melbourne has, then
Sydney property prices would rise by 17%-24% to reach similar yields. And prices
rose by these levels in Sydney in mid 2002, and in Melbourne in early 2002,
early 2008 and late 2009.
Uncertainty spells risk and risk impacts on expectations. With residential
property yielding negative returns, expectations of capital gains is the key to
future price increases. According to the RBA, 10.3% of households have at least
one investment property and another 6.5% have a property (excluding their
primary residence) that does not attract a rental income (mostly meaning a
holiday house or a property rented free to relatives). These investors will
likely be sellers if they lose their expectations of long term price
appreciation. What will drive these expectations? Consider this;
The mortgage rate is half of the yield equation.
The RBA is focussed on fighting inflation. House prices accounts for a 19.5%
weighting of the CPI calculation according to RPData/ABS. With the inflation
rate already at the high end of the RBA’s preferred band of 2%-3%, and with the
resources boom expected to lift wages, these conditions will favour a tightening
bias. (However, after six interest rises since October 2009 (taking the cash
rate to 4.5%) many commentators expect the RBA will likely to adopt a wait and
see attitude in the immediate future.)
the stroke of a pen, immigration rates and tax policies can change. And with a
minority government needing the support of a Green and three independents, the
risks of change are greater now than in previous years. The introduction of
death duties, capital gains tax on homes, higher stamp duties, and negative
gearing cuts can quickly reduce the attractiveness of property. In addition,
there has been growing pressure to cut immigration rates and this is likely to
intensify with the Greens vote, which will slow-down household demand.
Housing is already expensive in Australia when measured by the
ratio of median house prices to median income. (see comments below by Jeremy
Grantham of GMO). This dampens expectations of significant price increases as
buyers ‘cannot afford it any longer,’ thus reducing demand. Global surveys that
ranks Australian house prices as amongst the most expensive in the world also
dampens expectations. We expect housing affordability to become a major
political and economic issues in the period ahead.
As Europe has discovered, adult children are staying in
their parents’ houses for much longer. And in many other countries, having three
generations (grandparents, parents, kids) in one household is the norm, driven
partly by housing and childcare costs. Given affordability, major metro land
availability issues and of course the lack of transport infrastructure spending
across Australia in recent years, Australia may trend towards this development,
leading to lower rates of household formation.
But there will be an unexpected
socio-economic bonus. As three-generation households becomes more common, the
public cost of aged care will drop (or not rise as much) as kids and grandkids
become care-givers in return for staying in their parent’s home ‘all these
years,’ -- a situation already common in many other countries, particularly in
40% of dwellings are outside capital cities. And land supply
in regional centres is less constrained than the cities. With regional
development now a government priority due to pressure from the independents, a
tree-change movement could grow significantly, particularly if regional jobs and
infrastructure can be created by new government initiatives. This should ease
both demand and supply issues in capital city housing.
Stamp duty and agents commission can add around
4% in property transaction costs. In a low interest rate environment where
returns are in single digits, these costs loom large. In addition, online
advances in stock trading have driven equity market transaction costs to 0.3% or
less for most investors, making property investment an expensive exercise.
Negative influence of US property markets
The deep malaise in US property prices
that is receiving widespread media coverage could dampen sentiment in Australia.
And media reports do influence investors. An Australian Securities Exchange
survey of stock investors found that newspapers were the biggest source of
advice and information about the market.
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