Guest Post: Changing the Rules: Why our Property Boom is Over (Part 1)

Sam Birmingham runs a top quality networking site for young professionals called WeBe, which provides up-to-date information on financial matters, work-related issues, lifestyle news and reviews, and current affairs and opinion pieces. WeBe also provides a platform where members can have their voices heard, express opinions and share ideas with other like-minded Young Professionals.

Yesterday, Sam published the first in a series of articles explaining why the Australian property boom is over. Below is the first installment.
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Housing affordability was the most important issue in Election 2010 and the problem has only got worse, with the RBA continuing to hike interest rates. What is being done to improve housing affordability? The short answer is “bugger all”… But a rapidly-turning property market could be about to fix all that.

Despite remaining strong in the wake of the GFC, our property market is showing signs of stress.

Investors have been driven away by rising interest rates and prospective first home owners are staying on the sidelines. The Economist reckons Australia has the most over-priced houses in the world and some analysts predict falls of 30-40% over the coming years. The IMF is nervous about a developing bubble and even the head of the RBA has warned Mum-and-Dad investors that it is “a mistake to assume that a riskless, guaranteed way to prosperity is just to be leveraged up into property”.

Who is right?

As a recent article in The West Australian explained, the average loan was a mere $34,800 in 1985, with repayments taking up “only” 24% of the average wage, even though interest rates were 13.5%. Nowadays, the average mortgage has ballooned to almost $389,000 and, with interest rates at just 7.8%, the average homeowner’s monthly repayments chew up a massive 50% of their income!

Most of this declining affordability has taken place in the past 10-15 years, during which time the price-income ratio (the standard measure of housing affordability) has blown out by a factor of two. This can be seen in the graph below.

If you were ‘in the market’ over this period, you may not have minded so much, as the trend of ever-increasing prices ensured that property was a sensational investment. To get a feel for how much prices have skyrocketed, let’s compare the “real” price growth (ie. taking inflation into account), with increases in “real” incomes, rents and construction costs over the period.

While it is all well and good to look back at what has gone on in previous decades, what is more important is to look forward and try to determine whether the trend can continue…? Having gone from homes being a ‘single income, pay it back in ten years’ proposition, can we seriously expect prices to keep rising until even a dual income family has to work for thirty or more years just to pay off their mortgage?

The short answer: Not likely… Although you won’t hear that from a property spruiker – most of whom rely on claims like “there is nothing safer than ‘bricks and mortar'” and you can “expect the value of your house to double every 7-10 years”.

Does property really double every 7 to 10 years?

Wow, can property investment really be that easy? Surely not…?

Even though this exponential rate of growth might have been the case in previous years, let’s put the spruikers’ claim into action to show just how ridiculous it is:

  • Are you familiar with the power of compounding and the rule of 72? If not, click this link for a quick refresher.
  • Let’s take the “conservative” end of the property spruiker’s price growth spectrum; ie. assume that prices will double every 10 years, representing a compound annual growth rate of just over 7%.
  • Let’s also assume that wages grow by 5% per annum (Note: In reality, wages growth is likely to be closer to 4%, but let’s be optimistic for the purposes of this exercise).
  • Assume a median price-to-average annual earnings ratio of 8 in 2010, as per the graph above.
  • And let’s be optimistic and pretend that you only need to pay the interest component of your loan, with an interest rate of just 7.5%…

In case your algebra isn’t too flash anymore, let me put all that into words, just to make this 110% clear…

If we assume that prices increase at the lower end of the spruikers’ range, incomes grow faster than normal, the loan is interest-only and the interest rate is a mere 7.5%, the “prices double every 7-10 years” crowd would have you believe that, in the space of just two decades, the average income earner will be devoting 90%+ of their gross income towards paying the interest on the mortgage of their median house.

And that’s before even worrying about paying taxes, buying groceries, putting fuel in the car and paying off the credit card, let alone reducing the principal of their loan… Good luck?!!

You see, that’s the problem with exponential growth which outpaces the fundmentals, such as growth in wages or growth in the economy… It can’t keep going up like that forever.

Having said all that, whilst people continue to believe that “property always goes up”, for the most part, it will – such is the importance of confidence to investment markets. As the saying goes, “a rising tide lifts all boats”. But what happens when the tide turns; when this confidence drains out of the market?

It may not have been the case since the late-1980’s, but what happens if the factors that drove the property market ever-higher for two decades have started to turn?

We’ll find out more about those factors in the follow up article next week… Stay tuned!

