Rising house prices: not a wealth fountain. A money-go-round.

RBA deputy governor Phillip Lowe gave a great speech last night. Lowe is the guy most likely to replace Glenn Stevens when Stevens quits as Governor and it is worth paying attention to what he says.

Last night’s speech was pretty radical. In the guise of a dry discussion of Australia’s balance sheet, Lowe single-handedly deflated arguments for rising house prices.

That puts him in direct opposition to noone other than Prime Minister Tony Abbott. Abbott, of course, said in June “I do hope our house prices are increasing.”

The argument Lowe makes is so smart and so obvious it’s amazing we don’t hear it more often. He starts out by showing that the rise in “house prices” is really a rise in land prices.

Screen Shot 2015-08-13 at 10.33.46 am“[T]he figures that I have presented invite the conclusion that our national wealth has risen largely because of higher land prices. But is such a conclusion really warranted? Have we really become wealthier as a nation simply because the value of our land has increased?

“The answer would clearly be yes if this increase was because we had discovered more land. To my knowledge, though, this has not happened.[7]”

Lowe argues that the rise in house prices is not a nice neat story about the returns to city life increasing. He says prices rose because of financial deregulation and supply constraints.

This creates not a wealth fountain but a money-go-round, he explains.

“from the perspective of society as a whole, much of what is gained on the one hand is lost on the other: there are windfall gains from higher land prices but then everyone pays more for housing services.”

Lowe also reveals that the “baby boomers are ripping off the kids” narrative has some credibility even in that palest of economic ivory towers, the RBA.

“For an older person who owns their own home and has no children, the capital gain from the higher land prices more than offsets the expected higher future housing costs. Such a household is better off. The same is true for owners of investment properties, since they own multiple dwellings on which they earn a capital gain. In contrast, for young homeowners with multiple children, the calculation can look quite different. If they care about the future housing costs of their children, then, in some circumstances, it is possible that the higher future expected housing costs could exceed the capital gain on their dwelling. In a welfare sense, the increase in land prices could make them worse off, even though they own land. The same is obviously true for renters as they do not have any capital gain to offset the higher future housing costs.”

“I think many Australians have an innate understanding of the concept and share the concern. Many parents around the country look at the high housing (really land) prices and worry that their children will not be able to afford the type of property that they themselves have been able to live in, even if their children were to have the same life-time income profile as they have had.”

“So it is arguable that the main impact of higher land prices is not really to increase our national wealth, but to change the distribution of that wealth.”

He goes on to argue that if parents help their kids buy houses, high house prices are perpetuated. But their wealth effect is diminished because the people that have expensive assets are using them as collateral for buying more expensive assets. That is to say the high prices bring no benefit.

If, however, parents don’t help their kids buy houses, and instead spend up big (say on trips overseas) then house prices are more likely to moderate.

This latter scenario, as unpleasant as it may seem to some, is actually the better one for social stability. Because with Australia’s strong immigration profile, not everyone has parents who own property in Australia. The divide between new migrants and established citizens will only grow larger if property wealth is transmitted across generations.

The most important question in our economy: Why will we invest in housing but not business?

The Australian economy is not growing fast enough. Everyone knows it, but we’re in a sort of paralysis, watching the unemployment rate rise.

Consumer price inflation is under control. Normally the RBA would simply cut interest rates, because they’e not impressed with the economy – not one bit. Here’s what the RBA Governor said last week:

“There are sufficient spare labour resources such that we could probably enjoy a couple of years of non-mining sector growth somewhat above its trend rate before we needed to worry too much about serious inflation pressure.”

Basically he’s saying he sees a lot of slack out there, and capital investment is not quite high enough to tighten it up.

ABS capex

So why don’t they act to cut rates? The answer is that house prices are going gangbusters, especially in Sydney,

“Prices have risen in all capitals, with a fair degree of variation: the smallest increase has been in Canberra, at about 6 per cent, and the largest in Sydney, at 28 per cent… a bit more of the ‘animal spirits’ evident in the housing market would be welcome in some other sectors of the economy.”

