Special Report: The Melbourne property bubble

For several years now, I have argued that Melbourne’s housing market is built upon weak fundamentals and is overvalued relative to the other major capitals. And yet, Melbourne house prices have grown strongly in recent times, driven by record demand from property investors.

This report revisits the Melbourne housing market and finds that while the upswing in prices likely has further to run, valuations are once again entering the twilight zone, making Melbourne housing an very risky proposition for both first home buyers and prospective investors alike.

Current state-of-play:

The evolution of Melbourne’s housing market is illustrated by the next chart, which tracks detached house prices, as reported by the four main housing data providers: the Australian Bureau of Statistics (ABS); Australian Property Monitors (APM); RP Data-Rismark; and Residex, as well as a composite measure, which is the average of these indices.

Residex has the longest running house price series for Melbourne, dating back to the mid-1970s, whereas APM’s is relatively new.

Despite minor variations, all four series have tracked each other fairly closely.

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The June quarter price results for Melbourne showed the housing market growing at a solid clip. The ABS (10.3%), APM (10.6%), RP Data (9.8%) and Residex (8.3%) all recorded strong growth in the year to June 2014, with prices now also 6.7% above their September 2010 peak when averaged out across the four data providers.

Melbourne unit prices have experienced weaker growth, with the ABS (5.8%), APM (5.1%), RP Data (5.8%) and Residex (5.4%) all recording similar growth in the year to June 2014, with values up 2.5% since the March 2011 peak when averaged out across the four data providers (see next chart).

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The next chart plots Melbourne house prices in real inflation-adjusted terms. According to this chart, Melbourne has experienced two distinct booms in house prices since 1975. The first, which ran from early 1983 to early 1989, saw Melbourne house prices increase by 75% in real terms before retracing roughly 20% over the next six and a half years. The second and by far the greatest boom is the one which ran from the mid-1990s to mid-2010, and saw house prices increase by around 185% in real terms, before retracing by around 12% peak-to-trough. Following the latest price upswing, Melbourne house prices in real terms were just 3.1% below their 2010 peak as at June 2014, when averaged out across the four main data providers (see next chart).

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Melbourne unit prices have not rebounded as strongly in real inflation-adjusted terms, with prices still down 5.7% since their mid-2010 peak as at June 2014, when averaged out across the four main data providers (see next chart).

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Price momentum solid but clearly slowing:

The most recent annual results suggests that Melbourne’s house price growth has well and truly peaked. As at June 2014, annual price growth was 9.8% (houses) and 5.5% (units) when averaged-out across the four data providers, and clearly trending down (see next chart).

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Moreover, both APM and RP Data, which have reported their September quarter price results, registered a further slowing of momentum, with annual price growth in Melbourne slowing to 8.1% and 8.4% (houses) and 3.2% and 5.2% (units) respectively in the year September 2014.

Importantly, the single best short-term indicator for house prices – housing finance commitments – is also past its peak which, given past strong correlations, suggests that Melbourne house price growth will moderate further over the year ahead (see next chart).

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Melbourne housing remains expensive:

Melbourne’s house price growth over the second half of the 2000s was spectacular, clearly outperforming the national average (see next chart).

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The out-performance of Melbourne housing saw its median house price relative to the other capital cities rise to a level not seen since the late-1980s. Despite some retracement since then, Melbourne housing remains relatively expensive, with its value relative to the other capitals still well above the long-run average (see next chart).

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Melbourne is relatively well supplied and rental returns are poor:

Melbourne’s poor housing fundamentals are also reflected on the supply-side, where an ongoing construction boom has combined with relatively high rental vacancies.

Unlike most other markets around Australia, the construction of dwellings in Victoria (read Melbourne) has been running strong for four years, more or less catching-up with the booming population (see next chart).

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In population-adjusted terms, Melbourne’s housing supply has been relatively strong, albeit increasingly concentrated in small inner-city apartments (see next chart).

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According to Urban Melbourne, a website that tracks developments in the city, there are 23 buildings taller than 200 meters that are being planned or built, with a total of around 91,000 apartments in 530 projects in planning or construction across all of Melbourne.

The housing construction boom in Melbourne has eased pressure on rents which, after strong growth between 2006 and 2009, have flat-lined in real inflation-adjusted terms (see next chart).

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The easing of pressures in the rental market is also reflected in rental vacancy rates, which have typically been well above the national average, despite moderating recently (see next chart).