Unconventional Economist

Leith van Onselen is Chief Economist at the MB Fund and MB Super. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.

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Comments

  1. A year ago there was total denial the real estate market was in any bother. Now the recognition is beginning to dawn on the smarter folks that something terribly serious is happening to the property market, but as normal their blind faith is that they will have the oft spoken about 'soft landing'. Ha! No way hose! The bigger the boom, the bigger the bust. The property boom that began in here the late 90s started slowly and snowballed into the biggest property bubble the planet has ever experienced. This crash that's now underway unfolding will be absolutely the same. My advice to real estate speculators is panic, NOW! As this year pans out you'll finally recognize property in Australia is dead generations. This crash is going to be a big one!

    Tom Kline
    My Blog – BUSTING the Australian Housing Myths!

  2. Excellent work.
    The 1.1 million people being added to the over 65's in the next five years will certainly change the housing market. Our demographic gift is all about to end.
    Age is the the number one factor driving supply and demand, so I look forward to your projections and predictions.
    Population growth is also at approx 1% currently due to a massive shift in migration and so it will act a as the catalyst to explain the housing crash, however it is not that easy, as the Ageing population challenges for Australia are only just beginning.
    See, http://tinyurl.com/4s7m9su

  3. Im particularly pleased to see young (28) Sam Birmingham's contribution, because this is what motivated me (with the able assistance of Wendell Cox) to get the Annual Demographia Surveys underway, with the first released early 2005.

    As Leith said in commenting in an earlier article, Kiwis and Aussies didnt have a clue just how overcooked housing was in this part of the world, until these Annual Surveys were generated. And most importantly – the political and commercial establishments were in no hurry to tell them.

    I spelt out the politics of all this early 2008, within a rather lengthy paper "Getting performance urban planning in place" (available on my website).

    It is an extremely serious matter in both moral and social terms, when political failures occur (governments losing control of their costs and the ability to cope with normal growth), denying the young and disadvantaged, their right to the opportunity of affordable housing.

    Just check the 2010 6th Edition Demographia Survey http://www.demographia.com , to see the mortgage costs of homeowners in Dallas Fort Worth and Atlanta on the one hand and the bloated mortgage costs of those in Melbourne and Sydney. It is farcical.

    Indeed – they have persisted in conning a gullible public in to paying bubble prices, loaded to the eyeballs with bubble debt.

    Its real simple – if housing exceeds 3 times gross annual household incomes or 1.5 times GDP, its illusory or bubble wealth.

    Put another way, property and the quality of it, should be a reflection of the underlying income underpinning its value.

    Young Aussies and Kiwis can assist enormously in fixing these problems, by refusing to pay bubble prices and waiting until market prices are restored. By doing this, they are not only protecting themselves, but are being socially responsible as well.

    Hugh Pavletich FDIA
    Co author – Annual Demographia International Housing Affordability Survey
    http://www.PerformanceUrbanPlanning.org
    Christchurch
    New Zealand

  4. Leith van Onselen

    Demografix – I have written a detailed examination of the impact of Baby Boomer retirement on asset prices here (click to view). It think you will enjoy it.

  5. This article makes we want to go and join Sam's community.

    Like I said before, I and many young people I talk to are in no rush to buy properties at the current prices. Rent is ridiculous as well, but at least we won't incur the huge loss when the property market corrects itself.

    Besides, at 6% return on savings I rather rent, enjoy life and put the money on my savings account so I can build a decent, quality and environmentally friendly home when prices have come down.

  6. Leith,

    There is that graph again "Real House Prices and Fundamentals"…there is no way real rents are up only 15% in 30 years.

    I have spoken to ABS who have confirmed that the data comparison of "dwellings" for house prices and rents are two unrelated series, they cannnot be compared. I also spoke to the RBA spokesperson who first used that graph…he said that accurate information is very difficult to obtain and "it should have been issued with a health warning". All ABS information should be treated with caution, they are well meaning but complacent, in my opinion.

    The Economist confirms that they have used this ABS data to calculate Australian housing "fair value" at 63% over-valued…more nonsense. The Economist has been banging this drum since 2002. They will eventually be right when housing corrects, but if you had accepted their strident claims then you would have been misled.

    Think it through, rents have averaged roughly a bit less than a 5% return, they are tied to house prices. My data shows real "house" prices increased roughly 280% in that period and rents 225%. My 30 year data set is narrow but accurate and I made it in response to that graph. In 2004 MacFarlane complained about the quality of information on real estate in Australia, and still this false data influences the debate.

