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Many people express the opinion that residential property is first and foremost a shelter and therefore should only be considered from a social perspective. Many believe that it is a given right of every citizen of this country to have a roof over the head – rather than as a financial asset that can potentially make money for its owners.
Although it seems like a righteous position to hold, it cannot be denied that, in addition to offering a physical protection from the elements, residential property is, and always has been, an attractive investment option.
The old saying “property is the biggest investments one will ever make” has not been coined without reason. Besides, even when people say they are buying a “home and not an investment” they do not necessarily equate this statement with not making any money on their purchase in the future.
It would therefore be more pragmatic to consider residential real estate as “long-term accommodation” rather than just a “shelter”. It is both a  roof over the head, as well as a money making asset.
Property ownership is quite popular in <country-region>Australia</country-region>. According to the Australian Bureau of Statistics, as at August 2011, 67% of all residential dwellings were owner occupied. Although this proportion is slightly down since the previous Census in 2006, it has remained relatively unchanged for the past 50 years.
Those Australians who had a stake in residential property did quite well over the last six decades, as the following chart demonstrates.
 <img alt="seven_decades_of_prices" src="/images/stories/2014/02/10/seven_decades_of_prices.png" height="261" width="470">
Source: Based on ABS data and Stapledon 2007
Returns varied from decade to decade as property prices rose at different paces, but they have always remained positive. So will property owners be seventh time lucky? Chances are they will, given the <a href="https://www.propertyobserver.com.au/residential/australian-property-prices-in-2014-and-beyond-a-peek-into-the-future/2014013167457" target="_blank">past history of property prices in this country</a> .
What the above chart does not show is that property owners also had an opportunity to make substantial savings in the ongoing costs of accommodation (i.e. rent) once they had paid off their initial loan. This increased the actual returns to owners quite substantially.
The following chart compares estimated total returns on residential property from capital appreciation and reinvestment of imputed rents, which is conceptually equivalent to S&amp;P/ASX 200 Accumulation Index.
 <img alt="property_vs_shares" src="/images/stories/2014/02/10/property_vs_shares.png" height="275" width="470">
 
Sources: based on ASX and ABS data
The chart indicates that, over the long run, returns from residential real estate match returns from share market investments. This conclusion is also supported by a study undertaken by Russel Investments and published by the Australian Stock Exchange, the <a href="https://www.asx.com.au/documents/resources/ASX_Report_2013.pdf" target="_blank">Long-term Investing Report, July 2013.</a>
It is important to stress that residential property is a long term investment option – it delivers, but requires patience. Consequently, this means it can be outperformed over a short-term by other types of investments.
Take gold for example:
 <img alt="property_prices_vs_gold" src="/images/stories/2014/02/10/property_prices_vs_gold.png" height="299" width="470">
Sources: based on ABS and Perth Mint data
Over the long run, residential property outperformed gold. However, over a short-term, those investors who piled into gold in 2005 would have experienced a much greater rate of return than property owners - even after the 2012 and 2013 falls in gold price are factored in.
 <img alt="property_prices_vs_gold_short_term" src="/images/stories/2014/02/10/property_prices_vs_gold_short_term.png" height="299" width="470">
Sources: based on ABS and Perth Mint data
Just a note of caution: Do not take the above comment literaraly – property owners could still come on top, despite the proportionately smaller increases in prices compared to gold because of the leverage that is usually applied when buying a property.
For example, a $100,000 cash investment in gold in 2005 would now be worth $250,000 (i.e. $150,000 increase). That amount invested in the right property worth $400,000 in 2005 (i.e. as 25% deposit) would deliver by now $200,000 extra in owner’s equity.
There is one more reason why property should be treated as an investment. In particular, if you believe in the merits of diversification, individuals should always aim to spread their wealth across a wide range of assets to minimise financial risk.
Residential property is an asset class with proven long-term security, hence should be considered as a part of well diversified financial portfolio.
All working Australians already participate in local and overseas stock markets, various cash instruments and/or commercial property market via the superannuation funds they belong to. However, these funds do not invest in residential property.
Dixon Advisory was the first Australian company to offer individuals the opportunity to invest in residential property in the <country-region>USA</country-region> via its <country-region>US</country-region> Masters Residential Property Fund, but not in Australian property. So, diversification into Australian residential real estate is only possible via direct investment in your own home or in the investment property (as an individual or via self-managed super fund).
All in all, residential property is an investment regardless of whether it can be morally justified, or whether those buying the property do it with full consciousness of this fact or not. It is simply because the returns are too good and too consistent to treat it otherwise.
The social aspect of housing, that is, as an “affordable shelter”, is very important and should be widely debated. However, in my opinion, the issue stands a much better chance of being addressed properly with tailored solutions aimed at assisting specific sections of the community; rather than with Robin Hood like polices advocated by some commentators, that can potentially destroy the investment value of property in Australia.
Residential property constitutes a significant part of the wealth of this nation. There is merit in the aspiration to own a property as a way of building and accumulating wealth, and therefore, there is a good reason to keep the 'Australian dream' alive.
Undermining this aspiration and shaking confidence of Australians in property will not end well – either fif it leads to destruction of national wealth, or for those who are persuaded to opt out of participation if history continues unchanged. 
Arek Drozda is an independent analyst who has worked in the public and private sectors for over 20 years in business development, data analysis and in building geographic information systems.
 