If they cut interest rates to boost the economy at large, they run the risk of pumping yet more air into the housing market. Because the RBA sets the interest rate but can’t control where investment is made, they are stuck sitting on their hands, hoping something changes. What they really want to see happen is investment (capital spending) in the business sector.

“for accommodative monetary policy to support the economy most effectively overall, it’s helpful if pockets of potential over-exuberance don’t get too carried away.

Turning from housing investment to investment more generally, a more robust picture for capital spending outside mining would be part of a further strengthening of growth over time. Some of the key ingredients for this are in place. To date, there are some promising signs of stronger intentions, but not so much in the way of convincing evidence of actual commitment yet

So while the RBA is in wait and hope mode, we might as well ask why?

Why do Aussies believe buying a flat and holding it for five years will bring us a return, while having grave doubts about the wisdom of opening a panel-beaters, or a cafe, or a farm?

The obvious answer is that we have higher expectations of return from housing than from investing in businesses.

But that is a sort of truism. It doesn’t really give us anything to latch onto and think about. Let’s try to break it down. Here are seven theories of various plausibility on why Aussies might think housing has a better return than investing in business.

1. Pessimism

This topic got quite a bit of air time from a speech just last night by the man seen as the next Governor of the Reserve Bank, Philip Lowe. He talked about the way the community felt uncertain while coming out of the GFC.

“It is important that we guard against the possibility that this uncertainty mutates into chronic pessimism – that is, for it to become normal for us to think that our prospects are limited. If this were to become our normal mindset, then we would be well on the way to finding ourselves in the very world that we feared.”

I’m not too impressed by talking about pessimism, because even if it is 99 per cent of the explanation, it’s not under the control of policy. Better to focus on the 1 per cent you can control.

2. Risk perceptions:

It’s easy to turn a million dollars into zero in business. The survival rate is not that great. Of the businesses extant in 2009, 37 per cent were gone by 2013.

Not so in housing. Houses survive very consistently and you’re far more likely to turn $1 million into $1.1 million.

RBA house prices

The quick remedy to this is a catastrophic housing collapse. But the good remedy is much harder and more difficult to engineer – better returns to business.

3. Structural change

The flux in the economy recently has many sources, not least the internet, but also globalisation. That makes investing tricky. How to choose the right sector to invest in? Media, finance, manufacturing and retail all look suspect.

If leading businesspeople have experience in sectors that are dying, you can not expect them to invest. It’s hard to expect all that slack to be taken up by the people with experience in organic foodstuffs, professional service or biomedical industries, because they are starting off a much smaller base.

4. Tax structures

Hello negative gearing. Your moment to be led to the chopping block may be nigh.

Given everything that’s happening, do we need more incentives for investment housing, especially for existing properties?

And what about the other side? Do we need lower taxes on business? Could the next CSL, the next BHP or the next Woolworths currently be a medium sized business with a growth plan in the top drawer? What is preventing the owner from making that growth a reality?

6. Pale pink in tooth and claw?

Australia is a country where it is great to be middle class and where Clive Palmer is a dickhead. Why would you even want to be loaded? Alan Bond, Chris Skase, Gina Rinehart, Nathan Tinkler. I’m struggling to come up with a memorable business person that people might see as a hero. Could that be crimping my generation’s desire to risk it all to top the rich list?

6. FDI

Even if Aussies are pessimistic, why isn’t foreign investment picking up the slack? Do they know something about us?

7. The dollar

The Aussie dollar has been ridiculously high. With the mining boom over, it has gone to tumble-town, and hit a four-year low overnight, around US85c. That could be the spark needed to get the economy going again. The RBA must certainly hope so.

RBA calls it: Australia’s housing market has gone horribly wrong.

