Busting big housing myths

As we look to what's ahead for 2012, Property Observer is republishing some of our most noteworthy stories of 2011.

In my first official article for Property Observer (you can see my archives here ), I thought it might be helpful to go back to basics and bust a few housing “myths”. I hope this will be a useful guide for anyone who is thinking about investing in property and who has stumbled across the many sensationalist allegations that exist out there in the ether. In the weeks and months ahead, I will try and explore these issues in more detail.

The first housing myth is that it is easy to understand. Almost all people writing about housing know very little about the facts of the subject. Since 70% of households own a home, they feel like they are instant experts. This gives rise to an “anchoring bias”, which I will come back to another time. In brief, we tend to extrapolate out from our immediate housing experience and assume the rest of the asset-class behaves the same way. This is why, for instance, many successful people have a visceral certainty that house prices collapsed during the 1991 recession when they did nothing of the sort. 1

It is true that house prices in affluent areas (e.g., the Point Pipers and Tooraks of the world) suffered substantial price falls. But across the eight to nine million homes that exist nationally, house prices barely budged, as the chart below shows.

A similar dynamic reasserted itself during the GFC, wherein national dwelling values retraced by a modest 3 to 4% on a peak-to-trough basis. The $1 million plus market, on the other hand, fell by 10 to 20%. But, in contrast to what you might be led to believe when reading newspapers, homes worth more than $1 million actually only account for about 5% of all transactions. That is, this segment is irrelevant to 95% of home owners.

The truth is that housing is much more complex than the popular media would have us believe. The “we-are-all-property-experts” syndrome is likely one reason why there are so many misconceptions that abound about the asset-class.

A second, all-too-common myth is that Aussie housing benefits from unusually generous tax breaks. As this Reserve Bank of Australia study shows, the tax arrangements in Australia are not remarkable by international standards. CGT exemptions, negative gearing, investor depreciation allowances, and the like are found in many other countries around the world (see table below).

The tax-break proponents are especially fond of “cherry-picking” their claims. They will tell you that it’s a travesty the family home is exempted from capital gains tax, for instance. Or that negatively gearing is a phenomenon unique to our country (the table above illustrates otherwise).

What they neglect to mention is that, firstly, there is a substantial cost, or trade-off, associated with the CGT exemption: any mortgage debt held against the family home is emphatically not tax-deductible, in contrast to all other forms of debt (including investment property debt). This makes owner-occupied home loans very expensive, and encourages Australians to use more equity and pay back whatever debt they have quickly, which is obviously a good thing.

Indeed, the exception here is, ironically, the US, which does levy capital gains tax on the owner-occupied home in exchange for allowing mortgage debt to be tax-deductible. The result has been, unsurprisingly, higher levels of gearing (or debt) held against US housing, and vastly higher mortgage default rates (refer to the next two charts below). In the US, households have had every incentive to take on significantly more debt because it is tax-effective to do so. Those willing the Gillard Government to levy CGT on the family home should be wary of what they wish for: the likely outcome will be the US approach, and all of the risks that this entails.

Perhaps most importantly, those arguing that Aussie housing gets atypical tax subsidies typically forget to account for the fact that it is burdened with a raft of additional levies, such as huge stamp duties, which can amount to more than 5% of the value of a property, land taxes, and local government duties, which sum to a de facto land tax equal to 1% or more per annum.

Indeed, the OECD estimates that the round-trip transaction costs associated with buying a home in Australia are the fourth highest in the developed world, and equal an extraordinary 13% of the value of home (see chart below). By way of comparison, the cost of buying and selling a home in the UK is less than half this princely sum.

If we look at just vendor costs, Australia has the highest housing expenses in the OECD. Contrast this, for example, with shares where the round-trip costs are less than 1%.

A third myth is the popular claim that luxury, or more expensive, properties outperform cheaper ones. This is just not supported by the empirical data. Analysis produced by Rismark proves that mid-priced homes have actually delivered stronger capital growth than their dearer counterparts. And this also comes with considerably lower risk.

The luxury end of the market is “illiquid” – that is to say, it only attracts, by definition, a small number of buyers and sellers – and is afflicted by far greater risk or volatility. This is highlighted by RP Data-Rismark’s luxury property index, which is denoted by the red line in the chart below. Observe how during 2009 and 2010 the most expensive homes outperformed the broader market. Yet during the recent soft-landing, it has been this same cohort that has tanked, relatively speaking.

My fourth favourite myth is the “safe as houses” aphorism. As with most matters, the truth is more complicated. First, house prices do fall, as we recently witnessed. Second, the individual home is actually a risky holding.

