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.
12 thoughts on “Housing boom: where the shortage myth is relevant”
Gary Johnson
January 18, 2010 at 2:58 pm@AB
Knowledge is good AB..if it becomes wisdom. Education is good too, if there are opportunities to be exploited that were created by that education. Hard-work is also good, but working smart is better.
In my year 10 class at High-School, a very low class in learning standards…the next class down was the intellectually challenged so you it was very low on the ladder. Six of the worst learners in my class went on to run very successful businesses and in material terms are very wealthy people.
So it certainly was n’t education that got them there. Hard- working?..maybe, but I would say they were smart workers.
A lot of those in the higher classes and much better achievers academically went on to become alchoholics, drug addicts and employed in menial positions they loathe.
So from my experience in life, …it is “silly” to place so much emphasis on education for “edjakaishens” sake.
If I had my way, Australia would become a nation of shop-keepers…entrepeneurs who are self sustaining and independent..ie..self employed instead of relying on big business and govt to save them….commerce and business should be mandatory from a very young age and you would be amazed what could come of this.
And yes, I do believe it is a universal right that people are entitled to a roof over their head without the debt-slavery of a mortgage…but it does n’t have to be a sub-prime thing. As I mention to you ages ago, too much money is tied up in mortgaes in the first place that should be invested in job and real wealth creation…not the false economy of the Australian Housing Market.
abarker
January 18, 2010 at 3:23 pmIt’s good to hear about the guys who worked hard and went on to do well. And yes, some high acheivers do realise after school that the real world isn’t so accommodating. But they are the exception, not the rule. Besides, access to finance, the banking system, contract and legal frameworks and yes, dare I say it, even maybe the equity in their home helped them get there – nobody is a self made millionaire – everything people do now has evolved from hundreds of years of legal and financial evolution.
In most cases however, education will lead to a higher standard of living and a higher degree of satisfaction and happiness. I’m not saying people need to go to Uni to be rich – when I say education, I mean pick up a book – read a website – get more people’s point of view, or find out what they did. It’s not so secular like it used to be. The rich people’s stories are in books now. They are generally approachable. Not like back in the day when the banker rolled around in his chauffeur driven ghost back into his gated community while the paupers lived outside in slums.
As for your view of little Australia, that’s ridiculous. Not everyone wants to be an entrepreneur. Some people like the fact they can have a 9 to 5 job with an employer and feel secure that way. Not everyone has sales skills, merchandising or the necessary book keeping or financial savvy to run a business. Some people don’t want it. To suggest we bin big business and return to the agrarian subsistence style of living, that’s what’s silly. Besides, who says one of these little guys won’t buy the guy down the road, and the one next door, and suddenly up springs a big business? Should we put rules in place on that? It’s called Communism.
And yes, having a roof over your head is a right – owning the roof however is not. That is a privilege and, before that, a choice. Debt slavery? Debt is a tool. Like fire. Used responsibly it can be a very powerful thing. Yes there is plenty of money tied up in mortgages but that means banks are bigger, real estate agencies can hire more people, more work for property services such as conveyancing, property management, maintenance people etc. Would you recommend we wind all that back and put them all out of work?
If nothing else it provides stability. I know I can’t go riot in the streets about the injustice in our world, because I have to get up to go to work to pay my mortgage.