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 RELATED ARTICLES BY AREK DROZDA:
<a target="_blank" href="/news">Putting property investment losses into perspective</a>
<a target="_blank" href="/news"></a><a target="_blank" href="https://www.propertyobserver.com.au/finance/australian-property-prices-explained-independent-analyst/2014011367181">Australian property prices explained</a>
 
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An investment or just a roof over your head: How should we treat residential property?

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In my previous article, '<a href="https://www.propertyobserver.com.au/finance/australian-property-prices-explained-independent-analyst/2014011367181" target="_blank">Australian property prices explained</a>', I presented a chart that provided very accurate narrative on what has happened in the Australian property marketover the last three decades.  

It is safe to conclude that the same concept which allowed for the description of the past with such accuracy, should also be able to provide a reasonable guidance for the future.  
Of course, predicting exactly what will happen in 2014 and beyond is a tall order. Life is known to create such a variety of unanticipated scenarios that the reality will almost certainly play out differently to what everybody expects.  
Therefore, I prefer to think about the future in terms of a range of possible outcomes and likely probabilities of occurrence rather than as a single, definite result.  
The real benefit of such an approach is knowing how changes in economic conditions can potentially affect the outcome - not in picking the exact end result in advance.  
Since changes in some economic factors will have more profound effects than others, if you can identify in advance what are they, you can watch out for the tell-tale signs that a particular scenario is playing out – and act accordingly.  
You only need to be right about the direction property prices are heading to be able to benefit.
Please consider what follows with caution - in the “what if” category, rather than a certainty.  
Based on the income capacity of working Australians, residential property in this country is not overpriced and prices are far from bubble territory.  
The proof is in relative changes in the cost of buying over the last 27 years, which has been significantly below the relative changes in personal incomes over that time. Below is a slightly different representation of that information to highlight this point. 
<img src="/images/stories/2014/01/31/arek_jan_31_one.jpg" width="470" height="299" alt="arek_jan_31_one">
By rearranging the data we can create a chart that shows how much more property prices could increase at present and still be considered affordable (in relation to current incomes and as benchmarked to 1986). 
<img src="/images/stories/2014/01/31/arek_jan_31_two.jpg" width="470" height="301" alt="arek_jan_31_two">
The above chart indicates that current property prices are potentially undervalued by as much as 45%. Of course, this does not mean that prices will immediately move by this much but the potential for a substantial jump is there.  
Yet another perspective using the same underlying data reveals that conditions are now starting to resemble those in 2009. Although affordability in 2009 was not as extreme as in late 1990’s, it nevertheless led to a substantial price increase in 2010.
<img src="/images/stories/2014/01/31/arek_jan_31_three.png" width="470" height="277" alt="arek_jan_31_three">
Therefore, as history shows, if interest rates remain mostly unchanged and incomes keep growing, we can anticipate a significant jump in property prices in coming years.  
The increase could either be a rapid advancement of 10-20%, or even 30%, in the next 12-24 months if the 'good times' perspective prevails or, if pessimism dominates, it could result in an even more substantial jump but in the more distant future.  
Of course, this scenario can only play out on the proviso that there are no unexpected shocks applied to the system, such as a major international conflict, another economic calamity in the region, another collapse of world financial system, or a major natural disaster – to mention a few obvious cases.  
In terms of further outlook, if the relationship between costs of buying, incomes, rents and prices hold in the future, and the current rate of income growth continues, then it can be estimated that from now to the end of 2023 property prices could grow by as much as 140% under a historically low interest rate scenario (i.e. 5% per annum), or as little as 20% under a high interest rate scenario (i.e. 10% per annum).  
Under a more probable scenario of slower growth in incomes and interest rates averaging 7% per annum over the next decade, prices can still be expected to grow by 60% in the next 10 years.  
A much gloomier future is also possible but the probability of this scenario is rather small at this point in time.  
That is, a 40% drop in property prices is possible in the next decade but it would take extreme economic conditions for this scenario to play out. In particular, mortgage rates would have to persist at close to 20% per annum for a good part of the decade and income growth would have to drop to 2% per annum to bring prices down by this much.  
In conclusion, the outlook for property prices in Australia is positive - unless of course the world encounters another economic disaster of a magnitude that is hard to even imagine.  
Some insist that the next big event is 'just around the corner' so, it would be wise to keep an eye for the tell-tale signs of possible troubles brewing somewhere in the world but there is no obvious reason to panic just yet.    
Arek Drozda is an independent analyst who has worked in the public and private sectors for over 20 years in business development, data analysis and in building geographic information systems.
You can contact Arek on <a target="_blank" href="https://twitter.com/arekdrozda">Twitter</a>.
 
