Summary
Australian property prices are at historic highs. Earning yields are so low that there is no realistic scenario that a medium to long term investment can provide a good return. Similar conclusions apply to buying a property to live in.
In the short term, prices are unpredictable.
Signs of the Top
Friends report that their wives have been pressing them to get into the investment housing market. This is usually based on envious feelings towards friends who have made a killing from property investments.
Young people are telling me that they are worried that if they don’t get in now, they never will, and they feel desperate.
A relative of mine, who has in the past been a reliable indicator of market tops, has just built a large McMansion with borrowed money.
The Economist is calling Australia’s property market a bubble, saying that it is 50% over-priced.
Net rental yields in the inner cities of Melbourne and Sydney are down to approximately 2%. The price/earnings ratio is therefore now 50. This is higher than the US stock market at the peak of the Dot-Com bubble.
All of this is justified on the basis of the mineral boom and the China story which promises endless wealth to mineral exporters like Australia. It is forgotten that past mineral booms have all been followed by busts.
People are not concerned about low yields because they believe that prices will go up and that the rising prices will compensate for the low yields.
Past Bubbles
In 1888 my great-grandfather, George Macfarlane, had most of his inherited wealth plus borrowed money ‘invested’ in property in Melbourne Australia. At that time there was a property boom in Melbourne, inspired by the gold rush and high prices for agricultural commodities. In the crash that followed he lost most of this money and had to be recapitalized by his family.
Melbourne land prices finally recovered in real terms in about 1952. That is 64 years of no growth in land prices.
Similarly, real house prices in the US did not permanently exceed their 1888 levels until 2001. They briefly touched the 1888 levels in about 1990 but fell again in real terms by 25% before recovering 10 years later.
Japanese land prices are still 60-70% below their peaks of 1989 in real terms. In Japan, rental yields are high. As a Japanese person explained to me when I was there, property goes down in price, so you have to have high yields to compensate for these falling prices.
Ponzi Schemes
A Ponzi scheme is a fraudulent scheme which provides apparently high returns to early investors. These apparent high returns are financed by paying back capital, dressed up as investment returns. These early apparently high returns draw in more and more investors. Successive generations of investors are paid fake returns from the capital invested by later investors. Usually there is some story as to how the returns are generated. Eventually the whole thing collapses and many people are impoverished.
In Ponzi’s case, he claimed to be able to make money by arbitraging postal reply coupons.
In the case of Bernie Madoff’s fraud, the scheme was said to involve complex derivative transactions, market making, and there was a suggestion that he was front running customers’ orders.
Some Ponzi schemes are deliberate fraud, and other start as legitimate investment strategies that go wrong. The promoter will then institute a Ponzi scheme to cover up the failings of the investments for a time, in the hope of regaining lost ground later.
Auto-Ponzi Schemes
Other Ponzi schemes can occur without any obvious fraud and without any single central promoter. These are called auto-Ponzi schemes.
The central characteristic of an auto-Ponzi scheme is that it is self-organised by the victims.
The Dot-Com bubble of the 1990s is a good example. This started with a story that the Internet was going to change everything, that huge profits could be made by the winners in the Internet race, and that old bricks and mortar companies were obsolete dinosaurs that were doomed to extinction. There was of course some truth to this story.
Internet stocks started to go up. Those who held them made money and told their friends. Their friends invested and made money. The more people invested, the more people made money, and this turned into a self-fulfilling cycle. People pulled money out of normal stock funds and put them into internet based funds. This depressed the old-economy stocks and further pushed up the Dot-Com stocks.
Eventually three things happened. First, the world ran out of greater fools for people to sell their stocks to. Second, interest rates went up. Third, because starting an internet company was almost like printing money, the supply of internet companies expanded enormously. At about the same time, the stock retention restrictions of a number of internet companies expired, allowing founders to offload their stocks. This increased the selling pressure on these stocks.
Once the stocks began falling, people started to notice that many had no profits, and that they often didn’t even have many sales. The more they fell, the more people sold them, and the crash of 2000 was under way.
The US Federal reserve started printing money to prevent a recession, which in turn led to the housing bubble in the US, which is now deflating, with catastrophic results.
Housing Boom in Australia
It is difficult to get good statistics for real estate prices in Australia. Most statistics are marred by lack of comparability. For example, if a house is improved and is then sold for an increased price that reflects the improvement, this generally registers as an increase in house prices when it is no such thing. Adjustments are not made for changes in the sizes of allotments and changes in the sizes of cities.
However, as one example, a house I bought for $68,000 AUD in 1982 and sold for $400,000 AUD in 2002 is probably worth about $800,000 AUD now. Adjusting for the threefold increase in CPI in that time, the real increase is about 290% or 5% per annum compounded excluding rent earned or saved from the property. Adding a rental yield of about 4% for most of that time brings the return to about 9% real per annum, which is a very high return. The most successful stock markets of the last 100 years or so have only returned about 6-7% in real terms, so 9% is very unusual.
Average house prices in Australian capital cities where most Australians live are about $480,000 AUD and median earnings are about $60,000, so the average house costs about 8 years’ pre-tax earnings. This is a high level historically. When I first bought my house its price was about 4.5 times median annual earnings and now that house is now worth about 12 times median annual earnings.
Australia has not had a genuine property crash since the 1888 bubble popped. It is generally believed in Australia that house prices do not fall, particularly in the long run. Beliefs like this often accompany bubbles.
Current net yields for a rental house in the inner city of Melbourne are about 2% per annum.
