Exclusive: How can we spot a housing bubble?

Exclusive: How can we spot a housing bubble?
Exclusive: How can we spot a housing bubble?

With Sydney and Melbourne’s rising dwelling prices across much of last year, Australia’s property commentators are again looking at the possibility that our price growth is due to a bubble.

The economic phase is largely characterised by prices that have inflated beyond fundamental property values.

Those who have diagnosed a bubble in our housing market are either realists or fear mongers, depending on who you ask. Property Observer took the issue to a panel of economists and industry analysts, asking:

  • What are the warning signs of a growing bubble in the housing market?

  • Is Australia experiencing a property bubble?

Arek Drozda – independent property market analyst

Firstly, let’s define a bubble in more precise terms since there are many different approaches to describe this phenomenon.  I prefer the simple definition that a bubble is “trade in high volumes at prices that are considerably at variance with intrinsic values”.

By this measure, the Australian residential property market is far from bubble territory. In particular:

  1. The last time we experienced really high volumes of residential property transactions was in late 2006 and 2007. Despite reports of the biggest ever number of weekend auctions, the total volume of property transactions in 2014 is still subdued in comparison.

  2. This period (up to March 2008) also coincided with high prices and, most importantly, purchase affordability was at its lowest since early 1990’s.

The reason for low affordability was that the cost of buying (comprising of mortgage payments, council and water rates as well as other expenses associated with owning a property) ballooned to proportions far exceeding the pace of rises in personal incomes, making property prices at that time “considerably at variance with intrinsic values”. Simply, housing market was in a bubble then.

"Australia's residential property market is far from bubble territory" - Arek Drozda

Despite the recent gains in property prices, purchase affordability in 2014 remains at historically high level (not far from 2009 level when Australia and the world were in the depths of the global financial crisis). 

Therefore, there should not be any concern about the bubble until the volume of property transactions reaches 2007 levels and until there is a significant drop in affordability. Prices and interest rates still have a lot of room to move before this will happen.

Exclusive: How can we spot a housing bubble?

Shane Oliver – Head of investment strategy and chief economist, AMP Capital 

The characteristics of a bubble in the housing market are a combination of overvaluation in terms of the prices relative to fundamentals, excessive credit growth, with signs that investors are piling in using borrowed money and finally self-perpetuated exuberance, where past price gains are feeding current price growth.

We saw that in the major capital cities in Australia going into 2000, 2003 and 2004. We had many years of strong price gain. Housing related credit growth was above 20%, and property spruikers like Henry Kay were out in force. The market had become well and truly overvalued.

Some of those indicators are in place now. Housing prices are overvalued in comparison to wages and rental income, both in comparison to Australia’s history and on an international basis.

But we’re not seeing the debt driven frenzy that we saw ten years ago. Credit growth is in single digits, and we’re not seeing the degree of exuberance we saw a decade ago. Cooking shows still out-rate the home development shows.

In Australia, two cities are in double digits but the other capital cities are seeing growth under 5%.

Sydney was perhaps the most bubbly of all the property markets a decade ago, and it’s the one that had the weakest experience in the last decade, starting with the western suburbs in 2004 and 2005. So there’s a degree of catch up going on in Sydney, which partly reflects a return to confidence.

Average capital city growth is above 10%, but that growth is dominated by Sydney, which is up around 15% or 16%.

There are several things investors need to be worried about with Sydney. Firstly, there are probably better opportunities in the states than in Sydney right now.

Secondly, we have seen a strong recovery triggered by a reduction in interest rates, and they’re likely to be raised again, probably later this year.

"We’re not seeing the debt driven frenzy that we saw 10 years ago" - Shane Oliver

Thirdly, rental yields are quite low, so investors getting into property need to accept that they are a lot more dependent on capital growth to get double digit returns, if that’s what they’re expecting.

The term ‘bubble’ conjures up images of some sort of crash, a la some parts of the US, Europe and Japan in recent times, particularly around the GFC. But I don’t think we’re at that point yet. Rates will go up, and capital growth will soften but prices probably won’t crash. The important thing is for investors to have realistic capital growth expectations.

Exclusive: How can we spot a housing bubble?

Philip Soos – Property market economist and housing bubble researcher 

The first thing you’ve got to do is define what a bubble is. And with all property analysis it’s such a vacuous term.

I take the definition of economist Hyman Minsky. He defined an asset bubble as when the rent from an asset, or income from an investment, cannot pay down principal, interest and the running expenses. That means they’re making an income loss. The only way for an investor to make a profit is through capital gain.

That occurred in 2001 onwards when investors on aggregate became negatively geared in Australia. But it’s been worthwhile for most, because the capital gains have been enormous, especially in Melbourne.

There are three requirements of a housing bubble. Firstly, an increase in real housing prices. Secondly, an increase in the debt used to purchase houses, the mortgage debt to GDP [gross domestic product] ratio. That’s something that Steve Keen has popularised. And thirdly, net rental income losses.

"Right now, we’re seeing the largest bubble on record" - Philip Soos

You can also see a bubble through other indicators such as price to income, price to rent, total land values to GDP, the value of housing stock to GDP. There’s also the Kavanagh-Putland index – the total value of property sales on an annual basis relative to GDP – and the debt to cashflow ratio, which compares housing debt to income flows, or net rental income.

Right now, we’re seeing the largest bubble on record. In the post-war period we had two major bubbles. First was coming out of the war in 1974. That was a small housing bubble. It collapsed and gave us a severe recession.

In the late 80s, there was a massive commercial real estate bubble which gave us the early 90s recession. With those two bubbles, real prices and private debt moved up. The same trends are present today, but the trends are much greater now.

