Last week, a report produced by Demographia claimed a study of median house prices with incomes in Australia, Canada, Ireland, New Zealand, Britain and the US determined that Australia has the most cities in the “severely unaffordable” category.

While the mainstream media widely reported the study, occasional Business Spectator columnist, and the managing director of Rismark International, Christopher Joye, attacked the findings and the owner of Demographia, a consultant named Wendell Cox.

According to Joye, “Wendell Cox is a self-described opponent of smart growth, especially urban growth boundaries, impact fees, and large lot zoning” and an “urban planning consultant and lobbyist for the roadway (read: pro-development) industry.” While Joye’s criticism of Cox may be well founded, Crikey notes that Cox is not the only one with a vested interest in the performance of the property market.

Joye himself is the Managing Director of Rismark, whose website claims that it has “launched a suite of path-breaking managed funds to invest in residential real estate assets across Australia.”

Specifically, Rismark has developed an awarded “hybrid housing finance instrument” known as the Equity Finance Mortgage or EFM. An EFM works in conjunction with a traditional home loan, allowing the property purchaser to obtain additional funds (in a similar manner to a second mortgage), but instead of creating a further debt, the EFM provides the “lender” with an equity interest in the property.

Rismark’s EFM website notes that:

  • An EFM allows you to borrow up to 20% of a property’s value;
  • There is no annual percentage rate applicable to an EFM loan, unless you are in default;
  • You are not required to make any regular monthly interest repayments throughout the EFM loan, which you can hold for 25 years.

When the loan is EFM is eventually repaid, the borrower is required to pay up to 40 percent of the equity appreciation to the lender. In a rising market, EFMs may benefit both parties. The borrower is able to further obtain further cash at the time of the purchase (enabling them to acquire a more expensive property or reduce the value of their mortgage and subsequent repayments). The “lender” is able to receive a significant upside (earning a return of double the actual capital appreciation of the property).

The situation isn’t so rosy for investors (or lenders) in a falling market. That is because if the value of the property subject to an EFM is sold for a loss (and the borrower is not in default at the time), the EFM lender/investor is required to share in the realized capital losses. This is a handy feature for the borrower (whose capital risk is mitigated) but terrible for the lender who ends up making a capital loss on their long-term investment (of up to 25 years) and not earning any sort of yield along the way. In a sense, EFMs allow investors (or lenders) to invest directly in a diversified portfolio of residential property and then effectively swaps rental income for doubled capital gains.

Rismark manages funds which invest in EFMs (the actual EFM product is originated and serviced by Bendigo and Adelaide Bank) and earns fees based on funds under management (along with partners, including Macquarie Bank and Melbourne’s Liberman family). The AFR reported in 2006 that:

Rismark has just launched a high-return unlisted trust that will invest in the mortgages … investors in the trust will take a leveraged exposure to a select pool of the mortgages that show favourable return characteristics in strong locations.

It is arguable therefore that a poorly performing residential property market will lessen the returns on Rismark’s EFM funds and reduce management and performance fees which may be earned by Rismark. Who would invest in a long term asset like EFMs which earn no income and face a capital loss at maturity?

Potential conflict aside, Joye’s criticism of the Demographia study is worth further consideration. In particular, Joye claimed that:

Incomes are but one variable that determine long-term changes in house prices. House prices are determined by the intersection of a range of demand- and supply-side variables including interest rates, incomes, immigration, organic population growth, employment, and the supply of homes (or housing starts).

The argument is certainly correct in one sense — supply side factors have a large bearing on house prices. However, those supply side factors don’t change the fundamental premise that Australia’s are required to spend a significantly higher proportion of their income on housing than Americans or Britons. It is not without irony that in October 2008, according to the iPod index Australia had the cheapest iPods, but the most expensive homes.

Further, supply factors are dynamic — Australian unemployment levels are currently increasing, as that happens average incomes fall (unemployed people do not earn very much), as does organic population growth. At the same time immigration slows — people don’t tend to go to the trouble of immigrating to a country where they don’t have a strong change of finding employment. So while the supply of homes is increasing at a lesser rate, this will offset by other factors, specifically higher unemployment.

While the Price/Median Income ratio is not a panacea, in a sense, it is a similar indicator as a company’s price/earnings ratio. During boom times people are willing to pay a greater multiple of their income for a house — it is easier to obtain finance and purchasers are confident that their income, and the value of their property will increase. (Similarly, during boom periods, company price-earnings ratios rise, reflecting increased expected growth rates). While PE ratios fall in a recession, so too should house prices relative to income. When someone is worried about losing their job, they will spend less on a house and banks will adjust their LVRs downwards.

Interestingly, only two months ago Joye wrote on the effect of a resilient British supply side in The Australian, claiming that “[in] Britain, which does not suffer from the US problem of overbuilding…house prices have fallen by just 6 per cent from their peak.”

It appears that Joye was a little premature in his optimism — last week, The Times reported that British house prices have fallen 16.3 percent in the past year while The Independent noted yesterday that UK house prices could fall by as much as 40 percent.

Peter Fray

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