The residential property boom, which resembles more of a Ponzi scheme each week, reached new heights last year as panicked buyers swamped the market. Most of the fear was generated by real estate insiders who benefit from property transactions, with buyers stimulated by government stimulus and cliché (“property always goes up”). With real yields (after council rates, maintenance, body-corporate costs and most importantly, depreciation) in many capital cities about 2%, something has to give. That is, either (1) prices need to fall; or (2) rentals need to rise for yields to return to “normal” levels.

Property returns (be it for investors or owner occupiers, who are theoretically able to invest their money elsewhere) like any asset, should return a premium to the “risk-free” rate. Those returns are a function of rental yield and capital growth. Yield is easy to calculate, being the rental return less all costs (cash costs and depreciation). Capital growth is largely dependant on inflation or economic growth. In most instances, the rate of capital growth should resemble inflation, but in some cases, it may be higher (for instance, if an area becomes more popular due to better amenities).

With current “real” yields in capital cities sitting at 2-3%, and inflation of approximately 1%, capital city property is in many cases, providing a net return of less than 5%. At the moment, variable mortgage rates exceed 6% so investing in property doesn’t even meet its cost of the capital.

This is where the shortage myth is relevant. While many property buyers are unsophisticated and do not use much of their own money to purchase a house (property purchasers are among the highest leveraged investments most people would ever make) they are not completely stupid. No one would purchase an investment that returns less than it currently costs unless they believed that the income received (from rentals or capital gains) would increase in the future.

Property investors appear to believe (largely spurred by the real estate industry and the largely unsophisticated media) that rental costs will increase substantially (possibly caused by the mythical housing shortage). It is understood that the shortage will lead to higher rental yields and stronger returns and later, capital growth.

The problem with that theory is that demand and supply factors are working to counteract the shortage.

On the supply side, when prices increase, that provides motivation (in the form of higher profits) for developers to construct more dwellings. As Robert Shiller noted: “One fact is often forgotten: the construction industry is capable of building vast numbers of homes, including high-rise units, at far below the cost of homes in many urban areas today.” A looming shortage also compels the government to release more land and possibly ease zoning restrictions. The Financial Review reported last week that “the total number of dwelling approvals rose by 5.9% in November [2010] to 13,724 units, pushing total building approvals up by 33% over the year.” The long-term average for dwelling approvals is slightly more than 13,000 per month (approvals dropped below 10,000 earlier this year as prices slumped). The solution to high prices is funnily enough, high prices. An increase in supply will reduce rental yields and dampen capital growth.

Demand factors are also working against rental yields. The Age reported that “temporary skilled workers migrating to Australia have halved since this time a year ago, after more stringent workplace laws came into force”. Reduced skilled migration softens demand for rentals, further decreasing yields. When combined with historically low unemployment, the belief that rental yields will increase substantially appears to be based on scant evidence.

Last year, with immigration at record high levels and building slumping, the market was not far off equilibrium. As the employment and immigration ease and supply returns to historical levels the alleged housing shortage should disappear.

As Shiller noted: “We used to think homes were in the same category as cars: depreciating assets that grew obsolete, were costly to maintain, went out of style, eventually to be replaced. Now we think of them as claims on increasingly scarce resources with prices potentially sky-rocketing soon.”

The original theory — of property as a depreciating asset is correct. Houses don’t last forever. Similarly, no asset (even land) increases in price indefinitely. Eventually, market forces (like increased developer profits and reduced migration) will dampen yields, often forcing an overreaction on the downside as the price of the asset returns to its intrinsic value.

The days of endless capital growth in housing must come to an end. If rental yields don’t increase substantially, the current level of housing is unsustainable.