    I will not be surprised to see a correction in Australian house prices, I can see some evidence of it already, and I have seen them before. But note that the government has seen this too (and bank reliance on international wholesale debt) and for some reason (probably State Govt reliance on RE taxes, as you pointed out) has decided to attempt to "ban" the economic housing cycle…with taxpayer money.

    I applaud your efforts to inform and encourage the debate, as I agree trading established houses is an insane way to grow national private wealth, but the quality of information must improve.

    Bear in mind too that easy credit has been a brake on wage demands around the world, so this is all part of a very complex issue, especially if the trend to concentration of wealth is reversed.

    All the best,

  7. Its funny how the property pushers seem to ignore the good old law of supply and demand.

    If property becomes so expensive that no one can afford it then prices will drop. Unless some people imagine a city with half the houses empty and million living on the city edge in tents!

    Now where that is is a guess but applying reducio ad absrudum to it we can definitely say that 20 times AWE is too much. At that level all your wages would go on the mortgage … at least it would cure the obesity epidemic;)

    10 times is probably too much and 7 times would be a struggle.

    So all we are arguing about is the level, somewhere between 1 and 7.

    But, here's the rub, interest rates come into play, so it's not just the price. Anyone remember the 17%+ mortgage rates? 3 times AWE at 20% interest rates would be more unaffordable than (say) 7 times at 1%.

    So you can, if you want construct a table (or a chart) with price/interest rates vs AWE.

    This crates a scary picture. If the average is currently 7 times (or there about), then only a small movement in interest rates makes huge swathes of houses unaffordable.

    Australia is very vulnerable to this due to the predominance of floating mortgage rates.

    Now having a look around the World we see interest rates move upwards. As a debtor nation which depends on borrowing money everyday to function (with non-existent foreign currency reserves) we are very, very vulnerable to World rate movements. In other words; there are many scenarios where Australia has to raise interest rates no matter what the domestic economy does, simply to attract sufficient money here to survive.

    Vulnerable .. heck yes. End in tears probably.

  8. Demographics is destiny.

    Japan suffers from the same slow suicide of low birthrates of all 'western' societies… but they also didn't have a baby boom (the lost WWII) so they have an even older population than Aus.

    Their boom and bust (all assets, inc. property) was in the 1990's as their oldies invested in the boom with thier life savings.

    Since then Japan have failed to recover. Because there are too many oldies who are now trying to sell their assets as they move to retirement etc.

    Economist Harry Dent talks about it.

    We need to stop this slow suicide by increasing birthrates (not immigration). We need to make children reduce your tax so middle class parents can afford kids.

    Currently only welfare receipients have lots of kids, because each child increases their welfare income more than the child costs.

    Single men are refusing to commit and become fathers, as they fear having their future kids stolen by the dvorce lawyers. We need to make divorce fair. So that men actually are willing to commit and become fathers again.

    And we need to remove educational discrimination against boys that means girls thrash boys at school and so 6-out-of-ten uni students are women… There aren't enough professional men for the professional women who eventually will want families.

  9. I think one reason that the property-doubles-every-ten-years meme got into people's heads was because there was a long period between the 1970s and mid 1990s when it was approximately true. However, it was more to do with inflation running at about 10% than anything magical about property prices. Everything doubled every ten years or so, including incomes.

    Then again, the headline "why our property boom is over" is just as risible. Unless you have a time machine and can travel to the future, all you can really say is: if property price changes over the next ten years are similar to property price changes in past decades, the probability that they'll be like the previous 10 years is less than 50%.

    Which I would acknowledge isn't much of a headline, but it takes into account the fact that at times like this, we tend to see the arrival of new financial products which will sustain asset price inflation longer than any reasonable person would expect. E.g., interest-only loans, split-equity loans, longer mortgage periods, and government subsidies. Enough of that sort of thing and the boom times could run for quite a few years yet.

  10. Excellent article. The projections are plausible.
    The only thing I would question is the first graph, comparing median house prices to *average* earnings. Average normally means "mean". Isn't it normal, and more accurate, to compare median house prices to *median* earnings? Otherwise the enormous income growth of the super rich drags the mean-average earnings much higher, making property look les overpriced than it really is.

    Am I wrong on this? Anyone?

