However you frame it, the performance of residential property in the past year has not been good. And it certainly doesn’t look like improving any time soon. For an asset that many true believers claim “never drops in price”, since 2007, almost one-in-10 properties have has dropped in price. That is before myriad costs related to property ownership are considered.

According to leading data company, RP Data, more than 13% of properties bought in Queensland and WA have fallen in price since 2007. At the same time, the Financial Review stated that an increasing number of property owners are struggling with mortgage repayments. While off a low base, the proportion of home owners who were a month or more behind on repayments rose by more than 21% last month.

The major concern regarding house prices isn’t they are losing their “froth”, but rather, that the fundamentals underpinning housing are crumbling at the same time. This is not altogether different to what happened to dotcom stocks in the early 2000s. Before the bubble popped, speculators happily believed that IT stocks would have hugely increasing earnings — this vindicated sky-high multiples. Therefore, when it was revealed that dotcoms not only wouldn’t increase their earnings, but their current profits would also fall, the price of those stocks was decimated.

With net rental yields of about 2% in some areas, residential property has an imputed price-earnings multiple of upwards of 50 times earnings. What that means is that the buyers expect the income serviced from property to increase significantly in the years to come. The only reason a rational investor would accept a 2% return now, is if they thought that return would increase substantially in the years to come.

The problem is, not only does it look like income from property won’t be increasing, there’s a chance that it may drop.

There are supply and demand side factors for this.

From a demand perspective, much of the anticipated future rental growth is thought to come from population (and economic growth) increases. The belief is that with limited availability of land, as Australia’s population increases, demand will force up property prices.

There are two problems with this theory though. The first is that while it is not a perfectly free market, supply does react to increases in demand — as developers see the potential for profit, they construct more dwellings (often, after a slight time lag). More importantly, Australia’s population is increasing at a slower rate than in previous years. According to recent ABS data, increased mortality rates and sharply lower immigration levels has meant that Australia’s population rose by only 312,400 last year — an increase of 1.4% (compared with 2.2% in 2009).

The ABS also reported that around 149,000 dwellings starts occurred in the year to June. With an average 2,6 residents per dwelling, Australia is constructing enough housing for an extra 387,000 people each year. In short, there is actually a surplus of dwellings being built, rather than a shortage.

The second problem with demand based property price pressure is that income growth is likely to slow, rather that rise. Australia is in the midst of a structural low point in unemployment. At the same time, government revenues have been assisted by a once-in-a-lifetime mining boom, largely created through Chinese demand. Further, part of Australia’s recent increase in income levels has been created through the property boom, which has spurred construction and consumer spending to create a faux positive feedback loop.

Just to recap — Australian property is priced for substantial future income growth — but there is likely to be less demand for dwellings than there is new supply, and incomes are likely to plateau or fall.

So not only are the fundamentals underpinning future price rises highly questionable, but the current property prices are already too high. The complete lack of understating as to the intrinsic value of property was underlined by ANZ economist, Paul Braddock.

Braddock, whose employer has exposure to hundreds of billions of dollars of residential housing loans, told the AFR that “we believe average household incomes will grow between 4-5% over the next 10 years, so there’s no reason to think that house prices won’t do the same.”

There are two problems with Braddock’s view. First, it’s unlikely that incomes will grow by 4-5% given the state of the global economy. Second, house prices have far outstripped incomes since 1994. During that time, incomes have risen by 80%, while median prices have rocketed by more than 200%. Exactly how Braddock is able to claim that prices will track income growth in the next decade, when they have drastically out-performed income-growth in the last.

Even without worsening fundamentals, property is falling in price. As incomes steady and new supply comes on-line, the price drop will continue in earnest.

Peter Fray

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