“Unbalanced” and “out of proportion” are the words they use in a brand new report out today.

“Recent housing price growth seems to have encouraged further investor activity. As a result, the composition of housing and mortgage markets is becoming unbalanced, with new lending to investors being out of proportion to rental housing’s share of the housing stock. “

Do not get the impression the RBA thinks this will be a minor:

“In the first instance, the risks associated with this lending behaviour are likely to be macroeconomic in nature rather than direct risks to the stability of financial institutions.”

nb. “In the first instance…”

Who knows what sort of calamity could follow a macroeconomic event associated with a big house price fall? And if you think not owning a house makes you safe then you are wrong.

“…a broader risk remains that additional speculative demand can amplify the property price cycle and increase the potential for prices to fall later, with associated effects on household wealth and spending. These dynamics can affect households more widely than just those that are currently taking out loans: the households most affected by the declines in wealth need not necessarily be those that contributed to heightened activity”

This chart got the RBA concerned:

 

house price expectations

“… expectations of future housing prices seem to be influenced by the recent past (Graph  3.4). This tendency was stronger than average in New South Wales and Victoria at the end of last year. The risks associated with this behaviour are likely to be macroeconomic in nature if households were to react to declines in their wealth and any repayment difficulties by cutting back their spending. “

The recent rise in interest-only loans (yellow line below) also has the RBA worried about whether speculation is rife.

Interest only loans

They are so worried about house prices they are cracking open the weapons safe and rustling around for some ammo to try to scare off packs of hungry investors.

“The Bank is discussing with APRA, and other members of the Council of Financial Regulators, additional steps that might be taken to reinforce sound lending practices, particularly for lending to investors. “

The most likely step is not to mimic NZ and try to control Loan-to-Value ratios (as you can see in the above graph, LVRs seem to be under control). It is to make banks add a bigger buffer to their lending criteria. Currently they add 2 per cent to the existing interest rate. That might rise.

The last warning the RBA delivers may be important for anyone considering buying a small apartment in central Melbourne:

“A speculative upswing in demand can also be damaging if it brings forth an increase in construction on a scale that leads to a future overhang of supply. This risk is more likely to arise in particular local markets than at the national level.”

CAVEAT: The RBA points out that housing market dynamics are most skewed in Melbourne and Sydney. I’ve noted myself that buying in Brisbane looks like a pretty clever move.

FULL DISCLOSURE: The author is not invested in property.

Where in Australia should you buy a house?

The RBA kept official interest rates on hold again today at the record low of 2.5 per cent, while actual mortgage rates are low and falling:

Source RBA

So could house prices actually rise from here? One economist whose blog I read has built a buy/sell indicator. It’s currently on buy.

He reckons house prices will keep going up while the mortgage rate is not much more than the rental yield. He also theorises that Sydney prices rise first, and the rest of the country lifts thereafter. This theory holds water for me on an intuitive level. In the short run, a house in Melbourne is not a good subtitute for a house in Sydney, but in the medium term, perhaps it is. In the long-term, perhaps even a house in Adelaide could be a substitute!

But house prices in Melbourne seem a bit high to be making bold acquisitions for speculative purposes.

Luckily, house prices are very different across Australia. Sydney is way out in front. Perth, Melbourne and Canberra are a cluster. Then Brisbane and Adelaide are limping along at the back of the pack. Hobart doesn’t make the graph but it is somewhere back there too. 

House prices across australia

If you wanted to buy a house somewhere cheap, which makes most sense?

You’d want to choose a place with strong growth prospects. In recent times, all three laggards (Brisbane, Adelaide, Tassie) have shown a bit of pluck when it comes to the labour market (focus on the yellow lines).

QLD job adsSA job ads

Tassie job adsBut you want to be careful. Tasmania’s prospects are pretty dire, as discussed in this piece: How long until Tasmania is totally empty?

So which city are people most likely to move to?

Moving to ...
Google Trends says Go North!

