Safe as (straw) houses

Whilst I was on vacation escaping the bitter Melbourne cold, Morgan Stanley Chief Strategist, Gerard Minack, released an excellent research article on the Australian housing market, entitled Living in a Bubble. Mr Minack’s article received widespread coverage in the press (for example, see here and here), so it is likely that many Australian readers are aware of his analysis already. And fellow economics blogger,  Cameron Murray, has provided some nice analysis of some of the key themes raised in this article.

I was lucky enough to receive a copy of the actual article upon my return from leave yesterday. And let me say that it is an enlightening  piece of analysis that pretty much supports everything that this blog has said about the Australian housing market. For the benefit of our international readers and those whom this analysis has escaped, I thought that I would provide an overview of the key themes covered and share some of my own thoughts.

Houses expensive no matter which way you cut it:

In Mr Minack’s view, “Australia’s house prices are expensive on every value metric. They are expensive relative to history, and expensive relative to houses in comparable countries”. He provides four charts showing the extent of over-valuation. The first three charts show that Australian residential housing is very expensive based on standard valuation metrics:

  • house prices to GDP per capita are around 50% above fair value;
  • the value of the housing stock relative to household disposable income is around 35% above fair value (based on pre-2000 trend growth); and
  • house prices when compared to gross rental yields are about 40% above fair value.

Further, house prices started to move above fair value around 2000 on all three valuation metrics, which is when the Australian housing bubble began.

Mr Minack’s fourth chart, shown below, is particularly interesting. It compares the multiple of median house prices to median gross household incomes by city size in the September quarter of 2009 in several Anglo countries – Australia, US, Canada, UK, New Zealand and Ireland.

“The best-fit lines suggest that Australian house prices are around 40% more expensive than the average for UK, Canada, New Zealand and Ireland, adjusting for city-size. If the US is included, the overvaluation is around 85%.”

Bubble Drivers:

According to Mr Minack, “the single most important reason [for the housing bubble] is the increasing willingness and ability of households to increase leverage” [i.e. easy credit].

And in what should be a slap in the face of the property spruikers, he debunks the claim that population growth and housing shortages have played a significant role in driving-up house prices. As shown by the below chart, house prices outside of the capital cities have risen faster than capital city prices since the early 2000s.  As Cameron Murray correctly pointed out, “If such supply-side constraints really could explain prices, we would expect to see city prices climbing much more than in regional areas. Alas, this is not the case, with almost identical price gains in the past 15 years”.

Negative gearing explosion:
A large part of the increased willingness of households to increase leverage has come from the explosion of negatively geared (loss-making) housing investment. On this issue, Mr Minack’s research mirrors the findings of my earlier post, Negative Gearing Exposed. According to Mr Minack:

“Australia has become a nation of landlords: in 1988-89, 608,000 taxpayers reported rental income, by 2007-08 1,765,00 taxpayers did – 13½% of the total” [see below chart].

Whilst Mr Minack acknowledges that residential housing has been an excellent investment over the past 10 years, due to the robust capital growth, he warns that it is “extremely unwise to expect such gains to continue given current valuations. The investment fundamentals of housing have sharply deteriorated.

As shown by the below chart, “Australian Tax Office data confirm that residential investment is a poor investment: total rent has not covered total costs since FY2000 (the date the bubble started to inflate). In short, this is an investment that depends on capital gain for its payback. With net income not even covering interest charges, this is a classic Hyman Minsky Ponzi scheme”.

Furthermore, the percentage of landlords claiming net rental losses (where rent fails to cover both interest and other costs) has blown out from 50% to 70% over the past decade (see below chart).

According to Mr Minack, “it’s not just that there are more landlords, there are more loss-making landlords. This matters a lot. Much of the discussion on the residential market concentrates on owner-occupiers. But arguably property investors represent a significantly larger risk if they became widespread sellers of their loss-making investments”.

Bubble deniers often argue that the risk of widespread sales by investors is low since rental properties are mostly owned by higher income earners who are better placed to absorb losses. But Mr Minack debunks this claim as well:

“Only 3% of all loss-making properties are owned by taxpayers with a taxable income of over $200,000. Taxpayers who earn $80,000 or less own 80% of all loss-making properties…The loss is typically around 10% of income”.

