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RBA has no idea just how the housing market works

A week after delivering a slap to responsible savers through its 50 basis points interest rate cut (and handing a free kick to banks and speculators), the RBA’s minutes, released yesterday, provided one of the more bizarre attempted justifications for weakness in the property market.

The RBA provided that its decision to lower rates by 50 basis points was partially based on “information from liaison suggested that households were unwilling to commit to contracts for new dwellings because of concerns about job security and declining dwelling prices”. The RBA added that “despite dwelling prices declining relative to incomes and rises in rental yields, forward-looking indicators implied little prospect of an imminent recovery in housing construction”.

It is somewhat concerning that the organisation responsible for price fixing the base cost of funds in Australia has little or no idea how the housing market works and the reasons for the sustained drop in property prices over the past 12 months. It appears the RBA’s thinking is that house prices are falling because people expect house prices to fall and because people are fearful of losing their jobs.

However, this is a flawed understanding of property prices. Lower price expectations is the symptom of falling house prices not the cause.

Readers would be well aware that house prices have fallen (and will continue to fall) because their prices have far exceeded the intrinsic value. Returns that can be achieved from housing as an asset class are around half of what they should be (capital city residential property typically returns about 3%). Property prices have rocketed since 1997 largely due to excessive bank lending (which has caused the proportion of mortgage debt to GDP to more than quadruple). At the same time, returns on property have slumped as rents have failed to keep up with price rises. In short, one of two things will need to happen: (1) property prices will continue to fall until return on equity reach a reasonable level; or (2) rental prices will need to double.

Over the past year, home buyers have realised that (2) is highly unlikely (rents didn’t increase at all last year in most capital cities) and have simply delayed their purchase, or refused to meets seller’s inflated asking prices. For most people, renting is far cheaper than buying anyway, so there is little impetus to purchase a property.

There are many reasons for the housing bubble, but one key reason that the bubble is able to remain inflated for such a long period is because there only needs to be a very small number of foolish property buyers who are keeping the price inflated. With only about 10% of dwellings changing hands annually, the majority of home buyers staying away from the market were overcome by a small number of fools (10%) whose buying was able to keep prices high. As the number of fools diminish, property prices gradually fall — as has occurred in the past year. Since June 2010, real property prices have slumped by 10%. Even the staunchest of property bulls would concede that that drop is significant. Like the end of a Ponzi scheme, eventually the bitter realisation sinks in that the supposed profits are fictional, then the bottom really falls out of the market.

The RBA has completely misunderstood the current situation and is instead, trying to use monetary policy to prevent prices from adjusting to their intrinsic value (and at the same time, trying to boosting GDP through spurring construction spending).

The problem is, the reason for the property bubble is because banks have lent too much money to home buyers. Like in the United States and Ireland, this caused prices to exceed their intrinsic value (and also, led to a misallocation of resources from productive areas of the economy into housing, a relatively unproductive use of capital). Glenn Stevens’ RBA had been one of the more responsible central banks, aware that that the long-term effects of the housing bubble. But this responsibility appears to have vanished in recent times.

Interest rates are effectively the price of money. Price fixers like Alan Greenspan’s Federal Reserve have caused far more harm than good in recent years for setting the price of money too low (many blame Greenspan’s monetary ease for the global financial crisis). Australia’s housing bubble was caused by too much debt. It appears the RBA doesn’t understand this, and is doing its best to re-encourage the use of debt (by lowering interest rates) in order to solve the problem that was essentially created by too much one of too much debt. The RBA isn’t merely buying the drunk another drink, it’s giving them the keys to the bar.

Stevens and his merry band of price fixers would be well advised to stop taking advice from the real estate sector or poor run retailers or lobbyists unless Stevens wants his reputation to <a href="Property Observer.” target=”_blank”>turn out like Alan Greenspan’s.

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  • 1
    John Tevelein
    Posted Thursday, 17 May 2012 at 4:02 pm | Permalink

    The issues Adam raises can be solved by one action, remove negative gearing on investment property. Outcomes: 1. House values fall and rents rise to realistic levels. 2. Home ownership for personal use becomes attractive stimulating realistic borrowing. 3.Interest rates rise. Simple really.