The Brisbane connection looks to be the smartest option. Hmm, how much is one of those famous Queenslanders (a wooden house on stilts)?

Turns out you could get one in a great inner-city suburb for $610,000,

Queenslander

(or a perfectly adequate seeming flat in the inner city for $190,000.)

Now, despite its “beautiful one day perfect the next” weather, Brisbane doesn’t rate a mention in the top ten cities ranked by the Economist for liveability.

Melbourne scoops that award every year (Adelaide came 5th this year in results released today). But while we are being open-minded, it’s worth noting that that survey is horribly biased.

If we broaden our horizons we find that Brisbane makes the top 25 list for the much hipper Monocle Magazine quality of life ranking, getting a shout out for its excellent Gallery of Modern Art.

Is that enough to make you want to purchase your own place in the sun? 

Where did all the first home buyers go?

First home buyers are off the market. The current share of 12.6 percent is around the lowest on record.

Screen Shot 2014-07-14 at 10.44.00 am

The 2000s, where first home loans grew really fast and were about as big as other home loans, looks like an outlier period, but so does the current (post-2009) period, where there is little to no growth in first home loan value

Screen Shot 2014-07-14 at 10.21.36 am

What’s happening?

I was surprised to find cutting interest rates is not helping. First home buyer shares have sunk as interest rates have fallen. On average, cutting interest rates by a percentage point cuts the share of first home buyers by three-tenths of a percent.

mortgage interest rates

 

Rent is a significant factor. But it seems to work in the opposite direction to what I thought. In the long-run, as rents rise, the first home buyer share falls. I found a correlation of -0.39 per cent between rents and first home buyer share

rent growth each quarter

rent cost to mortgage cost ratio
Mean housing costs for mortage holders and renters in NSW, 2011-12 dolalrs

The whole thing looks like something of a mystery. But fortuitously, while I was thinking about this, a clue arrived.

The RBA released a big paper yesterday that said house prices are fairly valued, if you assume that house prices will keep growing at 2.4 per cent a year real (say 4.4 per cent to 5.4 per cent including inflation). That 2.4 per cent is the rate they’ve grown at, on average since 1955.

The paper breaks down some of the reasons for house price growth. At the moment, low rates are propping up growth, rather than expectations of appreciation, which are negative. When rates eventually go up, expectations about appreciation will have to change, or rental yields will have to boom, or house prices will turn downward.

 

rba reasons for house price growth

 

The paper suggests that if you think house prices will grow at the same rate as GDP, you think they are undervalued, but if you think they will grow at the same rate as real household disposable income (HHDY in the chart below), you think they are overvalued.

over valued or undervalued

 

There’s two more points I want to draw your attention to. The 10-year figure and the 30-year figure. If you are in the market for a first home, you may have focused on house-price growth in the last ten years, and see house prices as about 20 per cent over-valued. Hello first home buyers.

If you’ve focused on them across the last 30 years (Hi Mum and Dad) you might still see houses as 20 per cent undervalued.

This is no doubt an overly neat explanation, but it must go some way to explaining first home buyer reticence at this time of record low interest rates.

It might be time to sell your shares and your house

Another big financial crash could be coming.

There is a lot of evidence that markets are doing that thing they do. Getting out of whack.

It’s hard to believe that this could happen again so soon. In the past, major financial events have been interspersed with decades of good times.

But to count on history repeating would be … brave.

Here’s the symptoms of the problem. Stocks are super high, with the US markets setting records:

DJIA high
Source CNN

That could be a good thing right? Companies get high valuation when they have high earnings. And high earnings mean a healthy economy!

Hmm. 

Price to earnings chart
Source

This chart shows a ratio of stock prices to company earnings. It shows that prices sometimes get well out of line with earnings and the market can’t sustain that.

How can this happen?

As anyone who has played monopoly knows, the more times people pass Go, and the more money in the system, the higher the asking prices for trading properties. 

