In some ways, asset bubbles are like a treacherous ocean rip. They have the ability to suck victims in, hiding the danger, until it’s all too apparent — at that time, it’s usually too late for the hapless victim to react. Australian property peaked around May last year, since then prices have gradually fallen across the country. And if overseas experiences are any guide, we shouldn’t be expecting a soft landing.

Perth and Brisbane have led the downwards charge — each dropping by more than 6% in the past 12 months. according to leading analyst RP Data. Melbourne has fallen by 4.3% while Sydney has bucked the trend to be relatively flat. In real terms, prices in Perth and Brisbane have dropped 10% in the past year. This is a substantial decrease for an asset that many claim “never falls in price”.

The depreciation over the past year is unlikely to be a short-term move. There are two major reasons for this:

1. Australian economic conditions are in general, still booming. Australia is virtually at full employment — the unemployment rate is 5.3%, this is lower than the level for much of the past 40 years. Meanwhile, the participation rate of 65.6% is a near all-time high. As the Australian economy struggles, unemployment will inevitably increase, placing far more substantial pressure on house prices. (When house owners lose their jobs and are unable to make necessary interest payments, foreclosure sales force prices lower.)

2. It looks like the issue has already started to occur. Instead of factoring in a never-ending price appreciation, buyers are holding off on purchases. This has been borne out in a key indicator of the strength of the housing market is the length of time it takes a property to sell. This is similar to a “clearance rate” for the private sale market. Quite obviously, if a property is on the market for a longer period, the price being asked by the seller is too high. If the seller wants to offload the property, they would need to reduce their price expectations.

Compared to the income it generates, residential housing is returning owners an imputed yield of 2-3%. That means buyers are still factoring in substantial “capital gains” when they purchase property. As the market continues to fall and more buyers realise that capital gains in housing will no longer occur, this will cause a rapid downturn in prices, as buyers start considering the actual return generating by housing.

For property bulls, recent figures will be cause for grave concern. Fairfax-owned Australian Property Monitors reported that the houses “are now spending 92 days on the market on average, up from 53 days last year … Units are taking 86 days to sell, up from 57 days”. What that means is that vendors have yet to adjust to buyers new pricing expectations — in short, if you want to sell your house, you’ll need to lower the price.

The Age highlights some examples of the discounting already occurring, with vendors slashing the current price on some Melbourne properties by up to 30%.

As with any asset price correction, fear will become contagious. The emotional nature of a home (and the fact that for many, it is by far their largest investment), may even lead to panic selling. Residential property is also often purchased with a very large amount of leverage (the large Australian banks all allow mortgages with less than 10% equity down). A fall of 20% will mean that a very large number of people who have bought residential property since the foolish introduction of the boosted first home owners grant in 2008, will have their entire equity wiped out. (For example, someone buying the median capital city property in 2010 could have paid $50,000 for a $500,000 property. That $50,000 could quickly vanish, leaving the $450,000 debt and a property worth possibly less than $300,000).

Where will property end up? Like any asset, residential property needs to be valued according to the expected cash flows it generates. Currently, investing in property is no different to a sort of Ponzi scheme — the returns of 2-3% are far outweighed by holding costs and the rate of return available on other assets. So prices will need to fall by 40-50% to allow residential property to be more correctly priced (but like most asset crashes, will probably overshoot that level).

The effect this will have on the Australian economy, and the Big Four banks, which have hundreds of billions of dollars of loans on their balance sheets, will be stark indeed.

Peter Fray

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