  • 2
    Hamis Hill
    Posted Friday, 18 May 2012 at 8:39 am | Permalink

    Hopefully this article is the beginning of many more incisive analyses to follow. But fundamentally the housing market in Australai is corrupt. It is a speculative market. In my 1986 article “Housing and the Economy” Tertangala, I pointed out the posy WW2 housing markets imposed on Japan and Germany by conquerors who needed to counter poverty and the threat of communism. No money went ot housing, all investment went to industry . people lived in shanties but had employment and relative political contentment.Pre-war and pre-mineral South Australia whishing to foster an economy in a desrt state as a matter of policy developed low cost housing to lower wage demands and encourage the establishment of manufacturing. A corrupt, competition-free cartel of housing and banking industry interests have imposed a “what the market will bear ” price on housing controlling the market and using bank- induced capital gain to delude borrowers that their interest payments are being covered. The primary purpose is the highest levels of debt on tthe highest levels of interest for the highest, corupt levels of profit, while the economy itself is ruined. Acorrupt market ehich ignores the rules about wealth creation as laid down by Adam Smith who pointed out that housing is not a wealth creating asset and cannot produce the profits which sustain the einterest on borrowed capital. The solution is competition but entrenched private interests control the housing market at the local government level maintaining the destructive status quo and resisting with their monopoly profits all efforts to ratioalise their “industry. Perhaps the article “Politics, Housing and The Economy” is long overdue but look to the corrupt, housing/banking cartel as the corruption of the free market competition which will solve the problem.There is no competion in the housing market and it is nonsensical to discuss the market as if there were an operating free market. One of the enduring delusions which has led to this point. Greed pride ego all coming before this fall.

  • 3
    drsmithy
    Posted Saturday, 19 May 2012 at 8:17 pm | Permalink

    House values fall and rents rise to realistic levels.

    Rents are already at realistic levels. If anything, they’re a bit high.

    (This is of course ignoring the handful of places suffering from the mining boom where rents are outrageously high.)

  • 4
    CaptainLee
    Posted Tuesday, 22 May 2012 at 12:46 pm | Permalink

    So tell me, if the cost of constructing a apartment or house
    as raw materials, labour and margins of builders are pretty set,
    and not likely to drop 10%,20%, or even 40%. Cost of civil engineering
    , infrastructure and government charges also.

    Holding costs are still pretty high

    So its the raw land cost that only could go down… and are landowners,
    or perhaps land bank investors willing to drop even more.

    So supply and demand, affordability are all good, but no one is
    going to sell property below cost.

    This as it relates to new housing, but existing housing is valued
    somewhat on what it takes to buy new compared to used.

    Development will just not happen , will it?

    Are you not all focussing on one side of the equation?

    Could be wrong, be interested in anyones comments.

  • 5
    drsmithy
    Posted Tuesday, 22 May 2012 at 1:12 pm | Permalink

    Real building costs have not increased appreciably. Nearly all the price increases are in a) land valuation (due to artificial supply constraints), b) Government charges and overheads and c) developer profiteering.

    State Governments have become utterly dependent on stamp duty revenue for funding. Hence they have next to no interest in pursuing affordable housing (ie: land).

    Holding costs for land are not high (which is part of the problem - they should be VERY high). “Land banking” by big developers on urban fringes has been a significant contributor to the housing bubble.

    There are two significant cohorts of property owners who will under severe pressure to sell property over the next few years: Cash-poor Baby Boomers who need to finance their retirements and negatively-geared property “investors” who can no longer afford to subsidise their tenants in a stagnant (at best) real estate market, slowing economy and rising unemployment.

    The situation is all covered in great depth and detail by the Unconventional Economist at http://www.macrobusiness.com.au. Housing prices will have to come down by about half in real terms to return to affordable levels. The only real question is whether it will happen with a US-style crash or a Japanese-style stagnation.

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