The same thing can happen at a much bigger scale. The more cash in the global economy, the higher asset prices are.

Here’s evidence that cash is swilling around in the global economy like burger wrappers in the passenger footwell.

Greece government bond yields
Source

The Greek government can now borrow money at 6 per cent. In 2012 they had to pay over 30 per cent. That’s how much cash is lying around. Even though Greece’s problems remain dramatic (e.g. 27 per cent unemployment), money managers are happy to give €€€€ to the government. Similarly in Spain, where unemployment is 25 per cent, bankers are happy to lend money to the government at the lowest interest rates since 1789. Seventeen. Eighty. Nine. 

Meanwhile Dutch interest rates are at their lowest in 500 years.

You can also spy the global economy’s excess cash in the way Facebook is buying things like WhatsApp, for $19 billion, and in the near-record valuation of Apple even as iPhone enthusiasm is being studied by historians. 

Here’s how the New York Times describes it:

“Around the world, nearly every asset class is expensive by historical standards. Stocks and bonds; emerging markets and advanced economies; urban office towers and Iowa farmland; you name it, and it is trading at prices that are high by historical standards relative to fundamentals.”

Australian stocks have rallied hard in the last two years, and here’s a chart of Australian house prices, just to show that our assets are not immune. 

House prices
Source

Global markets have not got to this point without a reason. The billions pumped into the economy by central banks doing quantitative easing explains the surplus cash. 

The Bank of International Settlements has said that this has caused capital “misallocation” on a scale similar to the GFC. 

So what could happen next?

The United States is now planning to stop its five-year quantitative easing program, this October

The billions a month it “printed” will cease to arrive at the banks and they will have to go back to more old-fashioned ways of finding capital.

Then, we find out if economic growth can catch up fast enough to make all those high prices make sense, or if everything crashes. 

Plummeting asset prices in North America and Europe would hurt us, no doubt. But a fall in China has already begun and that simultaneity would be the worst case scenario.

Last time round, China was basically immune from global financial contagion. But this time, everyone agrees China is in an asset bubble that is already ending. 

china property prices
Source: Economist

If asset prices fall fast in China and the West at once, it will be time to move your savings into something very very safe.*

*You know I’m not a financial advisor, right? Right.

 

Hockey on house prices: Two incomes now necessary.

I went to the Melbourne Institute economics conference yesterday and heard Joe Hockey speak at lunch. He’s not bad on his feet. Even when he’s not across the detail, he bluffs well. He seems likeable and projects passion.

But he said something I couldn’t quite believe.

Let’s face the reality. Unlike our parents, our generation and the ones that follow will not be able to afford a house in a capital city on just one income.”

This little message came in the middle of a spiel about how the paid parental leave scheme would pay women to raise kids. I wondered if it was a slip-up. But no. He said it again later.

“Try living in any capital city in Australia on just one household income. It’s nigh impossible. But the mortgage still keeps coming in. And the bills still keep coming in.

While this matched my own experience quite neatly – I don’t own a house and wouldn’t consider buying one without going halves in it – I doubted a Treasurer should accept it as a fact.

But perhaps the problem is too far gone. Here’s a table I made that shows who might be able to afford what.

But perhaps the problem is too far gone? Here’s a table I made that shows who might be able to afford what. (The cheapest house I could find in Melbourne was this one bedroom unit in Noble Park for $160,000.)

house prices out of reach
The average house (~$550k) is unaffordable on the average wage

When lone-person households are our fastest growing demographic group, making up 24 per cent of Australian households, and single parent households are raising over a million children (961,000 single parent families representing 15 per cent of all families), house prices rises seem less like a boon to the economy and more like a social welfare disaster.

Systems that permit stability of tenure for renters should be introduced as a matter of urgency. Housing affordability is at least partly a policy question. As a starting point, Treasurers should talk about low housing affordability as a problem, not as a fact.