 
 
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Australian property prices in 2014 and beyond - a peek into the future

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Since property prices started to rise again a key question that comes to mind is – what about the bubble? Are we there yet or far from it? Opinions are many but I prefer to deal with facts and figures so, let’s examine the evidence…
Firstly, we have to define the “price bubble”. As it turns out, even this simple task is not without some challenges due to a variety of perspectives on the issue. Therefore, let’s settle on a simple and succinct <a target="_blank" href="https://en.wikipedia.org/wiki/Economic_bubble">definition from Wikipedia</a> which explains price bubble as “trade in high volumes at prices that are considerably at variance with intrinsic values".
So, according to this definition, the first precondition of a bubble is “trade in high volumes”. Since I do not have access to property sales data for the last few decades, the best proxy of this information is the number of mortgages issued by financial institutions, as published by the Australian Bureau of Statistics. This data series goes back to 1975 and is presented on the chart below. The red line on the chart is a 12 month moving average of monthly volumes of loans for purchase of established dwellings, new dwellings as well as for construction of dwellings. Loans classified as refinancing are excluded.
The spikes in volume can be clearly identified in 1984, 1988, 1994, 2003 and 2007. Volumes were also elevated in 2009 and are up in 2013 from a very low base but these appear so far to be “reactions” in a downtrend hence, rather unlikely candidates for a bubble.
 <img src="/images/stories/2013/12/03/total_dwellings_financed.png" alt="total_dwellings_financed" height="236" width="470">
The second precondition for the existence of a bubble is that “prices are considerably at variance with intrinsic values”. The definition of an “intrinsic value” is a much bigger problem. So again, let’s opt for something simple and widely used by economists. In particular, the most common approach to determine the intrinsic value of properties is to calculate price to household disposable income ratio, or price to rent ratio, and compare present and historical values. The second measure is my preference since there are long term data series readily available which makes construction of this indicator much easier. However, both those measures should show a very similar result.
I set the ratio of house price to rent as 1 for 1975, which is the start of housing mortgage data but I also calculated the ratio back to 1950’s - to a point in time when modern and unregulated post World War II housing market began in Australia.
Read more over page
 
 


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 <img src="/images/stories/2013/12/03/House_prices_to_rents.png" alt="House_prices_to_rents" height="288" width="470">
Looking at the above chart we can immediately identify a problem – the line only rises and it never fell back to or below 1950 level. The ratio first jumped in early 1950’s, then in mid 1970’s, again in late 1980’s and in early 2000’s, peaking so far in 2010. In other words, it implies that prices are “at variance to intrinsic value” continuously for 60 years now… Yet, despite that implied long lasting exuberance, property prices in <country-region>Australia</country-region> fluctuate periodically – they advance and then they pause or fall slightly, then they advance again to a higher level.
It means that this popular measure of intrinsic value is rather insensitive to short term variations in market conditions and therefore should probably be only applied in analysis spanning many decades or even centuries. In other words, simple measures like price to rent ratio, are rather inadequate for a shorter and medium term analysis, relevant to a person’s lifespan.  A more responsive measure is needed in order to determine whether prices are exuberant or not. I will explore this further in my next article.
For now, the only conclusion that can be drawn is that, according to our original definition, if we accept that 1950 is an appropriate starting reference point and that prices to rents ratio is an appropriate measure of a variance to intrinsic value, Australian property is in a very long term bubble that peaked so far in 2007 (the point of the highest volume of loans and high ratio of prices to rents) and that this bubble is currently deflating.
However, there is more that should be said. In particular, it is an awfully long term bubble and it may take an awfully long time to deflate, if at all. It is not out of the question that what we observe on the second chart is a reflection of ongoing structural changes in the housing market – therefore, that the chart indicates what the current intrinsic value is and not the variance from a historic intrinsic value, as this information is commonly interpreted. If what we observe is indeed the result of long term structural changes in the market, this “bubble” could as well inflate to even bigger proportions, as it happened in 1950s, 1970s, 1980s and in 2000s.
I will leave you with an interesting question to ponder about - what would it take to completely deflate this bubble and bring ratio of prices to rents down, back to 1950’s level? It would involve a serious modelling exercise to come up with a range of scenarios that could deliver that outcome but, as an illustration, prices would have to halve from current levels and, at the same time, rents would have to double to get us close to that result in the next 20 years. How likely it is to happen without a catastrophic economic shock or a drastic government intervention is not difficult to guess.
 
