September 2010
Source: Balmain
Author: Stephen Tunley - CEO Balmain Funds

The Case FOR Continued Appreciation

Nothing ignites more economic passion than a debate about the future direction of house prices in Australia. This passion fills internet chat rooms, results in high-profile bets between economists, and employs a host of talking heads and TV shows.

Everyone has a ‘position’ in property. Two-thirds of households own (outright or mortgaged) their own home - their biggest, and tax-free investment. One third are renters, some who intend to buy eventually, others who cannot afford or choose not to buy.

This paper is in two parts. In Part we explore the case for residential investment. In Part 2 we explore the case against. But firstly, let’s look at how Australia’s housing market has performed in recent years.

The chart below (presented by the RBA in a speech on 18 May 2010¹) shows capital city and ‘rest of Australia’ dwelling prices (houses and units) indexed to 100 and adjusted for inflation. Interestingly, despite a public perception that capital city prices have streaked ahead of the rest of the country, the chart shows otherwise².

FIGURE 1 Real Dwelling Prices* 1993=100

*Deflated by the trimmed mean CPI

Part One. The case for residential property investment

What drives property prices? Simply, it is demand & supply; the cost of funds vs rental yields/capital appreciation; taxation impacts...and the expectations for all of these factors.

Demand on the rise

Demand comes from population growth, demographics, household formation trends, expat/foreign investor demand, and stability of employment. All of these are currently increasing demand. Consider these factors:

1. Net immigration has been and is likely to continue being robust (approx 6.2 migrants per 1000 Australians per year), adding to household formation. In recent years, immigration policy has favoured skilled workers, professionals and business migrants, meaning migrants today already have the money (or capacity to borrow) to buy. (see table below for population growth )
2. A stubbornly high divorce rate (averaging approximately 50,000 divorces granted per year since the mid 1990s - around 2.5 per 1000 Australians) is also increasing household formation, a factor more significant than it was in the 70s and 80s.
3. Foreign investors and Australian expats (mostly in Asia, London and New York) think local prices are still cheap (particularly relative to the major cities in Asia) and a view that the Australian dollar will rise in the long term, meaning their investment now will benefit from a stronger A$ in future. (which explains why they are buying)³
4. Unemployment is near a record low, employees feel secure, and strong economic growth suggests wages and salaries will rise at above trend rates.
5. Pent-up demand has been building since 2003 when when at the last peak of high property prices/low housing affordability led to Generation X and Y staying longer with their parents, renting or sharing accommodation.

* Census date interpolated using dwelling completions

Supply continues to suffer

1. It has been frequently reported in the press that there is already a shortfall of 170,000 to 200,000 homes in Australia. As Figure 2 shows, growth in the number of dwellings has been falling while population has been rising. Note that from 1955 until recently, growth in the number of dwellings built has always exceeded growth in population. But since the latter part of the 2000s, population growth has risen well above dwelling growth, which would explain the current shortfall of homes.
2. Baby boomers (representing a large chunk of home owners) are staying put instead of selling for a smaller apartment⁵. After agent’s commission and stamp duty, it’s too expensive for them to downsize. This means the supply of ‘family’ homes expected from baby boomers selling is likely to be delayed until they are require institutional aged care (the oldest are now only in their mid 60s).
3. Many small builders were burnt in the aftermath of the 2004 property price downturn (particularly in Sydney) and exited the industry. Those small builders remaining see dealing with local Councils as fraught with uncertainty given the power of council (and organised ratepayers) to delay projects or demand expensive alterations – which can tip ‘border-line’ development projects into the ‘unviable’ category.
4. This leaves the big builders/developers who are subject to lending constraints (banks are lending warily), shortages in skilled tradespeople (lured away by the mining boom), and the limited supply of sites suitable for large-scale projects.
5. The two to three year lead-time in taking large housing projects to completion means the GFC-induced downturn in 2008 and 2009 will result in relatively less supply of completed dwellings in 2010 and 2011.
6. State-government uncertainty with land releases, zoning, building regulations, and infrastructure development (transport links etc) results in builders having difficulty in long-term planning, adding to supply constraints. Council levies on developers increase costs and can make the final house price potentially ‘unaffordable’ for the buyer – so development projects are either cancelled or postponed until the developer believes there is enough profit margin to compensate for the risk.

The result – a demand/supply imbalance and a continuing shortage in housing as reflected in tight rental vacancy rates and rising rents in recent years, particularly in NSW.

Funding costs vs rental yields - after tax

Gross rental yields are 5.1% (units in Sydney. RP Data-Rismark) and after costs of approximately 1.5% results in a net rental return of 3.6%.

