If you were trying to sell your 1987 Commodore VL, and someone offered you $30,000 for it, would all 1987 Commodore VLs be worth $30,000? No. They wouldn’t. Because the intrinsic value of a VL is nothing like the price paid by the single irrational car lover. But for a just a minute (until the next person purchased one), you could argue that the price of Commodore VLs would be $30,000.
The property market is a little bit like that, although on quite as extreme and no where near as homogenous.
This is because only a relatively small number of properties actually change hands annually — of the nine million dwellings in Australia, about 10% of them are sold each year. That means even if the vast majority of people believe that property is overpriced, property prices could maintain current levels, or even increase. How? Because that small percentage of buyers (often funded by large amounts of debt) are enough to create the illusion of a buoyant market.
Last week, The Economist found that Australian property prices were “overvalued” by 56%. The Economist determined this by comparing prices to rents (using a base year of 1975). It didn’t take long for housing bulls, or poorly informed columnists to criticise The Economist’s logic — quickly falling back on simplistic arguments such as the make-believe housing shortage or Australia’s miracle economy or our tax structure.
The problem with those arguments is that they are answered by the rent-to-price calculation (other than perhaps the tax argument). As The Economist noted:
One of the virtues [using the] price-to-rent ratio is that it takes them into account. If immigration is putting upward pressure on house prices, it should put upward pressure on rents too. And if developers can’t build homes, they can’t build rental homes either. Those factors may justify high prices. They don’t justify high price-to-rent ratios.
As this column has noted on occasion, if there really were a housing shortage, it would be very quickly borne out in higher rental costs. If someone has the choice between renting a property (for more money) and living on the street, most rational people would pay slightly more rent. This, of course, has not happened, with rents in cities such as Melbourne remaining constant in 2010, while property prices rocketed by almost 20%. Similarly, Australia’s miracle economy is not only dependant on housing prices, but also, has for some reason not translated to higher rental amounts.
But remember — for property prices to rise, it only needs a small proportion of people to pay an amount that is above the intrinsic value. These buyers are often using a large amount of debt to fund their purchase (last week the CBA announced that it would allow first-time customers to borrow up to 95% of the purchase price), so their rationality is diminished by the fact that they are not even using their own money. Moreover, at the end of a decade-long boom, purchasing an asset is as much of a status symbol as anything else. Keeping up with the Joneses is, in many cases, far more important to some Australians than paying the right price for a home.
Eventually though, even the small pool of laggards will dry up (as has happened in the US, Ireland and Spain), leaving a rump of buyers who have no interest in paying exorbitant prices for dwellings and leading to a rapid correction.
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There remains are two major reasons why people continue to purchase property in Australia — the fear that property prices will “never go down” and the “status symbol” value attached to housing. These reasons will eventually evaporate when the correction begins, and people realise they are better off being solvent and renting a property, than being foreclosed from their dream home.
As Benjamin Graham famously observed (in relation to a different kind of market), “in the short run, the market is like a voting machine — tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine.”