Dec 21, 2009

Big lie theory explains how the bubble inflates

Why are seemingly rational people paying so much more for property than they did even as recently at 10 years ago? They fall for the "property lie": the myth that property "never falls in value" and will be "more expensive next year".

Adam Schwab — Business director and commentator

Adam Schwab

Business director and commentator

Hitler’s propaganda chief, Joseph Goebbels, is believed to have devised the notion that if you create a big and audacious enough lie, and repeat that lie continually, people will inevitably believe it. Perhaps the "big lie" theory also explains how financial bubbles, seemingly so foolish (especially in hindsight) are able to inflate. If enough "experts" and journalists continue to repeat the same untruths -- eventually, those myths will be taken as lore. We saw this with the bubble in the late 1990s, the sharemarket bubble of 2002-07 and more recently, the residential property boom in Australia. While government policy (specifically the first home-owner’s grant, negative gearing and concessional capital gains) coupled with lax bank lending standards have facilitated the property boom -- it is the panicked buying of many young Australians (and overseas investors) that has allowed Australian residential property to increase by 10% between January and October this year. This increase came despite Australia probably still being in recession (if growth is measured on a "per capita" basis). In fact, residential property is virtually more expensive than ever on a relative basis -- Australian capital city residential properties are trading at around six times average household disposable income -- about double their historical level (and also double the prevailing level in the United States). Why are seemingly rational people paying so much more for property than they did even as recently at 10 years ago? The main reason is most likely fear -- this fear has been propagated by proponents of the "property lie" -- the myth that property "never falls in value" and will be "more expensive next year". Myriad property experts (usually, in some way related to the real estate industry) repeat the line and lazy journalists report their self-interested viewed unquestioningly. In yesterday’s Sunday Age, that Robert Larocca (spokesperson for the Real Estate Institute of Victoria) stated "unless there is a substantial change in the amount of homes that are being built and put on the market or the population starts to decline, we would expect this sort of [upwards] trend to continue". (The fear factor is even more powerful when it is combined with the fact that many people, especially first-home buyers, place very little of their own money into their property -- the majority of the purchase price is borrowed from banks). Then there is another, less talked of factor that has caused otherwise rational people to pay far more for housing than they ever did before -- that is, status. As Australia’s apparent wealth becomes greater, people inevitably become more materialistic. More so than ever, owning one’s home (rather than renting) is considered the major indicator that one has "made it". Not only is owning a house a major status symbol -- but the size and quality is also paramount. The "status theory" leading to higher prices was explained by former Goldman Sachs banker John Talbott in his book Sell Now (which was written in 2006 and correctly forecast the US housing bust). Talbott noted:
There are goods that economists have referred to as luxury or status goods because some people feel compelled to buy more of them as their price increases. People seem to have identified diamonds and jewels and motor yachts as product that they don’t mind paying exorbitant prices for.
The fact that the price is ridiculous signals that the owner has plenty of money and power and status and the high price also prevent status impostors from making the same acquisition. Under this model, the higher the price, the more exclusive the purchase and the greater the status achieved.
So there appears to be a combination of factors underlying the bubble -- easy finance, government policy, the desire for status and perhaps most importantly, a perceived shortage of property, which causes an inevitable bidding upwards of median prices as punters worry about missing out on their dream home. The only problem with the "shortage theory" is that when this column actually compared immigration and dwelling construction, it was revealed that there isn’t really a shortage at all. In recent months, as prices have risen, more dwelling starts occurred -- this is an example of the market at work. When prices increase, supply will be boosted as developers rush to enjoy the fatter margins. (In the Melbourne city area and neighboring Southbank, there are tens of thousands of apartments expected to start construction in the coming two years). Not only do the statistics fail to indicate a drastic housing shortage, but in a logical sense, any evidence of a dire scarcity of housing caused by immigration would not immediately be seen in property prices, but rather, in rental costs and yields. Immigrants to Australia generally do not have the ability, means or finance to instantaneously secure a property. Instead, they will almost certainly rent for the short to medium term. If there was a desperate shortage of housing caused by immigration, this would therefore translate to rapidly increasing rental costs rather than higher property prices (the higher rental costs would eventually lead to higher property prices only after a sustained increase in yields). The problem though is that rental yields have barely moved in recently. Even bullish property research group BIS Shrapnel noted that rental yields edged up by only 3.5% annually in recent years. Of course, the rental market, unlike the purchase market, is not affected by bank lending, or government policy or status and therefore, has increased a rate reasonably resembling economic growth. (By contrast, capital city median property prices have rocketed by more than 43% in the past four years -- a rate far exceeding economic growth and inflation). Almost every person boosting property has a vested interested of some sort, yet millions of Australians (such as Americans in the 2000s) are happy to believe the propaganda. We choose to believe the facts.

