Structure or cycle in housing?

Michael Yardney is a prominent property investor/advisor who writes a regular blog on Smart Company. Last week, Mr Yardney posted an article entitled What history can teach us about what’s ahead for property, which is aimed at calming nerves about the Australian housing market and convincing readers that residential housing is still a superior long-term investment option.

It was an intriguing piece to analyse because for once we had a property bull that was prepared to entertain the fact that property prices do sometimes go down. Indeed, Mr Yardley’s argument was that there are property cycles and you need to adjust your expectations to that fact.

Fair enough. But the piece still, sadly, left me cold. Below are key extracts from the article, along with counter-arguments to Mr Yardney’s claims [my emphasis].

I thought that today I’d delve into my memory and see what we can learn from previous cycles to help you understand where our markets are heading.

But before I do I’d like to remind you that while we’re currently in the slower stage of the property cycle, the bottom line is that as a long-term investment, property is hard to beat.

I remember reading a research report from Massey University suggesting that Australian residential property has been the best performing asset class over the long haul. The study dated back to 1920 and showed that property produced an average return of around 15% per annum (combining rental income and price gains) over all those years.

These figures don’t really reflect how good property is as an investment as they don’t take into account the power of leverage and the higher returns you can obtain on your own funds. When you factor this in property far outperforms all other asset classes over the long-term.

I had a bit of  a laugh after reading this claim. Just last week I stumbled across a report from Russell Investments claiming that after-tax returns from shares had outperformed property over the past 20 years (see below chart).

While I am not suggesting that Russell Investments is correct and Mr Yardney is wrong, the verdict about which investment is better over the long haul is unclear.

In any event, direct comparisons between the two asset classes are problematic as they are very different investments. Shares are highly liquid, more volatile, and have low holding/transaction costs, whereas the opposite is true for property.

Further, it is well know in investment circles that past performance is no indication of future profits. Just because Australian home prices have risen solidly in the past in no way means that they will continue to rise unabated in the future.

And whilst leverage works to enhance asset returns during an upswing, it has the opposite effect of amplifying losses when prices stagnate or fall – a risk that Mr Yardney glosses over. One only has to look at housing markets overseas to see that housing values can fall precipitously.

Arguably, the risks from gearing into housing are particularly high at present thanks to the low yields on offer, which are well below mortgage interest rates. Someone purchasing an investment property now would need to achieve solid capital growth just to offset the cash flow losses associated with holding property.

Back to the article.

But don’t get me wrong, while there’s little doubt that property is a potent wealth-builder in the long-term, it does go through the same kinds of cycles as other investment classes, which means that the reported high long-term average returns take into account periods of very high growth and also periods when property went nowhere for a few years….

But look at the property prices that prevailed 10 and 20 years ago and look at property prices today. Property investment is a long-term play – you need to be patient, as values in our major capital cities have doubled every seven to 10 years.

What were the factors behind those cycles?

It’s the old story of supply and demand. Property prices are pushed up by the demand created by a healthy economy, by high levels of employment, population movements caused by migration and immigration and positive market sentiment.

They are dragged down when the economy performs poorly, when interest rates rise, when employment and immigration figures fall, when supply exceeds demand and when the market place is nervous about their wealth and their future.

Cycles are an inevitable part of any investment market and our property markets are behaving normally at present.

Lets look at the real factors behind the so-called doubling of home values every seven to ten years.

First, there was the high inflation of the 1970s and 1980s that pushed-up the prices of everything, from homes to wages and food. When inflation is stripped-out of Australian home values, you find that home prices were actually relatively stable until the late 1980s (see below chart).

A breakdown of real house price growth by capital city is provided below:

Second, the strong gains in property values since the late 1980s were fuelled by an explosion of mortgage debt:

That’s been funded, to a large extent, by heavy offshore borrowings by Australia’s banks:

However, it is mathematically impossible for debt levels to continue rising at the rate of the past two decades. And without continual strong growth in mortgage credit, real home values cannot continue their upward march.

As noted by Data Diary yesterday, the recent sharp slowdown of mortgage credit issuance has resulted in the first trend-break in average loan values in 35 years (see below chart). If the slump in home lending continues, it will be difficult for house prices to hold steady, let alone increase.

Finally, the rampant buying of homes by the baby boomer generation had, until now, provided heavy tailwinds for home prices. However, with the baby boomers gradually entering retirement from 2011, and needing to free-up cash to fund their lifestyles by liquidating their investment property holdings and downsizing, home prices will face headwinds going forward. A recent study by the Bank for International Settlements (BIS) predicted that the ageing of the baby boomers would reduce Australia’s real house price growth by around 30% over the next 40 years compared to neutral demographics.