This shows every sign of being an Auto-Ponzi scheme.
Australia is Special
Australia has been “The Lucky Country” for a long time.
Whenever trouble looms, something always seems to come up. The decline in agricultural prices in the late 1970s was compensated for by a minerals boom and the discovery of vast Coal and Iron ore reserves that Japan needed. When the UK lost its place as a superpower, the USA appeared to save us from a Japanese invasion during WWII. More recently the decline of manufacturing here was followed by a new mineral boom, fueled by China’s seemingly insatiable demand for coal and iron ore.
Australia’s population is growing rapidly as a result of high immigration levels. This high level immigration is justified in part by the need to provide labour and skills to support the mineral boom. This population growth adds to the pressure on house prices.
Although Australia is one of the least densely populated countries on earth, the supply of land and the ability to develop existing land are limited by government policies. For example, Melbourne is surrounded by a Green belt which – at least in theory – cannot be developed. Release of land on the fringes of cities is controlled by monopolistic government bodies charged with maximising profits. Local councils generally have a veto on property development which makes building blocks of apartments in the inner cities a slow, expensive and uncertain process. Vacant blocks often sit idle for years waiting for planning approvals and for appeals against refusals. Hundreds of thousands of buildings are bound by “heritage” listings which limit development and even the colours that houses can be painted. All this limits housing supply.
The Australian population is very centralized in a few cities and Australia is a very urbanised country, though the myth of the “outback” remains a strong part of the culture.
Tax Policies Favor Property Speculation
Taxation policies also encourage investment in housing. The full nominal interest charge and other expenses of investment properties can be offset against any income. Capital gains taxes are charged on investment properties but at only 50% of the normal rate after 12 months. This is roughly equivalent to taxing only real capital gains because the 50% discount is roughly equivalent to adjusting capital gains to inflation. As a result of these policies, it is quite normal here for high earners to borrow large sums to invest in property and to claim deductions for the interest. This is called “negative gearing”.
For the primary home, there is no tax deduction for interest but gains are tax free, as is the imputed income from in effect “renting” the house to yourself.
Given these incentives to borrow in order to buy housing, it is no surprise that private debt and private borrowings from overseas are very high in Australia.
Winning From Real Estate in Australia in 2010
What started this posting was a question from a friend as to what I thought about buying an investment property now. I currently own an investment property as well – and live in a property owned by someone else – so the question is also personally relevant.
Here is the key parameter for real estate in large cities in Australia:
- Net rental yield of 2% before expenses. This is for inner city houses.
How can this be a good investment? You are not going to get rich from a 2% yield. Either the yield needs to go up quickly or you need to sell to someone else at a higher price later on.
I constructed this spreadsheet to investigate different scenarios. The spreadsheet analyses a 20-year investment. You can try changing assumptions if you wish. The main ones are
- The rate of increase in rents, above inflation,
- The inflation rate,
- The portion of the property price that is borrowed, and
- The target real rate of return. Typically I use 8% – this would be a good result. As an investor you should be aiming for a good result. You can also try 6.5% which is the long term return from the US and Australian stock markets.
The spreadsheet will then return a surplus or deficit, which will indicate whether the target return was achieved.
You can play with the parameters. Here is what I found:
- For 2.5% inflation with the house paid for in cash, and with no increase in rental yields then a return of 6.5% annually would require rents to go up by inflation + 7.7% annually. This would result in real rents increasing fourfold over the next 20 years.
- For 2.5% inflation with the house paid for in cash, and with gross rental yields returning to a more normal level of 6% then a return of 6.5% annually would require rents to go up by inflation + 11% annually. This would result in real rents increasing almost eightfold over the next 20 years.
I don’t see either of these scenarios as being realistic.
- If gross yields could fall to Japanese-style levels of 1% per annum, then rents need ‘only’ increase by CPI plus 2.5%, which is still higher than long term trends. This would still have rents increasing faster than earnings. Earnings have historically increased by CPI + 2%. Even given that, you would need to sell your property for a gross yield of 1%, which would mean a net yield of basically nothing. What would be the scenario that would allow that investor to make a good return?
To cut a long story short, I only found one remotely plausible scenario which would provide even a mediocre return.
- If an investor on the top marginal tax rate borrowed 80% of the purchase price and inflation was 10%, then a rate of return of 6.5% is achievable with a final gross yield of 3.0%. In this scenario, prices increase by 2% annually in real terms; most of the returns are from the tax deductibility of nominal interest.
The problem with this last scenario is that if inflation went up to 10%, the interest payments would become enormous and the property would probably become unaffordable. Interest on an $800,000 loan would be well over $100,000 annually. As explained in John Talbot’s book “Sell Now – The End of the Housing Bubble” this would also drive huge reductions in borrowing capabilities for most people and therefore prices would crash, as they have in past inflationary periods. People just cannot afford the initial payments on a loan because inflation pushes up interest rates, and therefore payments go up.
Note that in Australia almost all housing loans are adjustable and fixed loans are not available for terms over about 5 years. While in the long term inflation pays of much of the loan, in the meantime you cannot keep up the payments and lose the property. If you read the fine print of your loan document, you will probably also find that if prices fall, your loan may be categorised as high risk and a penalty interest rate charged to your loan. This happened to an acquaintance of mine, many years ago and he was therefore forced to sell the property.
Conclusion
I have not been able to come up with a scenario in which buying an investment property in Australia currently makes economic sense. It seems clear that real estate investments in Australia will under-perform from here.
Tim Josling
Learning Investing the Hard Way 