Australia’s debt profile similar to America’s:

Mr Minack also refutes the Reserve Bank of Australia’s (RBA) claim that Australia’s high household debt levels – currently 157% of disposable income – is not a major risk factor because it largely sits with upper-income earners: “…our [the RBA’s] assessment is that the increase in debt has broadly been concentrated in the hands of those generally more able to service it”.

Rather, as shown by the below chart, at the peak of the US housing bubble the top 20% of US households held an even larger share of household debt than their Australian counterparts. More debt as a share of the total is held by middle income households in Australia, most likely due to the high level of negatively geared property investment by middle income earners.

Furthermore, the argument that debt levels are safe since asset values have also risen accordingly (and household balance sheets remain strong) is questioned by Mr Minack:

“The essence of every asset bubble is that asset prices rise as debt levels rise. The process is linked: rising asset prices encourage more borrowers, and the higher asset prices often serve as collateral for additional borrowing. That is why debt-to-asset ratios do not look problematic at the top of most asset bubbles.

Mr Minack provides an ominous chart (below) showing the debt and asset holdings of American households ranked by income in 2007. At all income levels, asset values exceeded debt levels. Yet this apparent balance sheet strength did not prevent the widespread meltdown currently being experienced by the US housing market and broader US economy.

A bubble in search of a prick:

Mr Minack completely rejects the notion that Australia’s housing market is somehow different from the rest of the world and that our economy is not at risk from a significant housing correction:

“The global financial crisis was rooted in excess debt, particularly housing-related debt. Many analysts take comfort from the differences between the Australian housing market and America. But this was a global bubble, and house prices are down in many countries that had seen house prices rise over the past decade. Many of those other markets did not share the same peculiarities of the US market (fixed rate mortgages, non-recourse lending, sharp increase in supply). To say Australia is not America is to knock over a straw man.”

Although Mr Minack notes that bubbles more often pop than subside, he believes that it is unlikely that Australia’s housing bubble will burst abruptly and we will see large price declines in the near term, since this outcome would require broad-based job losses. Rather, the best case outcome for Australia is that real house prices deflate slowly as they did in Sydney from the late 1980s and from 2004.

Nevertheless, he warns that house prices can show no growth in real terms for many years. For example, real house prices in Melbourne did not surpass their 1891 peak until 2001 (see below chart). And he expects real returns on residential property investment to be negative over the next decade.

Mr Minack believes that there is a risk that flat to falling house prices could create “selling pressure” from negatively geared (loss-making) property investors looking to exit the market.

I will add that the pending retirement of the Baby Boomer generation is likely to accelerate selling by property investors. As discussed in my previous post:

“A key driver of Australian house prices since 2000 has been the explosion of negatively geared housing investment as the Baby Boomer generation reached their peak earnings age and started ‘saving’ for retirement by speculating on housing. But with the Baby Boomers soon to enter retirement, they will no longer be able to negatively gear. Further, since rental yields are pathetically low (around 3% after costs) and with the potential for continued capital appreciation diminished, it is highly likely that the Boomers will dump their investment properties en masse in order to fund their retirements, thereby causing a nasty housing correction”.

For these reasons, a housing correction is, in my opinion, inevitable. It’s only a matter of when and by how far prices fall.

Beggar thy neighbour:

In conclusion, Mr Minack takes a swipe at policy makers for allowing the housing bubble to inflate in the first place and questions the broader social and economic impacts arising from rising house prices:

“It was a major error by policy-makers to let this bubble inflate, in my view. There is no value to society from rising house prices. It is simply a wealth transfer to existing owners from potential buyers. Pumping up house prices creates no more wealth than the RBA printing an extra six zeros on every piece of currency. Worse, by increasing the leverage in the household sector and financial system, it increases the financial risks in the economy, as the last two years have demonstrated elsewhere. In short, there seems a strong case for policy-makers to aim to cap house prices.”

