Don't be made complacent by good recent economic data

The ‘feel good’ furore surrounding Australia’s real estate market continues to grow.

In Melbourne, news that overall turnover is some 15% above that recorded this time last year and a collective year-to-date clearance rate of 69% has been welcome news for those that work in the real estate industry and make their money from promoting the ‘buy now’ mantra – a phrase that doesn’t carry as much weight when prices are flat or falling.

In annual terms, both owner-occupation and investment lending in Victoria have increased by 2.5% and 18.6% respectively – proving the attraction real estate continues to hold as an ‘appreciating’ asset.

We’re once again witnessing increased competition around favoured stock that motivates the old angst amongst buyers, of ‘get in quick before it’s too late’ – a feeling Melburnians are all too used to seeing in a heated auction atmosphere which, out of all the states, Victoria rules.

However, whilst the positive data has provided an interesting ‘told you so’ moment from some of our popular property commentators (who are again trying to convince us that property can continually go up in value and effectively double in a time span of  anywhere between 7 – 10 years, depending on their stance) there is plenty of data that should pose a warning for those thinking we’re simply back in the same cyclical atmosphere which leads us through the ebb and flow of the oft-quoted ‘property clock’ where growth can forever outpace the rate of inflation.

John Edwards from Residex was one voice to highlight that sales transactions remain very low nationally, with January and February’s data “the lowest seen on an Australia-wide basis since 1999.”

This is a concern, because whilst the population continues to expand and new households inevitably form, we once again have to yearn for an improvement in the construction sector for any indication that the trend of demand to live and invest in established urban areas – which has played a part in disproportionately inflating capital city values – can be moderated through de-centralisation, the process of which is hopelessly hamstrung due to lack of investment in outer suburban infrastructure and ‘inelastic’ policy responses to demand/supply factors.

Notwithstanding, considering our relatively short-term existence, it’s easy to view Australia’s recent inflationary history as the ‘norm’ – imagining the patterns witnessed over a lifespan can repeat ‘forever more.’

Such is the claim of property investors who have ‘lived’ through 2 or 3 ‘cycles’ and foresee a future not much different from their immediate past.

However, if you delve back into the long-term history of house prices, it’s clear how the past 50 years is completely new in relation to the decades that preceded the hearty capital gains we’ve grown accustomed to achieving – gains which hit their peak in 2010 and are once again on the road to recovery – and gains which have shown a disproportionate inflationary trend which could never have eventuated from population growth alone.

Rather our recent historical gains have been primarily fuelled through a massive burden of private debt conjured up through the ‘magic money tree’ of liberal bank lending – far outside of the fabled deposit ratios we were fooled into believing in high-school economics.

I’ve previously written about the Herengracht index which charts a 360 year history of house and rent growth along an established strip of prime real estate in Amsterdam; the results of which concluded that outside periodic market volatility caused by wars, famines, and population factors - prices didn’t stray far from the rate of inflation – in real terms, they remained broadly unchanged.

Once completed, the study prompted respected analyst Robert Shiller to conduct his own long-term analysis of USA house prices, after which he stated – pre-GFC (2006) – that we can’t use the past 20 years to predict the future 20 years – a longer time frame is necessary if we’re to establish how sustainable our inflationary environment really is. In 2006 Shiller commented:

“The news is not good for homeowners. According to our data, homeowners face substantial risk of much lower prices that could stay low for a long time after.”

Whilst Robert Shiller’s prophecy is currently playing out in the USA – although exaggerated due to their irresponsible and unregulated system of sub-prime lending, we’ve yet to see any significant or comparable effect on prices in Australia, outside of a relatively short-term blip in median data, amidst various government-imposed measures to keep stimulating (propping up) prices.

Notwithstanding, the trend that Eichholtz’s study on the Herengracht index and Shiller’s of USA prices highlighted, is consistent with other long-term data – most notably data collected and analysed by Nigel Stapledon from The Australian School of Business, who in 2010 put together a detailed paper charting the history of house prices in Australia between 1880-2010.

Stapledon gathered the information for his study from various sources – including early advertised price ranges in print media during periods in which more detailed information was unavailable.

He then spliced this together with more recent house price indexes, producing a paper which clearly highlights how unprecedented – on a broader time scale – the comparatively recent, and for the most part unbroken, price hikes in residential real estate outside the rate of CPI inflation, has been.