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5 thoughts on “Big lie theory explains how the bubble inflates

  1. twhelm1

    If it looks like a bubble and talks like a bubble, and those inflating it exhibit the fear, status anxiety, and short-sightedness typical of bubble behaviour…. then are we sure it’s a bubble?

    You’ve offered some pretty compelling evidence: house buyers are paying a far greater proportion of their income than ever before (or than in other countries), and there is plenty of construction.

    But ultimately this comes down to numbers. It’s immigration and income growth versus construction rates… will the growth in rents be sufficient to justify the inflated prices being paid today??

    Based on the idea that the fundamental value of a property is such that the current income it generates plus the capital gain it receives is equal to the debt service on a loan to purchase it. Expressed in terms of yields, if the property is priced according to its value then the current yield plus the rate of capital gain equals the borrowing rate.

    The net yield on rental property in Melbourne and Sydney right now is approximately 3.5% (gross yield minus insurance, maintenance, rates, body corporate and agency fees). The borrowing rate (for a long term loan, like 5 years) is about 8%. So the capital gain I need to get to break even on a property purchase right now is about 4.5%.

    However there are some nice tax breaks for rental investors: I can reduce my current income tax by deducting current losses, and I don’t pay full income tax on my capital gains. So that required 4.5% might be more like 3.5% when the tax breaks are taken into account.

    If the income generated by an asset is rising at X% a year, then the asset value (when correctly priced) will also rise at X%. So if rents are going to rise on average at about 3.5%, then we’d expect a 3.5% capital gain to occur, which is what is needed to make buying property today worthwhile.

    So the $1m question is: is the current growth in the population of the cities (plus the growth in incomes of existing residents) sufficient to push rents up by 3.5% p/a even considering the supply coming on line each year?

    It’s an empirical question, but it doesn’t seem like too extraordinary a rate of growth in rents. Suppose 1.5 percentage points were attributable to inflation. Perhaps 1 percentage point of real wage growth. Is 1 percentage point growth due to immigration vs construction really that high? I’d hazard a guess that over the last decade, which witnessed both high immigration and quite a lot of construction, rents rose at about this level.

    So is it really such a cut and dried case that this is a bubble? Obviously we need numbers to figure this out…

  2. Jack Dempsey

    Why did you start with an example from Nazi Germany? That’s not fear mongering… Oh No!

  3. Rowan

    I vote bubble. Houses are too expensive for most people to buy, and yet, they keep buying them. As soon as Australia experiences a deep recession (which it inevitably will) the bubble will pop as people discover that they really couldn’t afford those mortgage repayments.

  4. Scott

    Rental market is affected by leases and contracts however which means there is a “stickiness” to the rents. i.e they cannot respond quickly to the market laws of supply and demand (much like wages). Also comparing Rents (which is a living expense, on the household P&L) to House Prices (which is an asset purchase, on the household balance sheet) is like comparing apples and oranges. A better option would be to compare rents to the interest in the mortgage repayments. I’d be interested to see that comparison.

  5. Orin Thomas

    One wonders what happens when the average property price exceeds the amount that the amount that a bank is willing to lend to someone on an average income. If banks continue to offer ludicrous amounts of money to people, house prices will continue to rise until they hit that limit. Then what happens? At that point the myth that property prices always rise will be busted. Unless the banks come up with some new funky math whereby they figure they can acceptably lend a larger amount to Joe average.

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