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Arek Drozda is an independent analyst who has worked in the public and private sectors for over 20 years in business development, data analysis and in building geographic information systems.
 
 
 
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The analyst in search of a property bubble: Arek Drozda

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“Since FY 2000, at the macro level, rents have not been able to cover costs (mortgage, maintenance, rates) and policy has produced a country of loss-making landlords who rely upon negative gearing.” Chief Economist of a large international financial organisaton.
The above statement echoes a common perception about the merits of property investment in Australia. Similar views are shared by many prominent and respectable social, economic and finance commentators and hance, get a lot of circulation in the media. Since media has big influence on public opinion, such views get absorbed by wide sectors of the community without much scrutiny as to their merit. The result is that we end up in a situation where there is a widespread misunderstanding about residential property investment.
Let me try to clarify this misunderstanding by explaining how income losses originate in the early years of residential real estate investments and what implications it has for the returns on such investments. In other words, why “losses” and “profits” can go hand in hand in property investment - and why it is not a misnomer as you may expect at first…
 
1. Property investors are price takers and, as individuals, have minimal impact on the market.
As much as investors would like to buy cheap to make big profits from day one, they are not the only buyers in the market. Hence, they have to pay prices that the market dictates. Investors also compete for tenants so, incomes from letting of residential properties are influenced by prevailing rental market conditions.
To illustrate the point, imagine you could buy a property for $500K, pay 5% in interest on 100% of the value of the property plus $5K in oncosts (i.e. $30K p.a. in total) and rent it for $40K p.a. (8% gross yield) to make a profit before tax of $10K. That property would also grow in value by 3% p.a.
So $0, nil, zip, zilch, nothing invested up front (apart from a promise to the lender to repay debts in due course or if something goes wrong) and a starting profit of $25K (comprising $10K cash and $15K in capital). There is only one question to ask - how many such properties would you like? You could probably stop working with 10, make most of your dreams come through with 20, and live a multimillionaire lifestyle with 30…
Let’s introduce a twist to this scenario and say, your cousin would like to do the same… and other members of your family, and your friends, and their family and friends… Suddenly, there would be a little bit more competition for the properties you intend to buy. So, how much such investment would be worth to you? Would you pay $600K for the property to earn “only” $20K p.a. (i.e. paying $35K p.a. in total costs and earning $5K net from rent and $15K in capital gains on original value of $500K)? Or maybe $700K would still be a good deal?
And let’s consider this case from a renter’s perspective. If it costs $40K p.a. to rent, would it be worth to buy the place for $600K and pay $35K p.a. in total costs and having an opportunity of making extra $15K p.a. in capital gains? Would paying $700K for the property be still a good deal?
The point is that prices at which properties change hands are the outcome of a complex set of circumstances, leading to individual decisions of buyers and sellers - the participants in the process, who collectively make the market. By default, since there can be only one buyer per property (whether a single person or a team), the price is usually the highest offer from all interested parties and is inevitably influenced by the cost of renting of comparable premises.
The following section explains how paying market prices works out for investors in the long run…
 
2. Long term returns on non-leveraged property investments match returns on share portfolios
<a href="https://www.asx.com.au/documents/resources/ASX_Report_2013.pdf" target="_blank">Exhibit 5,7 &amp;8</a>
If you accept conclusions of <a href="https://www.propertyobserver.com.au/residential/more-liquid-shares-just-outperform-property-over-last-20-years-if-you-dont-mind-the-volatility-rismark-study/2013081963840" target="_blank">studies on returns from shares and non-leveraged residential property</a>, both these investment classes deliver comparable results over a long term. As an example, according to RP Data, on average, property delivered gross rental yields of 3.6 to 7.8% p.a. (based on 1996 to 2013 data series) and capital appreciation of anywhere between 4 to 13% p.a. (2001-2011 data series) - results vary by State and type of property. These are<a href="/news"> quite respectable returns</a> and reflect <a href="https://www.propertyobserver.com.au/residential/the-two-speed-decade-for-home-value-growth-tim-lawless/2012021553403" target="_blank">relatively low risk of this investment class</a>.
In other words, investors who bought properties with cash, or who paid off the initial loan, are consistently generating positive returns form their investments. So, labelling property investors “loss making landlords” is rather unfair generalisation.
The next section explains implications of a prospect of stable long term returns for the risk appetite of property investors…
 