With the cost of borrowing around 6.5%, this results in a minus 2.9% return. For an investor, this equates to an after-tax return of around minus 2%, due to negative gearing benefits. This can be seen as acceptable if capital appreciation of around 10.2% -13.7% (in the year to July 2010 in Sydney and Melbourne ) is repeated in future years.

For a renter, mortgage repayments would roughly be similar to rent payments. The argument to buy improves when one adds the benefits of home stability (compared to rental uncertainty in the current tight rental market). In addition, a stable jobs outlook gives comfort to most potential buyers regarding their ability to service a mortgage.

Home owners also benefit from the property’s capital gains being tax free, making it an attractive after-tax ‘investment.’ In addition, recent stock market uncertainty and volatility has made equities a less attractive alternative to property.

How high could it go?

Gross rental yields in Australia’s fastest rising market, Melbourne, have fallen to 3.5% for houses and 4.1% for units, according to RP Data-Rismark. Which means other cities could see yields falling to similar levels under ‘boom’ conditions. For example, Sydney yields are 4.1% and 5.1% respectively. For Sydney to ‘boom’ as much as Melbourne has, then Sydney property prices would rise by 17%-24% to reach similar yields. And prices rose by these levels in Sydney in mid 2002, and in Melbourne in early 2002, early 2008 and late 2009.

The Case AGAINST Continued Appreciation

Uncertainty spells risk and risk impacts on expectations. With residential property yielding negative returns, expectations of capital gains is the key to future price increases. According to the RBA, 10.3% of households have at least one investment property and another 6.5% have a property (excluding their primary residence) that does not attract a rental income (mostly meaning a holiday house or a property rented free to relatives). These investors will likely be sellers if they lose their expectations of long term price appreciation. What will drive these expectations? Consider this;

What if interest rates rise further?

The mortgage rate is half of the yield equation. The RBA is focussed on fighting inflation. House prices accounts for a 19.5% weighting of the CPI calculation according to RPData/ABS. With the inflation rate already at the high end of the RBA’s preferred band of 2%-3%, and with the resources boom expected to lift wages, these conditions will favour a tightening bias. (However, after six interest rises since October 2009 (taking the cash rate to 4.5%) many commentators expect the RBA will likely to adopt a wait and see attitude in the immediate future.)

Immigration rates and tax changes

With the stroke of a pen, immigration rates and tax policies can change. And with a minority government needing the support of a Green and three independents, the risks of change are greater now than in previous years. The introduction of death duties, capital gains tax on homes, higher stamp duties, and negative gearing cuts can quickly reduce the attractiveness of property. In addition, there has been growing pressure to cut immigration rates and this is likely to intensify with the Greens vote, which will slow-down household demand.

Affordability

Housing is already expensive in Australia when measured by the ratio of median house prices to median income. (see comments below by Jeremy Grantham of GMO). This dampens expectations of significant price increases as buyers ‘cannot afford it any longer,’ thus reducing demand. Global surveys that ranks Australian house prices as amongst the most expensive in the world also dampens expectations. We expect housing affordability to become a major political and economic issues in the period ahead.

Household formation drops as affordability worsens

As Europe has discovered, adult children are staying in their parents’ houses for much longer. And in many other countries, having three generations (grandparents, parents, kids) in one household is the norm, driven partly by housing and childcare costs. Given affordability, major metro land availability issues and of course the lack of transport infrastructure spending across Australia in recent years, Australia may trend towards this development, leading to lower rates of household formation.

But there will be an unexpected socio-economic bonus. As three-generation households becomes more common, the public cost of aged care will drop (or not rise as much) as kids and grandkids become care-givers in return for staying in their parent’s home ‘all these years,’ -- a situation already common in many other countries, particularly in Asia.

Regional development

40% of dwellings are outside capital cities. And land supply in regional centres is less constrained than the cities. With regional development now a government priority due to pressure from the independents, a tree-change movement could grow significantly, particularly if regional jobs and infrastructure can be created by new government initiatives. This should ease both demand and supply issues in capital city housing.

High transaction costs, better investment alternatives

Stamp duty and agents commission can add around 4% in property transaction costs. In a low interest rate environment where returns are in single digits, these costs loom large. In addition, online advances in stock trading have driven equity market transaction costs to 0.3% or less for most investors, making property investment an expensive exercise.

Negative influence of US property markets

The deep malaise in US property prices that is receiving widespread media coverage could dampen sentiment in Australia. And media reports do influence investors. An Australian Securities Exchange survey of stock investors found that newspapers were the biggest source of advice and information about the market.

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