Stapledon points out a series of seven ‘major economic cycles’ which include the two great depressions of the 1890s and 1930s, the gold rushes in the 1850s and 1860s, along with various and significant fluctuations in population growth throughout the analysed time scale.

Each played a part in the consequential boom and bust cycles to 1970, however when smoothed out, price growth to this date broadly tracked the rate of inflation changing little in real terms.

Even from 1970 to the most recent boom, prices stayed relatively stable, rising on average only 3% per annum.

However, the latest boom, which peaked in 2010, has dwarfed anything seen prior or since, and in this respect it’s worth quoting Stapledon in full:

“While much has been written about the excesses of the 1880s boom, in terms of magnitude of cyclical upswings in house prices, the price rises of the 1880s pale next to those of the last cycle starting in the 1990s. This last cycle has seen house prices rise by 111% in real terms versus, by comparison, a modest 33% in the 1880s.”

Yes – over the past 20 years, we’ve had the “mother of all property booms” in residential real estate and consequently, we have an asset class well suited to rampant speculation.

Property currently makes up 15% of the total value of assets held by Australian SMSFs and with the government threatening to dip its sticky fingers into super funds, along with evidence that median values are once again on the up, an increased move towards negative gearing is inevitable.

As the Reserve Bank’s assistant governor Christopher Kent recently noted in his speech “Recent Developments in the Australian Housing Market”, investors need no longer fear any capital loss – effectively waving a 'go ahead, green flag' of encouragement to any still sitting on the sidelines whilst at the same time noting recent rises have been driven by “repeat-buyer owner-occupiers as well as investors.”

Potential first-home buyers suffer the unfortunate haphazard consequence of being born too late to enjoy the leverage party with RateCity noting the average first-home buyer’s loan size has not only doubled in the past decade, but now sits almost three times higher than the level borrowed 15 years ago - a figure which is apparently 82% above the inflation-adjusted average loan size.

However, those thinking the past 20 years is a good enough cycle on which to base the next 20, best of luck to you because despite our buffers and to some extent fair economic management through a GFC environment, to expect the real price of residential real estate to continually rise outside the rate of inflation has its fate in a shaky end, as history will attest.

It’s easy to look across the expanse of ocean that separates us from both Europe and the USA and come up with a fairly academic case as to why ‘Australia is different’.  We have the mining sector, low unemployment, population growth, supply constraints, wage growth… all of which is used as evidence to calm would-be investors against any thought that we could suffer the same fate. The premise is, whilst we can continue to pay our debts and prop up consumer spending, it’s ‘all alright Jack’… or is it?

Prior to the GFC, any talk of regulation in banking was effectively brushed aside under the concept that policy was well equipped to deal with the resulting consequences.

However, changes which have been ushered in during the post-GFC environment are no buffer against price rises and arguably only offer limited security against a future which must by definition forever be bigger than the past in order to ensure continued capital growth (a needed reality to our current system of banking).

As Giovannu Dell’Ariccia – an advisor in the research department at the IMF – wrote last year, in a detailed paper entitled “Property Prices and Bank Risk-taking”, discussing the effectiveness of policy changes in light of the GFC:

“We should recognise at the onset that there is no silver bullet. Each policy entails costs and distortions. And effectiveness is limited by loopholes and implementation problems. Broad-reaching measures (such as a change in the monetary policy rate) are more difficult to circumvent but they typically involve greater costs. More targeted measures (such as maximum LTV ratios) may have more limited costs but they are challenged by loopholes, which may jeopardise their efficacy.”

His analysis is worth reading in full – primarily because it outlines how difficult it is to restrain credit when there is no “unifying theory of how banks behave over the business cycle and react to changes in asset prices, much less a theory about how banks react specifically to real estate market developments”.

Therefore, at the risk of being called a ‘nervous nelly’ – or worse still – a ‘doomsayer,’ reading recent reports that evidence a return to ‘no deposit’ lending and suggestions that ‘shonky’ practices still sit relatively ‘comfortably’ in our newly ‘regulated’ environment should cause concern.

Therefore, whilst increased confidence and rising medians along with ‘on the face of it’ good economic data can calm worries of an imminent crash, we are in no way immune. Retiring with a debt-free roof overhead is preferable. However, when it comes to investment, take my advice and remain well diversified.

Catherine Cashmore is a market analyst with extensive experience in all aspects relating to property acquisition.