While many Australians are coming to the realisation that the housing party is over, with the Financial Review reporting that first “buyers joy turns to despair” there are still a few who haven’t quite read the memo. Like Australia’s big banks, Westpac, ANZ and NAB, who reported higher profits based on lower “bad debts”, despite mortgage delinquencies increasing sharply. Plus, there are also a few commentators who continue to propose reasons for why housing isn’t really overvalued.

Property valuer Michael McNamara, who earlier this year shrewdly warned of dangers of negative gearing last week purported to defend property prices based on a misguided premise — not appreciating the difference between a “gross” yield and a “real” yield.

While acknowledging the recent price falls, McNamara, a former head of Australian Property Monitors, claimed that:

“Putting the bad news aside, nominal GDP is running strongly, investors are more active than they have been for quite some time and gross rental yields in most state capitals are around 5% … Today, yields in Sydney are at 5.4% and rising. There is no glut of accommodation, no rising unemployment. Quite the opposite.”

McNamara concluded that “the housing market is characterised by resilience and stability given that high yields underpin prices”.

The problem? Investors in any asset aren’t paid on the basis of a “gross” yield. To all intents and purposes, gross yields are completely irrelevant. What matters for any investment are the actual cash flows that are derived, or the “net” return earned. In the case of property, the gross yield is the rental paid divided by the purchase price (or more accurately, net realisable value). However, a property investor needs to pay all sorts of expenses — for example, property management fees, rates, body corporate fees (in some cases), insurance, utilities and depreciation of the structure. In many cases, that will usually turn a “gross” yield of 5% into a net yield of between 2%-3%.

By using “gross” yields, McNamara is providing a completely fallacious comparison — when you place your money in a bank account, the yield paid is on a “net” basis — when you invest in a company, the profits are reported on a “net” basis, the gross profit of the business is in most cases, irrelevant.

So the main premise of McNamara’s argument — that a yield of 5% will underpin property prices, is completely wrong. That leads to another problem — currently, Australia is enjoying near “perfect” economic conditions — practically full employment, low interest rates, and relatively low inflation. So if anything, property yields will worsen in the years to come as unemployment and interest rates increase, leading to rising mortgage delinquencies. The future for property appears at best bleak, and at worst, catastrophic.

And if the American and European experiences are any guide, a property downfall leads to a general economic downturn, which creates a vicious cycle, further dampening property prices (the situation is worsened when the population awakens to the gross of misallocation of resources into the relatively “unproductive” housing sector). In the US, slumping property led the general economy off a cliff, increasing unemployment (property and construction are a major employer), leading to foreclosures, and further falls in property prices. This caused prices in some areas to not only drop to their “intrinsic values”, but in many cases, overshoot on the downside.

As Ben Hurley noted in the Financial Review: “in working class [areas] around the country, mortgage repayments are cutting deep. Delinquencies are climbing. In this month’s half-year reporting season, [ANZ] told shareholders [that] loans that were past 30 days due had risen by 41 percent. UBS subbed it an ‘ominous lead indicator for the domestic economy’.”

Ominous indeed.

Peter Fray

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