I couldn’t agree more. As discussed in Bringing it Home, in light of the major role that excessive credit has played in creating Australia’s housing bubble, and that the Australian banking sector faced insolvency requiring a Government bail-out during the GFC (via the bank funding and deposit guarantees), there is a clear role for greater regulation of mortgage lending to prevent the excesses that lead to asset bubbles. One solution is to introduce macro-prudential measures, such as maximum loan-to-value ratios,  debt service to income limits, or limits on the amount of loans that can be extended against short-term funding sources. Such measures would help to strengthen the resilience of Australia’s financial system by mitigating the build-up of excesses in credit growth and asset (house) prices.

Had such macro-prudential measures been in place globally during the 2000s, it is possible that the GFC would never have taken place, since the kinds of speculative housing lending undertaken in the United States and Europe would not have been possible. It is also likely that Australia’s house prices would never have surged like they did post-2000, since access to credit and the ability to undertake highly leveraged purchases would have been muted. Houses would now be much more affordable as a result.

Furthermore, the new Australian Government should, in it’s first term, undertake another Financial System Inquiry (FSI) to examine some of these financial stability issues. The previous Inquiry (the ‘Wallis’ Inquiry), completed in 1997, never envisaged systemic risk engulfing financial markets as well as intermediaries, as occurred during the GFC. Nor was the Basel Committee’s idea of macro-prudential regulation (discussed above) ever considered. Finally, the Government’s October 2008 decision to guarantee bank funding and deposits completely ignored one of the original FSI’s key recommendations – that no government would ever guarantee any part of the financial system. The long-term implications of using the Government’s balance sheet as role of guarantor of last resort for the banks’ wholesale debts is also unclear and needs to be comprehensively examined by such an inquiry.

Let’s hope that the new government tackles these important issues.

Till next time.

Cheers Leith

Unconventional Economist
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  1. Thanks Leith for another very good article, as I type this i am listening to real estate show..hmm.
    I'm a boomer (early 50's) own my home and 1 investment flat outright. Have 2 other investment props and just sold 1 of them in inner west Sydney as I semi retired as I agree with all the comments above. Now one other reason that will make boomers sell is that a lot of them were employed in the manufacturing industry which has now moved mostly to Asia. This has led to a lot of redundancies and when this money is spent (travelling around Aus etc) a lot of their investment props will come onto the market as they cannot find any jobs in a non existent manufacturing sector. 6% in bank deposits looks better even with paying a bit of tax. Cheers.

  2. Hi Leith,
    As some one who has mirrored your beliefs for a long time to doubting friends it's great to find such fact filled posts. Some questions regarding the bigger picture.

    If were so dependent on China. Could we potentially be in greater trouble than the USA during the GFC.

    If China bursts, unemployement goes up as the mining industry that has propped up our 'solid economy' through the GFC suffers. Shares (read stock market) and spin off benefits to community from our mining boom go down. Super and investments such as property are sold to prop up less than expected retirement benefits, or sold as unemployment affects morgage repayments. I've over simplified it but it is a rather bleak possiblity as it doesn't just concern real estate. Is it an unrealistic one? Is it likely we see the both real estate and stock market fall significantly together? Where would people hide their super and investments to survive such a nuclear financial winter?

  3. Hi Leith,

    excellent post, I feel like your blog has picked up Steve Keen's torch which is fantastic.

    I think your dead right and on the money again with this post and Gerard's comments.

    Sometimes in life it is easier to run with the flock than to 'think different' in fact being different causes odd sideways looks and internal giggles. "Oh so you "rent" well never mind, you might be able to get an apartment or move out of Melbourne". I have had quite a few comments like this over the last 8 years.

    What makes me laugh inside is that whilst we rent, it costs us less than 15% of our total income and we save. We have saved a lot of money and it is working hard for us including the compounding interest.

    We want for nothing, don't need anything and are really happy.

    I guess Australians are blinded by the notion they have to have own a home to be "happy" and safe and secure… yeah right most of the people I know pay 35% plus straight to their mortgage every month. Ouch.

    Think life is easier when you have savings, no stress about bills and can invest your money.