Rismark was the first Australian group to disclose empirical research that quantified precisely how risky a home is. We found that the capital gains generated by a single family home vary markedly over time, and exhibit annual volatility of around 15 to 18%, assuming that you hold on to it for a typical six- to seven-year period. That means that your home has similar risk to the overall sharemarket. In contrast, if you could invest in an “index” of housing, which represented, say, the national housing market (or about $3.5 trillion worth of homes), your annual risk would fall to just 3 to 5%. This is about half the risk of Australian government bonds, and about a quarter the risk of Australian shares.

 The difference between the volatility of an individual home compared with a nationally diversified portfolio of housing is similar to contrasting the risk of a micro-cap listed on the ASX with the volatility of the ASX All Ordinaries Index, which includes every company listed on the exchange. As Miguel de Cervantes’ saying goes, it makes sense to try and ensure that all your eggs are not in the one basket!

The good news is that there will shortly be new investment products available that allow you to take insurance out against the risk of house prices falling, or to invest in a nationally diversified index. More on that another time.

A fifth myth is that because houses trade only irregularly, there is sparse data on the subject, and we cannot, therefore, truly know what is happening to prices. In actual fact, RP Data captures about 40,000 to 50,000 homes sales every month (or more than 1,000 per day), which means that we have a wealth of information on price movements. This allows us to create very sophisticated measures of house price changes, which directly control for the fact that we are observing different types of homes transacting over time. You can read more about RP Data-Rismark’s index methods here.

My sixth myth is that Australian house prices are massively overvalued and set to fall by 20 to 40%. You may recall that my regular sparring partner, associate professor Steve Keen, famously predicted in 2008 that Aussie house prices were “going to fall by 40% or so in the next few years.” Well, he could not have been more wrong. Dwelling prices in Australia’s capital cities are currently 30% higher than their March 2008 peak, just prior to the GFC hitting our shores.

Put differently, dwelling prices are nearly 70% higher than where Dr Keen expected them to be. My other mate, the economist Rory Robertson, challenged Dr Keen to a bet on this note, which the latter lost. As a result, Dr Keen ended up walking from Canberra to Mount Kosciuszko wearing a T-shirt exclaiming “I was hopelessly wrong on house prices” (or something to that effect).

Related to this myth is the claim that national “median” prices of $500,000 to $600,000 are seven to eight times national disposable household incomes, and hence way above where they “should” be.

 Based on RP Data’s sales database, I can tell you that the national median dwelling price across all regions is today only $418,000. Median dwelling prices in the capital cities and non-capital city areas (where the latter account for about 40% of the population) are $468,000 and $325,000, respectively.

Rismark produces a quarterly average dwelling price-to-average disposable household income series. This analysis uses the ABS’s National Accounts measure of disposable incomes, which is the most timely series available. If we strip out a few non-cash items from these data, we find that Australia’s dwelling price-to-income ratio is 4.5 to five times. This is clearly far removed from the hysterical claims that dwelling prices are seven or eight times incomes (see chart below).

What the doomsayers ignore is the profound structural change that took place in the Australian economy over the 1980s and 1990s. Although many may have forgotten, inflation in Australia used to be much higher than the 2 to 3% pace that we have gotten used to seeing. 

Inflation averaged around 6% per annum between 1980 and the middle of the 1990s. Since 1995, inflation has averaged slightly less than 3% per annum. This is in large part attributable to the good work done by the RBA. 

It has also had deep ramifications for the housing market. In particular, the stability of inflation around the RBA’s 2 to 3% per annum band has permitted a structural downward shift in mortgage rates. This is illustrated in the next chart below. Observe how between 1980 and 1995 mortgage rates averaged 12.6%. Yet since that time they have averaged only 7.3%. If the cost of debt falls through the floor on a permanent basis, how do you think households react? They gear up, which is exactly what happened, with a structural upward shift in both household debt levels, and Australia’s house price-to-income ratio over the late 1990s and early 2000s. The key point to note is that this was a once-off event, and will not likely occur again.

A final myth is that housing is not a productive investment. Now this is just complete crap. 

In standard economics theory, the two most basic necessities for a functioning economy and, more precisely, productive labour, are: food and shelter. We can interpret “shelter” as covering both residential property, which is the accommodation required by a functional labour force, and commercial property, which is the accommodation needed for productive businesses.

You can either be a “producer” of food and shelter by investing in, and owning, the underlying assets that supply these services/products by owning farms, homes, or commercial buildings; or, alternatively, you can just “consume” these services/products and not invest in the assets by simply buying food from the supermarket, renting a home, or leasing space in a building.

There is a final option where you can both consume and invest by living on a farm (and eating its produce), owning and occupying your home, or owning and occupying the building in which your business operates, as some companies do.

As an investor in agriculture, housing or commercial property, you derive returns as you would with any other productive asset: via a mix of both growth in the capital value of the asset and income from the sale of the products/services (i.e., food, residential accommodation, and commercial accommodation).

The bottom line is that new or established housing is just as productive in the services that it furnishes to the wider economy as farms, factories or commercial property. More on that topic another time!