Anyway, back to the article.

What’s ahead for property?

Eventually the cycle will move on – it always has. And traditionally the more affluent suburbs tend to perform well at the beginning of the property cycle and that’s what is likely to happen again this time around…

As our economy and the sharemarket picks up, more affluent Australians will be back in the market upgrading their homes with many chasing similar types of property pushing up values in our more “up market” suburbs.

As values increase in these inner ring suburbs, the price differential between these and their neighbouring suburbs will increase. Soon buyers will start looking for ‘bargains” in these adjoining suburbs and the increase in property values will ripple out to the middle ring suburbs.

This increase in property values and higher rents will start to draw investors back into the market. However, many beginning investors will hold back at this early stage of the property cycle, waiting for more signs of certainty.

Of course while they are waiting many will miss out on significant property price growth the savvy investors who get in early and buy counter cyclically will enjoy.

There’s no mention of the significant risks facing the housing market or weighing-up of alternative (safer) investment opportunities (e.g. fixed interest). Even with acknowledgement of cycles, it’s more of the tired old “property only goes up… better buy before you miss out” argument, only worded differently.

Once again, past performance is no indication of future profits.

What about affordability?

Every cycle I hear the cry; “Property prices are too high! They can’t keep going up like that.”

I remember it in the early 80′s and then again in the late 80′s when people said house prices just can’t go up any more. “They are so high our children will never be able to afford a house.”

But prices doubled over the next decade until they again said the same in 2003 as prices rose through the boom that started in 2001.

Of course many are saying the same again now.

It is difficult to deny that homes were far more affordable in the 1980s than now. Australian capital city median multiples (median house prices divided by median household income) were around half what they are today (see below Demographia chart):

And mortgage interest payments absorbed a far smaller proportion of household income:

To add insult to injury, the above chart does not include the repayment of higher loan principal. When added alongside mortgage interest, housing affordability now compared to earlier periods is even worse.

Such low levels of affordability will act as a constraint on house price growth going forward.

Back to the article.

However, while most of us are sympathetic to the plight of the average first home buyer struggling to get into their first property, I feel that even if they don’t admit it, secretly most home owners enjoy hearing how house prices keep rising.

Those of us already in the “game” take comfort from the fact that our homes, our castles, are quietly but consistently increasing in value. And deep down we hope this continues because not only does it make us feel wealthier, it actually makes us wealthier.

Mr Yardley really lost me here. The biggest inter-generational transfer of wealth from young to old in history is a “game”, apparently. Let’s ignore the stress caused by higher debt burdens. Or that Australia is now increasingly vulnerable to external shocks because of the huge accumulation of debt, much of which has been borrowed from fickle international capital markets. Or that productive enterprises have been starved of funding because Australia’s banks have channelled the bulk of their lending towards housing. And I might add, if Mr Yardley remains in the game, he is currently getting less wealthy, though I can’t vouch for how that makes him feel.

In summary, our property markets are behaving normally working their way through their individual property cycles… Are you ready to exploit the opportunities that will arise?

Individual property cycles, sure. How about a structural shift towards unwinding the giant credit bubble that Mr Yardley so enthusiastically participated in building.

Cheers Leith

unconventionaleconomist@hotmail.com

www.twitter.com/Leithvo

41 Responses to “ “Structure or cycle in housing?”

  1. Rob JM says:

    And I thought history taught us that the collapse of the 1890′s housing bubble in melbourne led to property prices not catching up in real terms for another 90 years.

  2. Ranier Wolfcastle says:

    I’m curious: from memory Joye cites ~4.5-5.0 as the multiple, which is quite different from the numbers in the Demographia chart. What is the difference between how Joye gets his number and how they do?

    • Hi Ranier. This report from the Australian Institute of Actuaries provides a good overview of the different price-to-income methodologies (see pp 5-10).

    • The Prince says:

      I’m tempted to say the truth…

      UE and others have covered this before Ranier.

      The easiest way to explain it is that Joye uses two different measurements.

      First, his hedonic index – which you can’t see how he puts together – is different to ABS Capital City house prices.

      Second, his definition of income includes superannuation contributions, WorkCover premiums, Church/charity income, the imputed rent on your house (even if you occupy it and don’t rent it out) etc – this is from the National Accounts per householde, not from an actual determination of real pre-tax individual income.

    • The multiples quoted are of little importance.