    Also we can move at anytime!

    Anyhoo, love your blog it just reinforces that we are right to have chosen out own path.

    Thanks Leith!

    The Mainlander.

  4. Leith van Onselen

    Thanks for your feedback guys. Sometimes I wonder if I'm being too pessimistic when writing these blogs, especially when many colleagues, friends and others disagree with my opinions on the Australian property market. But facts are facts. Also, being compared with Steve Keen is a badge of honour for me. I'm a big fan of his work and typically agree with his analysis. It's just a pitty that he got caught in that stupid bet with Rory Robertson and that it has diverted attention from his key warnings about excessive debt levels.

    Damian. The scary situation that you have described is possible if China's economy stalls significantly and Australia is caught in a simultaneous terms of trade, credit and demographic crunch. Although, I wouldn't try to ascribe a probability to such an event occurring (your guess is as good as mine).

    One thing that would work in Australia's favour if such an event eventuated is that our government has far lower levels of debt compared with the US and higher starting interest rates. As such, the government and RBA have far more scope to respond to a major crisis than the US. But we would likely still experience significant pain.

  5. Great Post Leith,

    Your handling of the subject matter shows your respect of the facts, your reader’s intelligence, unlike the dribble one reads in 99% of the broadsheets.

    To take two quotes from Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay (first published 1841)

    "Of all the offspring of Time, Error is the most ancient, and is so old and familiar an acquaintance, that Truth, when discovered, comes upon most of us like an intruder, and meets the intruder's welcome."

    "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

    Best Regards,


  6. A nice gentle warning, the piece does not try to scare. I lived through a large property crash (UK 1989)and it had a specific trigger, the removal of a beneficial tax rule for home owners. The removal of negative gearing would be a similar trigger and I believe there is no way a government would risk appearing to be responsible for a property crash, so this will stay and keep properties at unrealistic levels.

  7. Thanks for the ongoing analysis Leith. It's hard to get a good, balanced approach these days.
    I'm in my mid 30's and have been working overseas for quite a few years. I'd like to buy a place back in Australia but the bar just gets raised higher and higher. After years of feeling that I was missing out, I now take comfort from having sat on the fence.
    Looking in from overseas, it seems like alot of people have been getting rather greedy in Australia and the majority of the middle aged and younger generation are going to pay the price, if they are not already.
    Given the level at which median house prices sit, there does not seem to be much point in returning to Australia in the next 5 to 10 years by which time sanity will hopefully prevail. The last thing I want to see is heavily in-debt Aussies get burnt by a correction or heavy interest rate rise but they have dug a pretty big hole to climb out of. I hope for their sake that the adjustment is gradual but I fear that markets can be unforgiving.

  8. It is interesting that the prices had a massive peak in 1890. Could this subsequent boom and bust be attributed to the significant wealth in Victoria generated from the Gold Rush, flooding the market with capital? This could have led to the idea that there was a massive “undersupply” of houses and when the bubble burst, prices plummeted. The crash coincides with the end of that era.

    Is this similar to the mining boom/availability of finance situation that we are seeing now? Without any proper investigation is seems suspiciously similar. Between 1880 and 1890 Melbourne’s population doubled.

  9. While I agree with you on the housing bubble. I would differ on the solution.

    The last thing we need is more interference in the markets. The government has made a mess of it so far so why will they be able to fix it. History proves that governments can't fix anything, they just make more mess.

    Instead let the people who have made malinvestments learn from their mistakes.

  10. Damian –
    Steve Keen, among others, has addressed the misconception regarding China – consider that there was limited changed in Chinas uptake of Australian resources,they did not increase their purchases, so they did not offset the effects of the GFC – it had no impact. China did not save us – it just kept on doing what it was doing – the Stimulus package saved us – people simply refuse to believe it and hence point to China and say they saved us.

    If China had have stopped buying it would have impacted our balance sheets – yes – but not in the way people think. Remember the VAST majority of Australia are not miners, nor service mines. In fact not that many of us are even share holders, further the vast majority of the stakes are held off shore.