 
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3. Low volatility creates opportunities for higher leverage
Since cash purchases of residential real estate are very rare, due to sums involved and difficulties in acquiring fractional ownership of a property, such investments are usually made with borrowed money. Buying an asset with borrowed money is called leverage, or gearing, and both owner occupiers and investors can take advantage of it.
Volatility in property prices is relatively low, especially on the down side. So, it is quite common for investors to buy residential properties with loans of up to 100% of purchase price plus full cost of purchase expenses (in such cases lenders take additional security over other unencumbered assets of the investor). The last six decades of persistent growth in property prices created expectations that this upward trend will continue in the future which gives borrowers and lenders confidence to enter into arrangements that are otherwise considered very risky (<a href="https://www.propertyobserver.com.au/residential/should-you-invest-in-shares-or-property-tim-lawless/2012110757682" target="_blank">e.g. for share portfolios</a>).
By applying maximum leverage to investments that already deliver positive returns investors have the opportunity to turn respectable profits into more substantial ones. However, the leverage comes at a cost in the initial stages of the investment when interest payments are not fully covered by income from rent. As borrowed money is paid off and/or rental incomes grow, those losses are eliminated.
The next section explains how those small losses can deliver big returns over time…
 
4.  Losses are actually additional capital injections that make leverage possible
Explanation of this step requires applying unconventional approach to account for profits. In short, the logic goes like this: the loan is required to secure possession of an income producing asset and it has an annual cost which initially is not covered by income from that asset (the reasons are explained in point 1 above). The annual operating loss (regardless whether reduced by negative gearing or not) and/ or investor’s contribution to the purchase price are considered capital outlays for the investment - not the purchase price of the asset. It therefore follows that these real cash outlays are what should be used in calculations of investor’s true returns.
To illustrate, a $500K apartment bought last year in Sydney with 100% loan (so, no cash outlay) that increased in value by say, 10% over the last 12 months (so, $50K gain) but generated $10K after-tax loss (i.e. which is actual cash invested), delivered in reality 500% return to the investor (of course net returns will be less due to capital gains tax and other costs if property is sold).
And it works in a very similarly way for owner occupiers. For example, a property purchased with 10% deposit that doubles in value (i.e. 100% return on purchase price) in reality is a 1,000% gross return on the original cash investment (for net return figure all costs of owning that property over the period would have to be deducted).
Of course, it is needless to say that the less leverage applied, the more those returns will approximate normal returns (as outlined in point 2 above). Also, that both property owners and investors can lose equally big if their bet on rising property prices goes the other way and properties decrease in value over time.
I am first to admit that this method of accounting for profits is controversial and can be criticised on a number of grounds. More importantly, this information taken out of context and in hands of unscrupulous peddles of “make zillions in property” seminars can be outright dangerous. However, it does not change the fact that for home owners and investors alike it is the real, hard cash that counts at the end of the day, not paper profits calculated for tax or other accounting purposes.  This method has its merits as it shows true net cash position after disposal costs, relevant taxes and debts are accounted for. It also demonstrates that even small increase in property prices can lead to substantial returns for property owners. There is no “black magic” or “secret formula” involved – this is simply how leverage works.
And to conclude…
 
5. Government or taxation policies have nothing to do with it
As I explained in my previous article <a href="https://www.propertyobserver.com.au/news/let-s-get-the-facts-straight-negative-gearing-benefits-less-well-off-investors-more-than-it-does-the-rich/2013111266324/Page-1" target="_blank">“Negative Gearing: The three facts that will challenge your assumptions”</a>, there is very little about negative gearing that would allow drawing a conclusion that landlords in Australia have to rely on it exclusively to make their property investments viable. There are no other government policies that would directly contribute to the viability of property investing either. Residential property as an investment class has its own merits - for owner occupiers as well as investors, with or without negative gearing, with or without leverage.
Majority of Australians already participate in this class of investment, either as owner occupiers and/or investors. We are not a nation of gullible property speculators, sinking money into dubious assets - but it takes some financial acumen to understand it. Off-the-caff comments, sensationalising selective aspects of property ownership or investing, without explaining the context, will not help those who are unable to participate in the Australian Dream. Promoting basic financial education is more pragmatic and would be more considerate...
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Arek Drozda is an independent analyst who has worked in the public and private sectors for over 20 years in business development, data analysis and in building geographic information systems.
 
 
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