      Whether you are looking at RPdatas figure which has gone from a multiple of 2 to 4.5 over the last 30 years:

      http://media.crikey.com.au/wp-content/uploads/2009/12/dwelling.jpg

      Or Demographia’s which have gone from around 3.5 to 8.

      Both show a similar real increase in prices against income regardless of the different methodologies used.

      • Stavros says:

        Ranioe…I think Critical Influence was one of the first bloggers to pick up on this issue: http://criticalinfluence.blogspot.com/2010/11/lies-damned-lies-and-housing-statistics.html

        Basically this bloke looked into the figures (Nation Accounts) used by the industry to lie and claim the income-multiple is only 4.5. He found it includes income sources that cannot be used to pay off mortgages (such as, the national accounts definition of ‘households’ include private non-profit organisations like churches and clubs).

        But like BB has pointed out…what ever mehtodology is used, the trend since the 80s is clear. House prices and incomes in Oz are way out of wack compared to historical trends.

  3. Steve says:

    I still cannot get over the amount of disclaimers & regulation those in the finance industry face, whereas these property spruikers face none of that and continue to spruik their flawed arguments with no intervention.

    Imagine if a financial adviser wrote an article saying you should leverage up into shares as much as you can, he’d be shot.

    • Deenominator says:

      Exactly.

      What about “shares double in value every 7 – 10 years” or “get in now or you’ll never be able to buy shares”?

      Even if you replaced shares with bananas you’d be in trouble, but apparently when it comes to houses you can say what ever you like..

  4. jesse says:

    “if Mr Yardley remains in the game, he is currently getting less wealthy”

    Ouch. Don’t worry, all property investors have a fail-safe plan: hold their assets until conditions improve, until real estate only goes up again.

    • darklydrawl says:

      Jesse,

      You forget that some (dare I say many) of these folks are on some rather tight LVR’s. Any capital gains are drawn down as the the deposit for the ‘next’ RE investment(s). The whole daisy chain scheme depends on property values being stable at the very least. Below is a direct quote from a property investment website I read the other day.

      “One of the basic rules when it comes to investing in residential property is that it is advisable to hold a property for at least one ‘doubling cycle‘, seven to ten years, if you want to see a reasonable capital growth. I have rarely seen anyone sell within five years and make money…are you in for the long term?

      The cost of stamp duty when buying together with agents fees when selling, means you will almost always lose (alright I must admit I had one of my 12 properties that tripled in value in three years so I could have sold it and made money but I didn’t as I could just draw down the increased equity at the time).”

      Read the last line carefully and tell me that is NOT a problem when property values are falling and the bank calls you to adjust your LVR on 11 properties.

      From: http://investmentmentor.com.au/news-commentary/from-the-desk/

      Many people have used their PPR and/or IP as an ATM over the last 20 years…

  5. Adrian says:

    These guys have vested interests so they’ll push the argument until it can be pushed no more.

    Pretty much everyone at the global CFA Institute conference this week point to rising interest rates.

    But Australia is different so our houses always go up, and our interest rates won’t effect our affordability. You never hear the truth from the industry or the government, but many developers I know tell a different story.

    The RBA will do it’s best to keep rates down, but there is nothing they can do about the $600B odd that is foreign sourced on the big four’s loan books. That will only change if the banks dip into our super and Bill Shorten has the key ready.

  6. Lefty says:

    “However, it is mathematically impossible for debt levels to continue rising at the rate of the past two decades. And without continual strong growth in mortgage credit, real home values cannot continue their upward march.”

    This fact seems so simple and clear that it should be self-evident. However, around the property blogs you will come across no shortage of zealots who will continually deny such mathematical facts and still expect to be taken seriously.

  7. Sandgroper Sceptic says:

    The Yardley article is vomit inducing. Renting is much cheaper than buying and values would have to fall 50-60% before they would be equivalent. Interestingly that is an order of magnitude similar to the price to income multiples that have been mentioned here. You would be far better off renting or moving back in with friends/family than taking on debt to buy these overvalued assets. Debt slavery beckons for many.

    The only thing buying has over renting at the moment is the ability to control one’s immediate destiny i.e. you are your own landlord. But that goes out the window if you have debt as effectively the bank is your “man” and if you cannot meet your monthly nut then you are beholden to the bank’s whims. Lose your job, or need to move to maintain your job or change in family circumstance all mean that you are better off renting!

    So unless you have 100% cash and really want to own, rent.

    • JC says:

      “The Yardney article is vomit inducing”

      + 1.