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Melbourne’s stronger house price appreciation and sluggish rental growth has combined to provide Melbourne housing with the equal lowest rental yields in the nation (along with Sydney). Melbourne’s gross rental yields of 4.1% (houses) and 4.6% (units) are well below the other capitals (4.5% and 4.9% respectively), making Melbourne housing a poor investment proposition from an income perspective (see below charts).

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Melbourne’s economy is weak and too reliant on housing:

After badly under performing in the two years to June 2013, Victorian state final demand – a proxy for gross state product – has rebounded more recently, growing by 2.6% in the year to June 2014 versus growth of only 1.9% nationally, but is clearly trending down (see next chart).

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Victoria’s labour market, however, remains in poor shape.

Victoria’s headline unempl0yment rate (6.8%) is tracking well above national average of 6.2% (see next chart).

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Full-time jobs growth in Victoria has also slumped, down 0.1% in the year to October (see next chart).

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Similarly, growth in the aggregate number of hours worked in Victoria fell by 0.3% in the year to October 2014 (see next chart).

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And labour underutilisation – comprising both unemployment and underemployment – is higher in Victoria than nationally (see next chart).

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Perhaps most concerning from a employment perspective is that a major driver of employment growth in Victoria over the past decade or so has been construction, most of which relates to housing (see next chart).

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Construction is also the second biggest full-time employer in Victoria, behind manufacturing (see next chart).

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Looking ahead, Melbourne’s economy and employment market are likely to face further headwinds.

The manufacturing sector – Victoria’s third biggest employer overall and largest provider of full-time jobs – is set to lose tens-of-thousands of jobs as the local car assembly industry closes by 2017. Modelling by the Productivity Commission predicts that around 27,000 jobs cost be lost in Victoria once the car industry shutters, whereas Allen Consulting Group, using economic analysis from Monash University, estimates that Victoria could lose around 33,000 jobs.

Melbourne’s heavy reliance on the construction industry also poses a conundrum for the state’s economy, since it requires the current high rate of dwelling construction to be maintained in order to sustain both employment and growth more broadly. As soon as dwelling construction slows, so too will the economy, resulting in significant job losses.

On the other hand, if current high rates of construction are maintained, then rents and house values will come under increasing pressure as the flow of new supply competes with the existing housing stock, bringing with it an earlier end to the price boom and sowing the seeds of a more serious downturn.

The nature of demand is highly speculative

Although less extreme than Sydney, Melbourne’s housing demand is being driven to a large extent by investors. The latest ABS housing finance statistics revealed near parabolic growth in the value of investor finance commitments over the past year, with the proportion of loans going to investors also hitting a record 46.9% of total mortgages (excluding refinances) in the year to August 2014 (see next chart).

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As is the case with Sydney, the current make-up of Melbourne mortgage demand is not conducive to sustainable house price growth. Investors, whose decision to purchase property are based on weighing-up alternative investment returns, are more likely to be fickle and cut-and-run as soon as conditions change, or more profitable opportunities are presented elsewhere. This places Melbourne housing on a more fragile footing than if demand was driven primarily by owner-occupiers, who tend to buy into housing for the longer-term.

Bottom Line:

Melbourne’s housing fundamentals are weak, with relatively abundant supply both in terms of new dwelling construction and high rental vacancies, as well as poor rental yields on offer. Valuations are also stretched relative to the other capitals, courtesy of house price growth that significantly outperformed the national capital city average since the mid-2000s.

As a point of reference, the last time Melbourne’s housing was so overvalued relative to the other capitals was in the late-1980s, after which Melbourne house values underwent a significant correction, retracing roughly 20% over the next six and a half years in real inflation-adjusted terms.

Melbourne’s economy and labour market is built on equally shaky foundations. The construction sector, which has driven a large share of the jobs growth and accounts for 10% of full-time employment, is inextricably linked to the rate of dwelling construction. As dwelling construction falls from current elevated levels, so too will jobs growth in both the construction sector and related industries. The manufacturing sector – the biggest full-time employer – is also facing a large retrenchment with some 30,000 job losses possible as the local automotive assembly industry closes by 2017.

While Melbourne’s housing market is structurally sick, there remains solid price momentum on the back of record high investor demand. However, the predomination of investment flows driving price gains means the current price rises could also turn more quickly. As with Sydney, the extreme investor participation, combined with the mini construction boom and a local economy geared towards housing, is a dangerous combination that has likely already have sown the seeds of a future correction.

Overall, Melbourne’s poor fundamentals makes it a risky proposition from an investment perspective. While a rising tide of cheap credit continues to lift all markets in the short-term, there is the risk of a significant price correction in Melbourne once the current spate of investor-led demand eases and broader macroeconomic conditions deteriorate. Avoid!

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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