It has been said that the four most dangerous words in investing are “this time it’s different”. However, it seems someone forgot to tell that to Australia’s housing bulls.

Low interest rates will be permanent in Australia — any risk of going back to the bad old days of 10% plus home loan rates or 75% loan to valuation ratios? Not a chance. This time it’s different.

Capital city residential property yields as low 2% after costs. That means investors are making far less than the “cash rate” on a riskier investment in the hope that a bigger fool will come around and pay more for that asset. Don’t worry, with property, this time it’s different.

In this regard, it was interesting to read Rismark chief (and Business Spectator columnist) Chris Joye’s justifications for Australia’s sky-high property prices in which he noted that he would “eviscerate the long-standing myth that the Australian housing market is in the throes of an unsustainable bubble”.

Joye’s justification for property not being over-priced was two-fold. First, it is claimed that lower mortgage interest rates has meant that affordability of Australian homes has actually improved since 1985 (this accounted for 31% of housing’s price rise). Second, Joye observed that 61% of the extraordinary house price appreciation was due to rising incomes. In relation to the first point:

“The increase in household debt-to-income ratios, which started during the early 1990s, and the coincident rise in Australia’s dwelling price-to-disposable income ratio, can be partly attributed to the circa 40% reduction in average mortgage rates between 1980 and 1995, on the one hand, and 1995 and today, on the other.

“… more formally, mortgage rates averaged 12.6% between 1980 and 1995. Since that time, mortgage rates have averaged a little less than 7.5%.”

In other words — this time it’s different.

If interest rates remain low forever, and perhaps things really will be different. Of course, if they don’t, and if the world’s 30-year love affair with debt comes to an end, then funding costs most likely increase. As Stephen Bartholomeusz noted, debt is becoming increasingly scarce, with a combination of prudent bankers and panicked regulators resulting in a substantial tightening of lending across Europe.

In Australia, banks have been able to rapidly increase their mortgage books in the past two decades largely through obtaining relatively cheap funding from Europe. If that funding dries up in the coming years, and it looks like that will occur, this lending growth is unsustainable. In that regard, ANZ has already indicated that it will be setting variable mortgage rates according to their cost of funding, not necessarily the RBA cash rate. Credit, like any other good or service, is subject to the forces of supply and demand — as funding dries up, that will leave two options — either banks will stop lending (which will be seen in tightened lending criteria and lower LVRs) or the price of borrowing will increase. Either result will have dire ramification for house prices, which have grown largely due to increase lending.

Joye’s second rationale for Australia’s high prices is also contentious — that is, Australian incomes have risen enough to justify 61% of the increase in house prices. Joye claimed, “if we simply index the 1985 median dwelling price by this measure of incomes, we can account for 60.1% of the total increase in Australian housing costs over the past 26 years”.

However, this observation comes down to how one defines income.

If we were to consider wages rather than income, the picture is quite different. Using ABS wage data going back to 1994 (rather than 1985 as Joye used), wages have increased by about 90% in the past 17 years. During that same period, the median house price has risen from $148,000 to $448,000 (the median price increase would have been more pronounced in capital cities, which have seen a larger rise). So wages have risen by only 90%, property prices have rocketed by more than 200%. The difference is that Joye doesn’t base his comparison on wages, but rather on incomes.

There has been an ongoing dispute about how what should constitute income between Joye and economist Leith Van Onselen. Van Onselen has stated that the income figure suggested by Joye is overstated as it includes owner imputed rents and contributions to superannuation. This is a fair argument, given that home buyers usually can’t access superannuation.

In addition to the that, another key reason that the income increase appears so much higher than the wage increase is because Australia has near-record-low levels of unemployment and record high labour participation rate.

Put more simply, while wages haven’t increased enough to justify the increase in house prices, more people are working, which means there is more income per household. The female participation rate has risen from 60.3% in 2001 to 64.8% now. In total, the ABS reports that the total number of employed persons has increased in 8.7 million in 2006 to 11.4 million in 2011. (Previously, many of those female workers would have undertaken unpaid “home duties”, which, while valuable, are not included in calculating economic data).

For Joye’s arguments to hold, this time it needs to be different. That is, Australia’s unemployment rate will need to remain at structurally low levels and participation rate remain high — forever. If Australia encounters a US-style recession (or a repeat of the early 1990s recession), then income levels will fall (due to less people working, as well as lower economic productivity generally). The labour force participation rate in the US has dropped by 2.6 since 2007 to levels last seen in 1984.

(There’s also the argument to be made that needing two incomes to purchase a house that would previously be bought on one income means that the real standard of living for Australians has also been reduced.)

In the event that labour force participation drops, the problems will reverberate because higher unemployment (or underemployment) will also lead to increased foreclosures, exacerbated by the substantial increase in mortgage debt (which has increased as a proportion of GDP from about 20% to almost 90% since 1997). Even now, with near record employment levels and still high property prices, there has been an increase in the number of mortgage holders who are “under water” — that is, they owe more on their mortgage than the value of their property. In Western Australia, almost 5% of mortgagors have negative equity.

Is the Australian housing bubble a myth? Sure. If this time it’s different.

Peter Fray

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