Let’s say you were offered the chance to buy a pub.

The pub has always been popular with the locals. It is well located in a nice suburb and each year the customers seem to spend a little bit more for drinks and food. In fact, for as long as you can remember pubs have been a great investment, usually performing well in good economic times and holding up in bad times.

As a result, investors attach a premium to pubs — they bid up the price more and more each year. Everyone wants to own an asset which always goes up in price. The salesperson who wants to sell you the pub says that the vendor wants a $1 million. The good news is that while you haven’t got anywhere near $1 million saved up. you will only need to spend $50,000 up front because you have convinced your bank manager to lend you $1,050,000 to cover the balance of the purchase price (and transaction costs).

Last year, the pub generated sales from liquor and food of $40,000 and had costs of $20,000 – that means it made a profit of $20,000. You suggest to the seller that the pub seems a bit expensive, giving a “return” of only 2 percent on the purchase price, but the seller’s representative assures you that pubs never drop in value — Australians love beer, and there is actually a shortage of pubs in the area.

Interest payments on the $1 million that you borrow will end up costing $73,000 each year (you got an interest only loan) so in the first year of owning the pub, you will losing around $53,000.

Should you buy the pub?

While there are other factors (such as what returns you can get from other investments) a shrewd investor would almost certainly avoid an investment which involves investing $50,000 to buy an asset which (after finance costs) loses a substantial amount of money. The only possible (flimsy) basis for buying the pub would be with the hope that another person pays more than $1 million for the pub in a few years.

If you haven’t already guessed, the pub is analogous to the median price and median rental yield for Australian residential property. For the past few years by investing in the median capital city property (using finance) you actually lose money — in fact, the only way to profit from an investment in property is to hope that there is a “bigger fool” who is willing to pay even more for an asset which generates a negative return. If you think that this scenario seems a bit like a Ponzi scheme then almost you’re right.

Why did the price of the pub in our example (which was based directly on the returns received from investing in housing) increase so much beyond its intrinsic value? Largely because a financier was willing to lend the purchaser 95 percent of the purchase price. When considering how much to lend to the borrower the bank wasn’t concerned about the returns on the asset but rather was comfortable with the fact that the pub around the corner, which generated a similar low return, sold for $1 million last year.

Or perhaps the bank believed the explanation given by the selling agent — that there was a shortage of pubs in the area.

The problem with that rationale is that if there really were a shortage of pubs, then the pub would have market power to be able to increase the prices for beer or pies so that it generates more profit. The only thing is, what the agent said wasn’t really true. The previous owner of the pub was a pretty shrewd operator, but he knew that if he put the price of beer up by too much, then his customers would stop coming and instead go to the pub around the corner.

That’s a bit like the so-called housing shortage. If there really were a shortage, it would be reflected in higher rental costs and greater yields for owners. Instead, the reverse has happened. In Melbourne, rental yields have actually fallen over the past year, while in most other cities there has been little or no income growth.

The “house shortage” is also contrasted by empirical evidence. Property expert, Michael Matusik conducted a study of the vacancy rate (based on the number of properties available for rent divided by the total rental stock) and found that that the actual vacancy rate in Australia is 4.1 percent, rather than 1.8 percent as suggested by the highly conflicted Real Estate bodies.

In fact, the prospects for property are even bleaker than for our pub.

Property owners will face a series of new challenges. In the past year immigration (especially from overseas students) has dramatically fallen. A higher Australian dollar will exacerbate the drop off, meaning that it is likely that the current anemic returns will further decrease (universities are budgeting for a further fall in overseas student numbers). Meanwhile the cost of finance, which for the past decade has been historically low, will almost certainly continue to rise (as banks pay more to roll-over overseas sourced funding), meaning that the net returns on property (after interest costs are considered) will fall even further.

When prices of an asset class correct, they tend to over-shoot. When investors realise that there is no prospect for capital gain and the net income position from owning a property is negative they will most likely exit the asset class in droves. The wave of selling tends to encourage more selling as property owners seek to preserve their capital. Greed (and the hope for a capital gain) will quickly give way to an even more powerful emotion — fear of loss. This fear of loss will lead investors to make even more irrational decisions, and sell property to below even its intrinsic value.

As for property prices always rising — that is not necessarily the case. Between 1891 and 2001, in real terms, Melbourne property prices did not increase at all. That’s 110 years of no real capital gains.

Peter Fray

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