    Right now we are still benefiting from the stimulus. Not Chinas increase in spending (there was none – they just maintained it).

    Having said that – however – come another dip and we are in a position to create another stimulus to see through the next dip as we have such low Public debt to GDP relatively speaking – HOWEVER – due to the massive scare campaign run by the right – this will not be an option. So come the next dip China will pull back (already is), and there will be no stimulus. That will be a the killer.

    The one feature which is never discussed amongst Bloggs like this and Steves is the real reason why prices are high – it is artificial market manipulation – Land Banking.

    How is that a country with one of the lowest densities on earth – almost uninhabited – can have such scarcity of land ? It is not houses that are expensive – but land.

    One of the best indicators of an artificial housing market is the relative value of agricultural to urban land values. Australian farms, (look at Tassie Dairy Farmers) are giving it away. Ten meters to the left, zoned housing, and it is through the roof. How is it that you can buy a house in the cattle paddocks 20, 30. 40km from Melbourne (literally)for almost half a million dollars for a quarter acre (2 million dollars an acre)- yet the farm next door without planning approval is on the knock for next to nothing. Couple of thousand acres for less than 2 million……..something SERIOUSLY askew. And don't tell me its about planning, sustainability and the environment – there is nothing in these joints that will last more than 10 years, no services, no planning, nothing – just a government directed market.

    Land Banking.

  11. Been reading Harry S Dent for 15 years. He predicted all this back in the late 1980s and we started selling up in 2006, as he recommended, and now sitting in cash. Since discovering broadband the field has broadened. I believe Harry and Steve (Keen) have developed mutual respect.Here on the Sunshine Coast lotta property investors/'leveragers' getting nervous. Some capitulating already. Keep the faith…and Watchunder!

  12. Very good article.

    I have been bearish on housing since 2005 and i hope one day my holding off and renting will be vindicated with the inevitable crash.


  13. Supply and Demand. More houses than people every year. Melbourne the greatest city in the world. Housing loans are really hard to get, and people only default when unemployment rises, it's lower that the developed world. Also in Melbourne, rents and mortgage repayments as a % of average income are the same they were 110 years ago. Nothing to see here, move along. Also, negative gearing policies oprop up property investment.

  14. Anonymous "Supply and Demand"

    The concept of supply and demand does not work very well with financial assets. When the prices increase, so does demand. This creates bubbles.

  15. I enjoyed the post a lot. There is something I do not understand and maybe it's because I do not know the details of the negative gearing system . While I accept that removing negative gearing altogether would cause a substantial sudden drop in house prices which might have strong "unwanted" side effects, I wonder whether it would be possible to phase out negative gearing, over a number of years. Certainly many investors would drop housing but for others, a smaller rate of negative gearing might not change the investment decision. What I also wonder is why there is NO political party willing to tackle the issue. And I am not talking about the big parties, but the smaller one, which could gain many votes because there are so many people priced out. Is it because people are not making their voices heard? Mario

  16. Leith van Onselen

    G'day Mario. My earlier post, Negative Gearing Exposed, provides a detailed examination of the efficacy of negative gearing and its impact on housing prices and the rental market. In that post, I recommended some policy amendments – specifically removing negative gearing concessions from pre-existing housing and retaining it on new construction only.

    I am not surprised that the major parties won't touch negative gearing, since its removal would lead to large house price falls, but I too am very surprised that the smaller parties (e.g. the Greens) are not pushing hard for its removal.

  17. Thanks for your reply Leith. I agree, removing negative gearing concessions from pre-existing housing and retaining it on new construction only would make things better and would be easier to sell than just an altogether removal. The idea of a sharp fall in house prices scares many, even non house owners, and particularly politicians. But, as you correctly point out, there is another issue that should be clearly highlighted: negative gearing implies a redistribution of income. I have to pay more taxes because someone else is paying less thanks to negative gearing. This is "unfair", so crazily unfair. I have been in Oz for 3 years now, but I do not think this point is stressed hard enough, and I am not sure that everyone realizes it. Keep sending the message through. As loud as you can. Mario

  18. Hi Leith
    Just chanced upon your blog, thanks for your great, fact-based discussions of the current state of the housing market.