    The only thing I can think of that will stop prices falling is that it will be politically disasterous for whoever is in power when it happens. Pollies will take any short term measures to stave it off. More home-buyer grants, increasing tax breaks for investors, encouraging foreign investment in Australian real estate, etc. None of these will actually fix the problem, long term, but pollies are more concerned with their own short term survival.
    I'm waiting to buy, and I'm planning to wait a few more years.

  11. Thanks for the comments, folks. And thanks also to Leith for sharing my article!

    As someone in his late-20s, the divergence of opinion amongst my peers re. our property market astounds me… I guess that is what inspired me to share these thoughts in the first place.

    On one hand, I've got all those friends who have seen their parents get "rich" off the family home, who believe that property always goes up, who got into the market early and who are refinancing their capital gains to fund holidays, new cars and/or buy their first(/second/third) investment property.

    On the other hand, there is a growing groundswell of VERY frustrated young Australians who can't afford to buy a home and, frankly, have given up on ever buying a house unless something changes, big-time!

    Then in the middle I've got a bunch of friends who are shackled to $400k-$500k mortgages, with well-paid jobs, but who are still struggling to keep their heads above water. They can't bear to sell (perhaps they don't want to go back to being tenants, perhaps they are already in negative equity, perhaps they believe things will turn), but nor can they cope with the 30 year commitment that they have entered (/been induced) into… One can only wonder about the negative impact this has on their home life, relationships, dreams of having kids one day, etc?!

    Anyhoo, that's enough bleakness for now… Happy Thursday and stay tuned for more updates!

  12. Very interesting read. I am based in Hong Kong, and here we have seen affordability edging towards 50% of late because of increasing home prices. But this figure has already overstated the affordability. Nowadays, mortgage rates in Hong Kong can be as low as 1% (floating, pegged with interbank rate). With the flood of liquidity thanks to two rounds of quantitative easing, mortgage rates remained exceptionally low for the past 2 years. Certainly there are bubbles here and there every where in the world. The only question is when the bubble is going to burst.

    Here's my Hong Kong Real Estate Forecast 2011 at Also sprach Analyst

  13. Demography is destiny

    an important consideration is if the correlations are actually associated or if they are coincidental. Just like the storks population rising with the human one does not make if a proof that storks deliver babies. The same is true of analysis of Japans economy. There are other significant factors than just their domestic economy there

  14. Nice article Sam,

    by the way it is not just Gen Y that have put a hold on buying there are a lot of Gen X that also have put off the purchase and have chosen to remain debt free.

    Well done on Webe.com.au as well.

    WordPress site?

    Cheers, C.

  15. @The_Mainlander As someone sitting on the border between Gen X & Gen Y, I agree that Gen X'ers are equally frustrated… Perhaps the older generation have had it even worse – after all, there was/is less pressure on Gen Y's to buy, given that they're only just starting to hit the "settle down and have a family" stage of their life…

    Thanks also for the website feedback. FYI: It has been built with Drupal.

    @Anonymous (13/1 @ 2:32pm): Fair cop re. lack of consistency from "average" to "median"… Ideally, I should have dug out more data – will try to tidy things up in future posts. I won't be surprised if the outcome is fundamentally the same, though.

    @All Cheers again for the feedback…

    As far as I'm concerned, the most important thing is that these important issues and counter-POV's are finally starting to get an audience… That's the beauty of blogging and the democratisation of media, isn't it?!

    Eventually we need to help Joe Public to realise that things (whether they be houses, oil or widgets) can't increase in price faster rate than incomes ad infinitum… And certainly not without causing severely dislocation in society / economies in the meantime!

  16. Depression Looms

    Great article, Sam.

    I'm encouraged to see that real incomes and real construction costs have tracked closely together, over time. I purchased a block of land years ago to deliberatly escape the speculative nature of RE (and bl**dy RE agents) and to only have to deal with construction & material costs. I'm planning to build this year, though I have reason to pause though, since prices will fall, as you say.

    Perhaps I'd get more valued for my (borrowed) money if I waited and bought when/if they go down 20%. I've agonised if I should even borrow at all, since interest rates are going up. My strategy is to fix it for 5 years and maybe let the looming hyperinflation in fiat currencies help me pay to pay it off – fast.

    So it might be a strategy that might work for others, despite the looming slump in prices because once inflation sets in you won't be able to borrow enough, quickly enough of a devaluing currency to get into the market. Thought, anyone?

  17. Let OZ Goverment study carefully “Icelandic way” to deal with the banking mess, that inevitably will occur, because the other option taxpayer could find himself in, is “Irish”…
    But who gives a damn about overseas experiences in the so different “Lucky bubble”?