    • Steven Shaw says:

      and expect rents to soften in a bust (no increase 6% as the property lobby is trying to spruik up). Ironically, this means that the prices would need to fall further to even things up.

      I would characterise the choice as _borrowing_ verses renting and add that when you borrow, the bank owns the house and is your landlord of sorts (if less involved/hands-on).

  8. Marcia says:

    Smart Investor published an article last year comparing the returns to Australian property and Australian shares over the last 20 years (I’m afraid I got the dead-tree version so I can’t post a link). What they found was that either could be argued to have the highest returns, depending on what assumptions were made with respect to transactions costs, leverage, franking credits, tax etc.

    IIRC the main flaw in their reasoning was that they did not consider that the end point of their analysis period was at the peak of the property cycle and a middling point in the shares cycle.

  9. Andy! says:

    I read Mr Yardney’s market commentary every fortnight for interest & entertainment.

    My favourite to date was from a few weeks ago, entitled “the myth of risk”
    http://www.smartcompany.com.au/property-investor/20100428-the-myth-of-risk.html

    Enjoy.

  10. Sam Birmingham says:

    I love that a “leading expert in wealth creation through property” such as Mr Yardney can throw around phrases like “long-term investment”, “best performing asset class”, “how good property is as an investment” and “the power of leverage and the higher returns you can obtain on your own funds” without any regulatory oversight… It fills me with confidence!

    In other news, he might be interested in recent calcs which found the “real rate of return on a typical home” in the US over the past 35 years to be –0.575%pa — Ouch! http://web.hbr.org/email/archive/dailystat.php?date=050911

  11. JR says:

    Two points:

    Saul Eslake cited the lack of housing supply in his guest piece, and nobody called him on it.

    wrt to how the bubble will burst…in the British example, it is currently being kept inflated by zero interest rates, but that is unlikely to continue. It seems to me unlikely (but tell me I’m wrong) in the current inflationary environment that the Aus govt would push interest rates to zero.

  12. PhilBest says:

    Yes, JR, what I recently concluded is that inflated land prices are themselves a drag on the productive part of the economy; the economy simply cannot sustain the cost burden indefinitely, regardless of what the government and the banks do to prop it up. Postponing the bust surely only makes it bigger and more volatile.

    I had many arguments on Interest.Co.Nz with Kieran Trass, the author of a book on housing cycles and property investment; whose arguments were very like Michael Yardney’s. I kept telling him that his book was out of date in that it did not discuss the new paradigm of “save the planet from global warming”, anti-sprawl development processes that make land prices so much more volatile.

    Britain’s increasingly volatile land price “cycle” since their 1947 Planning Act, is a 15 year one. Japan’s land prices have been going down for 20 years from their bubble peak. Good luck if you are a property investor hanging on for “long term gains” under this scenario. The clever British investor (following the advice of, say, Fred Harrison) would be buying and selling at the right points in each cycle, not hanging onto their property for long term gains. Buying at the WORST point would doom an investor to negative returns for most of the next 15 years.

    By the way, Japan is rebounding economically. No-one seems to get the connection between the resumption of sensible land prices (at last) and economic recovery, though. “Wealth” from rising land values might feel good for some people, but for everyone looking to actually PRODUCE anything, rising land prices represent a COST burden and even an outright barrier. I think this is economics lesson number one that everyone needs to take out of all this. Incumbent, inefficient owners of land are often sheltered by the barriers to entry faced by competitors. Remember that most long term econ growth comes from new startups. The genius of free markets is “creative destruction”, not incumbency.

  13. PhilBest says:

    Yardney: “…..However, while most of us are sympathetic to the plight of the average first home buyer struggling to get into their first property, I feel that even if they don’t admit it, secretly most home owners enjoy hearing how house prices keep rising.

    Those of us already in the “game” take comfort from the fact that our homes, our castles, are quietly but consistently increasing in value. And deep down we hope this continues because not only does it make us feel wealthier, it actually makes us wealthier…..”

    Leith: “…..Mr Yardley really lost me here. The biggest inter-generational transfer of wealth from young to old in history is a “game”, apparently. Let’s ignore the stress caused by higher debt burdens. Or that Australia is now increasingly vulnerable to external shocks because of the huge accumulation of debt, much of which has been borrowed from fickle international capital markets. Or that productive enterprises have been starved of funding because Australia’s banks have channelled the bulk of their lending towards housing…..”

    HEAR, HEAR. These property price bubbles, and the supply side policies that cause them, could hardly have been more cunningly devised than if some Quislings in the pay of an enemy power had devised them. They are economic WMD’s. Yet they create a massive, national-suicidal, constituency of support for their perpetuation.

