A drop in the price of residential property tends to happen far more slowly than a share market correction. There are a few reasons for this. First, property price data is very difficult and costly to calculate (there are several organisations that determine property price movements and they all come up with very different results using complicated measuring devices). When data is provided more slowly, people tend to also make slower decisions (it is far more of an emotional decision to sell one’s primary residence than to part with 1000 BHP shares). There is also the fact that property owners tend not to “margin called” in the same way that share buyers do.

More importantly property is a highly illiquid investment — aside from very substantial transaction costs, more than two-thirds of properties are occupied by their owner. Even if you think property prices are falling, most people are very reluctant to sell their home. Part of that reason is logical — most people would need to buy a new home anyway, so they will be “buying and selling in the same market” and there is minimal net gain. If “trading up”, people are better off waiting as the raw discount in the price of a new, more expensive property will be greater than the price drop of the current property. Then there is the less logical reason that most people believe that property never falls in price, so it is never a good time to sell. (Note, these reasons do not apply to investors, who will most likely be the first to sell when prices start falling).

A third reason why property tends to be slow to adjust to its “intrinsic value” is because the majority of property purchases are largely funded by debt. Price is of course far less relevant to a purchaser when they  pay only 10% themselves and borrow the rest. Banks however make more profit when they lend more, so bank executives (who are paid on the basis of short-term bank profits) are encouraged to expand borrowing. Banks then lend money to purchasers based on the price of recent property sales.  So a bank lending too much to one borrower leads to other banks lending a little bit more to another borrower (all based on overly inflated prices to begin with), and the cycle continuing.

All those factors combine to mean that property is a very slow moving beast. The US property market was over-valued at early as 2003, but it took five years before prices collapsed. In Japan, it took prices almost a decade to reach their peak in 1989, but 20 years later, still remain 40% below their highs.

Australia has witnessed a property boom since 1997 (interrupted only by a brief pause in 2008 as the GFC and higher interest rates crimped demand). But recent data indicates that the bubble may be starting to wobble (it is still quite a way from popping though). A good indicator of future housing prices is the auction clearance rate — a low clearance rate implies that vendors have overly high price expectations on their property. Last year, booming Melbourne maintained a remarkable clearance rate of more than 80%. Sydney was a bit lower, but still hovered in the high 60s, low 70s.

However, several factors — most notably, unaffordability, high interest rates and falling migration are acting to very rapidly reduce the clearance rate. In Sydney last month, Australian Property Monitors reported that the clearance rate had slumped to 53% of auctioned houses sold — down from 67% last year (the clearance rate last weekend was also 53% in Sydney). In Melbourne, the situation has deteriorated even more rapidly, with the clearance slumping from about 80% throughout most of 2009 to 57% last weekend.

Meanwhile, other signs of the bursting bubble are emerging.

For example, the Sydney Morning Herald reported recently that glamorous couple Gary Baker and his wife, the Hermes boss Karin Upton Baker, were forced to sell one of their six apartments in a Bondi block for only $1.5 million, after the couple paid $3.5 million for the same property in 2008. The couple had spent more than $12 million buying six apartments in the complex, but were stopped from converting the building into luxury apartments after two owners refused to sell.

Last week the Financial Review warned of “fears of unit oversupply in Melbourne” — a fate that this column has been warning of for months. The over-supply may have something to do with the 120 or so apartment developments (and more than 25,000 unit dwellings) currently being marketed in Melbourne. When combined with dwindling demand from overseas students and lower immigration the alleged supply shortage myth becomes even more mythical.

Then there were reports (also from the Financial Review) on Monday that Macquarie Group is being implicated in an alleged series of loan falsifications by defunct Perth-based mortgage broker, Mortgage Miracles. This appears to contradict the oft used excuse that the Australia mortgage market is pearly white, compared with the insidious US mortgage sector, which would lend to NINJAs and all sorts of other unsavory characters.

Even the Fairfax papers, a traditional mouth-piece of real estate bodies, has turned decidedly bearish. My co-panelist on Sky Business’ Business View, the excellent Greg Hoffman, produced this stunningly logical piece (which was the second most read business article on the Fairfax websites), pointing out that the intrinsic value of property is, heaven forbid, dependant on its cash returns- – like every other asset. Hoffman noted, “the Australian property price debate is divisive and emotionally charged but, whatever your view, it’s foolhardy not to acknowledge the possibility that capital gains may not always be counted on to bridge the gap between the rental income (or rent saved) and a fair return on your capital”.

Postscript: Further to last week’s challenge to Chris Joye, one of Australia’s more articulate property bulls, has declined my offer of a $50,000 wager on the property market.

Peter Fray

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