Housing prices began to lift off in 1996 and peaked in real terms in 2010 – we’ve never had such a sustained growth in housing prices.

If and when it the bubble bursts, it’s going to induce a pretty severe economic downturn. We’ve never had anything quite like a bubble of this size. The biggest one we’ve seen prior was in the 1880s, when there was a bubble in Melbourne and Sydney. When it burst in the 1890s, it destroyed the economy and produced a depression worse than the one seen in the 1930s.

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Exclusive: How can we spot a housing bubble?

Catherine Cashmore - Independent market analyst

People buy property based on expectations of future growth. 

The prices buyers are paying in some areas of Melbourne indicate a sense of exuberance – a bullish expectation that the good times will continue. 

This is not just evident in the residential sector, but the commercial sector also. Time on market has reduced, reserves are being surpassed, auction clearance rates are holding up despite the increased number of listings, lending data is still indicating we're on an upward trajectory – the list goes on.

As is the case in any cycle, the tide is quick to change if purchasers feel growth prospects will not be realised for the period of time they intend to hold the investment – and we do face significant headwinds in the local economy. 

This could be the result of a number of economic forces which usually act in combination – i.e., not one rate change alone but rather a series of projected rate hikes, job insecurity, fluctuations in the stock market, a report indicating a change to housing policy, restrictions on lending, lower wage growth, and so forth.  

"Inevitably, the tide will turn" - Catherine Cashmore

Buyers will move in sentiment faster than vendors.  Vendors have typically gone through a period of conditioning prior to placing their dwelling on the market. Therefore they are 'set' on achieving a price. Hence the market often stagnates at the turn of a cycle, and housing data can often miss the true drop in prices should vendors be forced to sell. 

This growth phase has a number of forces behind it.  In Sydney and Melbourne (not so much other states), wealth coming into the country from Asia (by way of migrants and off shore lending) is significant and should not be overlooked. I go into further detail here. Our loan data doesn’t pick this up. 

However, money being poured into infrastructure by the current administration, and the boom in building activity, will also bear an upward influence on land prices, although not necessarily on individual unit prices, which are subject to oversupply in city areas.

Inevitably the tide will turn. However, if you're asking me for a 'crash' prediction, while I have no doubt we will experience one, we are, in my opinion, a way from it yet. 

As for why prices are as high as they are, and the impacts this has on society as those on the fringes are increasingly forced out (as I point out here),  I would advise reading my latest article, which addresses the matter in detail.  

Harley Dale – Chief economist, Housing Industry Association Exclusive: How can we spot a housing bubble?

Price increases for residential property are being driven by Sydney and Melbourne. There is evidence that the price recovery is broadening, but overall growth outside our two largest capitals is modest. We don’t have a classic bubble scenario in Australia where a frenzy of speculative activity is rife and widespread.

Price increases in Sydney reflect the response to what was a severely supply-constrained market for nearly a decade, although we wouldn’t want to see current rates of growth sustained for a long period. The rate of growth in Melbourne should ease.

"We exaggerate price weakness when it occurs, but then lament a reversal to price growth" - Harley Dale

In general our population is increasing and our economy is growing, albeit not at the trend pace we would prefer.

We will see some broadening of dwelling price growth relative to that which is currently evident.

We don’t want to see the situation get out of control, but it isn’t.

We exaggerate price weakness when it occurs, but then lament a reversal to price growth. Let’s just carefully assess how prices behave over the course of this year and stop sensationalising the issue.

Exclusive: How can we spot a housing bubble?

Andrew Wilson Senior economist, Australian Property Monitors 

A bubble is certainly a nebulous concept because it is something that’s not really defined – other than the fact it ranks with other nightmare bedtime stories as a frightening concept for investors.

The reality is a lot different from the fear. The perception is that unsustainable growth leads to a collapse in housing prices.

That’s not the experience of the Australian housing market. In Australia, our market has been characterised by strong periods of growth, followed by moderate price corrections.

We’ve rarely seen any period of annualised price decline, and when we do it’s at very minor levels, with decline rarely over 5% in any year, while we see double figure growth at times.

We about the housing market in cycles, like the business market. And of course they’re very closely related in terms of their underlying drivers.

"As Mr Clinton once said, 'It’s the economy, stupid'.” - Andrew Wilson

If we look at the bottom of a cycle, in Australia the trough is always higher than the previous trough point. So the underlying trend is always upwards.

If the trough point is lower than the previous one, we should be concerned, because we’d be seeing a more exaggerated bubble shape.

So we actually have moderation in the correction phase - we have more of a “wave” shape rather than a bubble shape, and the thing that drives that is the underlying upward trend in our economic cycles.

We have income growth, with competition for labour putting upward pressure on income, which gives us the capacity to pay for houses, and we’ll continue to have that with a healthy economy.

That pattern will continue unless there is some catastrophic economic event. But we’ve had very strong downturns in economic activity before and we didn’t see that any bubbles burst.  

We have a rigid financial environment, which reflects risk aversion from banks. We don’t have a market for lending like the U.S. had, with a lot of speculative lending, which can give us that bubble shape.

As long as our economy continues to grow and as long as we have a rigid and risk adverse financial system, we won’t see a housing bubble.

We also have an underlying shortage of property in most centres. Those that have the biggest property shortages tend to have the more modest corrections, and don’t have the same peaks and troughs of those markets that have a more abundant supply line.

As Mr Clinton once said, “It’s the economy, stupid”.

And as long as the economy continues to be a strong performer in terms of economic growth, we’ll avoid any steep declines in housing prices.



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