    • PhilBest says:

      I recently read “Love Letter to America” by Tomas Shuman. This was published in 1984; Shuman was a KGB defector. He lists myriad ways the KGB used to subvert a nation; ideals of mass high density urbanisation and the “de-land-isation” of people, was one of them.

      He also says of the generation of Americans first targeted for indoctrination via the universities:

      “….the semi¬literate and unstable American generation of the ‘crazy’ 1960′s is now approaching the age of 40. These people, who were too preoccupied with protesting the Vietnam war, the drug/ rock music scene, taking part in ‘love-ins’ etc., to study and prepare for assuming their civil responsibilities, are now in positions of power and decision-making in government, business, media, social life, entertainment (Hollywood), military, and intelligence services. Not all of them? OK, some of them are. You are STUCK with them, until they retire or resign. You cannot fire them it’s against union regulations. You cannot, unlike the USSR, send them to Alaska, after declaring them ‘enemies of people.’ You can not even openly and effectively criticize them– they have invaded the media and control public opinion. Un1ess you want to be cal1ed ‘McCarthyist,’ you cannot change their attitudes and mores. At this age people are usually ‘set’ in their ways as individuals. YOU ARE STUCK with them. THEY change your attitudes and opinions, they navigate the domestic and foreign affairs, they are making decisions and choices for YOU, whether you like it or not.

      To change the direction of America’s future and to return to the basic American values, proven to be efficient and productive for almost 200 years of historically unprecedented freedom and affluence, you have to educate a NEW generation of Americans, this time in the spirit of patriotism and CAPITALISM….”

  14. Rod says:

    Rising house prices are caused by gov’t policy. Issue/print less money and prices go down and vice versa. Rising prices don’t indicate wealth generation unless you are a skilful trader.

    It seems there is a limit to how much debt even complete mugs will take on. It occurs when all income is gone on debt repayment and other necessities can no longer be bought with cash or credit.

  15. Mr Q says:

    Yardley: “Those of us already in the “game” take comfort from the fact that our homes, our castles, are quietly but consistently increasing in value. And deep down we hope this continues because not only does it make us feel wealthier, it actually makes us wealthier.”

    Really? If it’s the house you live in, it doesn’t make you one cent wealthier if it’s worth $100,000 or $1,000,000. It’s still exactly the same house, provides you exactly the same income (0), and provides the same functionality. If your house value goes up, you don’t suddenly get liquid gold pouring out the taps.

    What you might get is equity in the property – but even that’s pretty false – whatever you buy with that you still have to pay back. And if you lose the house because of your idiocy, you can’t buy a similar house for what you paid for the first one – they’ve gone up too. OK, you can buy something at mortgage rates – but you still have to find the additional money to pay it back. It’s only slightly less foolish than taking out a personal loan.

    Worse, if you’re in the market to upsize (perhaps you’ve got a couple of extra kids for instance), rising house prices make you poorer – because the price differential between the house you’ve got and the one you want to buy is higher.

    The people who are wealthier as a consequence of house prices going up aren’t the owner-occupiers – they’re the investors that are sucking the blood out of the rest of the economy like so many leeches.

  16. Steven Shaw says:

    I was googling for historical house prices today (many old chart up the last 10 years of the boom). Unfortunately I came across this sorry chap talking up the usual “property doubles even 7-12 years”.

    http://www.retireonproperty.com/propertyinvesting/research/australian-property-prices-since-1960.html

  17. Seanm says:

    Creditor Preditor.

    Read a good article that compared credit growth to a shark having to continuously swim forward or it dies.

    Who or what is it hunting?

    Now you know what the RBA and Glenn Stevens do for a living. Creditor/Preditor.

  18. Tonydd says:

    Thanks Rob, Your first par is golden in explanation of the recen current circumstances.

  19. Jani S. says:

    I am stunned after reading this text!! I accidentally ended to read your blog and I could swear that you’re writing about the housing bubble situation in Finland, on the other side of the globe.. 
    Even the graphs about real house price index (albeit we had a huge drop in 90′s), housing debt and average loan size match totally, not to mention the one-liners from spin doctors of real-estate agencies and banks.
    It’s obviously a global phenomenon (a conspiracy perhaps:) ) which seems to put the younger people under huge amounts of debt and let the older generation become rich at their expense or as you so nicely summarize it: ‘biggest inter-generational transfer of wealth from young to old history’! 
    Look forward to your upcoming postings!