One of the most common things people say when discussing the residential (capital city) property market goes along the lines of “the property market seems vastly overpriced, but I can’t see any reason for it to drop”. Bear in mind, these statements have been made not by the financially illiterate, but by investment bankers, lawyers and fund managers, who, despite their considerable intellect, are a prone as anyone else to being caught up in a bubble. In making such a statement, one is effectively saying that they believe an asset class has become removed from its intrinsic value, but that the market is permanently broken and the assets will remain overpriced indefinitely.

It is not a surprising thought pattern, especially if someone has only been aware of the property market in the past 13 years. Moreover, given the government and Reserve Bank have provided unprecedented assistance to property sellers in 2008-09, it is forgivable for thinking that the moral hazard created by low interest rates and the first home owner’s grant is permanent.

Alas, the federal government can only stick its finger in the property dyke for so long.

One of the few legitimate reasons for the recent increase in property prices in capital cities has been increasing rents underpinning investment yields. While those rents have been far outstripped by price gains, the increase has at least in some small part vindicated the dwelling price appreciation. However, rentals are dependant on demand (and, of course, supply) factors — if there are a large number of potential tenants seeking a property, that will provide a very accurate indicator to property managers (who often manage a portfolio of more than 200 dwellings) that rental prices can increase. This has occurred in recent years as “cashed-up” foreign students moved to Australia to study, leading to a significant increase in demand for rental properties.

However, it appears like young love, demand from foreign students is not forever. Last week, the (admittedly self-interested) International Education Association of Australia warned that foreign student numbers would drop by 100,000 (or just under 20%) this year, due to a combination of a high Australian dollar, new visa requirements and attacks against Indian students. If this forecast drop occurs, then the inner-city rental market in capital cities such as Melbourne and Sydney will damped substantially. This will lead to already depressed yields dropping even further.

Apart from reduced immigration, there are three likely key drivers for a potential housing correction.

First, the growing risk of a global “double dip” recession leading to higher unemployment. One of the key reasons that the property market in Australia avoided the downfall witnessed in the United States and Britain (as well as Ireland and Spain) was because the flexible Australian workforce encountered minimal levels of unemployment. While recorded US unemployment is 9.9% (but really, closer to 17% when long-term unemployed are considered), and UK unemployment is 8%, the rate in Australia is a mere 5.4%. According to Fujitsu, mortgage stress affected 900,000 households in August 2008, this fell to 561,000 in March 2010, largely, because most Australians were able to keep their jobs. If unemployment in Australia did rise to overseas (or 1991) levels, expect a substantial property correction.

(The unemployment risk has been heightened by government stimulus, specifically the first home buyer’s grant, which effectively “brought forward” housing demand. As Dan Denning from the Daily Reckoning noted yesterday, “when you ‘bring forward demand’ you bring it into the world prematurely. In a financial sense, this means home buyers who, financially speaking, may not be ready to endure the hardships that come with rising interest rates and unemployment. They can only hope that things don’t happen. If they do, the demand brought forward could get crushed.”)

The second possible catalyst for a property correction is if the reverse happens — that is, the global economy overlooks European and US debt concerns and a possible China bubble and continues to grow in earnest. While less likely, if this happens, expect the RBA to further tighten monetary policy and increase interest rates to prevent inflationary pressures.

As this graph, prepared by Chris Joye and Rismark, indicates — higher interest rates are a considerable factor in determining house price-income ratios. The higher the prevailing level of interest rates, the lower the house price to disposable income ratio. Presently, with historically low interest rates (even after the recent rate rises), Melbourne and Sydney house prices are tending to be about six times household disposable income — around double the historical rate.


The third possible catalyst for a housing correction is a possible Australian bank funding squeeze. It is no coincidence that banking and residential property sectors have been two of Australia’s strongest performing areas since the financial crisis. Courtesy of a government guarantee on foreign funding, banks have been able to continue to support the housing sector. This has allowed property prices to continue to rise (and also, importantly, for banks to maintain the value of their security on their balance sheet, making them appear “safe”). The problem is, about half of Australian banks’ funding comes from overseas. If European debt worries continue, and Australian banks need to rely on local savings to fund loans, then the housing market will slump as loan-to-valuation ratios drop and lending tightens.

Just to clarify — what will make house prices correct? If the economy dips, then unemployment will lead to increased stress and foreclosures, and a dramatic shift in buyer expectations. By contrast, if the economy strengthens, then the RBA will most likely be forced to raise rates to more natural levels, resulting in higher service costs and lower price-disposable income ratios. Finally, if Australian banks are no longer able to service their considerable funding costs overseas, then they will not be able to continue to bankroll the bubble. Can the housing bubble burst? You bet.

Peter Fray

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Peter Fray
Editor-in-chief of Crikey