    One point which I'd appreciate your clarification on – you mention that net rent has been declining steadily over the last 10 or so years. This is due to an increase in "loss making landlords" which is associated with the CGT and negative gearing policies, as investors are banking on capital gains. Also, Chart 3 in your Negative Gearing article seems to show that rent has increased far more slowly than house prices over the period 1987-2009, in fact if I understand it correctly, it shows that rents have risen very modestly in real terms over the last 25 years.

    If CGT/NG have caused the amount of rental loss to increase, doesn't this imply that rental yields have declined and hence that these policies are in fact keeping rents down (ie lower than they would be in a world without CGT discount/NG)? What (in your view) would the trajectory of house prices/rents look like had the NG changes in 1987 and CGT changes in 1999 not occurred?


  19. Leith van Onselen

    Hi Sri. I'm glad you like the blog. I'm not a believer in the view that the NG/CGT concessions have had any significant impact on rental costs. This is because the overwhelming majority (90% plus) of investment property purchases are for pre-existing dwellings and have, therefore, not added to housing supply. Rather, property investors have simply been displacing would-be owner occupiers by turning homes for sale into homes for let. To illustrate this point, consider an investor that buys a pre-existing dwelling from an owner occupier. After settlement, the supply of rental properties is increased by one dwelling, but the demand for rental properties is also increased by one (since the previous owner occupier has become a renter). Accordingly, the rental supply/demand balance is the same.

    Rental yields are low because prices have been bid up, not because rents are too low. In my view, had the NG/CGT changes never ocurred, prices would be much lower, rents would be about the same, and rental yields would be significantly higher. This point was broadly validated in my NG post by the fact that rents did not rise across Australia when NG was temporarily removed from 1985 to 1987.

  20. You often hear Investors say "INTEREST RATES WENT TO 17% IN 1990 & PRICES DID NOT CRASH PEOPLE STILL COPED". The inference they draw is that rates can rise again & people will cope? Interestingly a 7% home loan interest rates in 2010 is equal to over 22.5% interest rate in 1990 (when Comparative Incomes / Loan Size / …Percentage of Income to loan payments etc are applied). Just imaging people thought it was tough back in 1990 when rates got up to 17% but at a 7% rate in 2010 is equal to a 22.5% rate in 1990. FYI in 2008 interest rates were 9.5% . A 9.5% interest rate would be the equivalent of a 30.5% rate in 1990 terms. Affordability will inhibit the capital gains that INVESTORS need to make Negative Geared Rentals work. Without large Capital Gains Investors will start flooding the market. Now travel back to 1990 & ask yourself would you enter the market at a rate comparable to 22.5% with forecasts saying it will go to 8.5% which is a 27.29% 1990 rate..Food For Thought?

    In Jan 1990 interest rates hit a record high of 17% & people managed to keep their homes then so how would this compare in todays housing market?…The 1990 Median house price was $100K with a 20% deposit & a loan of $80K payments @17% interest over 30 yrs would be $1140 pm or 32% of wages with average family wage of $42K pa…so in 1990 @ 17% the worst interest rates in Aust history payments only ever got to 32% of average family income…Fast Fwd to 2010 Median price is $500K less 20% deposit & a loan of $400K payments @ 7% interest over 30 years are $2661 pm or 43% of wages with average family wage of $75K…in 2008 interest rates were 9.5% this would work out to payments of $3365 or 54% of current wages …. Now historically for the last 30 years interest rates have averaged 10.11% this would works out to payments of $3545 pm or 57% of wages going to mortgage payments ….So summing up current housing mortgage payments @ 7% is still worse than when rates were at 17% but just imagine what will happen when rates rise? AFFORDABILITY will not allow future CAPITAL GROWTH & investors will D*U*M*P __ P*R*O*P*E*R*T*Y because without MASSIVE CAPITAL GAINS Property investment WONT WORK!

  21. Most people in Australia think life is a lot easier than what it is, or will be when they realise that from nothing there is nothing. Investing in property like sheep without a brain. There will be character building years for people.