In a previous article, I analysed four of the common arguments used by those who deny there is a bubble in Australia’s residential property market. The bubble deniers have employed other explanations for the largest run-up in prices in Australia’s 131 years of land sales records.
Restrictive government regulations
One argument is that restrictive government regulations (RGR) limit the supply of land and timely dwelling construction through zoning controls, development, planning and building laws, driving up housing prices. This idea gained popularity in the US during the property boom, with some economists asserting that it is a substantial factor in creating a bubble.
The major difficulty is that RGR can only affect rent prices and thus the market-efficient price for land. The logic is straightforward: if RGR limits supply with demand holding constant or rising, and property prices increase, then it follows that rents too must rise proportionally as well. If rent and land prices diverge, however, this argument falls flat – as is the present case. Housing prices have experienced a far greater run-up than rents since 1996. Further, markets would have already priced the supply-side distortions into the cost of housing long before the bubble began. There is no change in RGR that could explain the increase in housing prices from 1996, skyrocketing in 2001.
The other case against this argument is that the boom-bust housing cycle has existed for centuries in many countries, far before bureaucrats perfected the art of red tape during the 20th century.
The theoretical and empirical literature provides little help with this topic. Some studies show RGR comprises a large factor, some claim a smaller impact, and others argue it results in no tangible effect, and that correlation is often confused with causation. Even the idea’s leading proponents acknowledge the benefits of RGR could well outweigh the costs.
Arguing that a greater supply of housing could limit skyrocketing prices is similar to saying that the 17th century Dutch bubble driven by tulip mania could have been mitigated if farmers had grew more tulip bulbs. The problem is not on the supply side; rather, debt is used to fuel a pyramid scheme, resulting in a tremendous demand surge that significantly raises prices.
This is not to say that RGR shouldn’t be changed; many aspects need improvement. The case for RGR causing bubble-level pricing, however, is slim to non-existent.
Low inflation and interest rates
Another explanation cited is the structural downturn in inflation and interest rates that began in the late 1990s and continues today. Interest rates peaked in 1990 when the RBA radically increased interest rates to combat inflation, culminating in the recession “we had to have”.
That year, the standard mortgage rate stood at approximately 17% and real interest rates at 11% (nominal rates were higher). Eventually, the rate of inflation fell, and interest rates followed. With cheaper borrowing costs, households could take on greater levels of mortgage and personal debt.
But the decrease in inflation and interest rates can only explain part of the increase in household debt. In 1990, the household debt to disposable income ratio was 46 per cent, rising to almost 160 per cent today. The household debt to GDP ratio jumped from 19 per cent to 86 per cent.
Even as far back as 2004, the RBA noted that the decrease in inflation and interest rates could only explain a doubling of household debt relative to incomes, and probably less. Household debt has more than quadrupled over this period.
If this argument were credible, the 1960s should have prompted an even greater household debt ratio as rates were the lowest on record throughout this decade. This did not occur.
Returns to property
That residential property provides substantial and ongoing returns to investors and owner-occupiers, based on fundamentals, is another argument.
Two types of return tempt house buyers: owning a property valued by the market at a higher price than it was purchased for (capital gain), and increases in the rental income (yield). Property owners hope that they will make a substantial capital gain when they sell, and that rental income can overtake costs over the long run.
Data from the ATO tells an interesting story. On aggregate, net real rental income has resulted in continuing losses starting at $966 million in 2000, and peaking at $8.8 billion in 2008. Rental income has not exceeded interest costs since 2000, let alone met the costs of maintenance, rates, agent fees, and property tax.
No rational investor knowingly purchases an asset that yields a negative return. Investors are sacrificing cash flow to build assets and realise eventual capital gains.
The problem with this state of affairs was explained long ago by the late economist Hyman Minsky, who showed state capitalist economies cyclically generated crises due to the interaction of financial markets with the productive economy. Minsky’s analysis revolved around describing three stages of financing.
Hedge finance: income flows from an asset is sufficient to pay down both principal and interest on the debt financing asset purchases. Prices are based upon fundamentals.
Speculative finance: income flows cover only interest, not principal, requiring debt to be continually rolled over. Asset owners may experience financial stress, but it is not widespread, and fundamentals are in kept largely in check.
The final stage is Ponzi finance: income flows cover neither principal nor interest charges. Owners are completely reliant on escalating sale prices (capital gains) to make a profit and meet the cost of the debt. Prices are completely delinked from fundamentals at this stage, resulting in the dreaded bubble.
The tipping point comes when the household sector is so overloaded with debt there exist no more ‘greater fools’ willing to commit to a lifetime of debt serfdom to purchase property. With few buyers and many sellers, prices stagnate then rapidly fall as assets are unloaded en masse onto the market. With demand falling in the housing sector, coupled to an inevitable increase in unemployment, a vicious deflationary spiral occurs. Economy activity grinds to a halt.
That Australia’s residential property market has resembled the Ponzi stage of financing for the last 11 years is nothing short of astonishing. The market would have collapsed during the GFC in 2008 were it not for another First Home Owner’s boost re-inflating asset prices to a new, higher peak.
Trusting the “experts”
Rational discussion about the state of the property market is fraught. Many outspoken bubble deniers are conflicted by their interests in industry and government. Many – not all – are employed by, consult for, manage, and/or own organisations with a direct interest in maintaining the status quo of an overvalued property (land) market. These institutions are primarily commercial lenders, investment banks, real estate intelligence firms, insurance, real estate agents, Treasury, the RBA, vote-seeking politicians, and the mass media.
Skilled and intelligent specialists, trained in neoclassical economics in leading US institutions, did not see their enormous housing bubble until it burst in front of them with horrendous consequences. What makes Australia’s “experts” any more competent?
As investor Jeremy Grantham has noted: “Bubbles have quite a few things in common but housing bubbles have a spectacular thing in common, and that is every one of them is considered unique and different.”
Join the conversation
Comments (20)
Paul Regis
Business Analyst (logged in via email @live.com)
An intelligent article that tells us what is happening, yet the predictions of a correction don’t seem to happen. Why not?
Something is pumping money into the property market because that money has nowhere else to go. People in my office are unable to afford to flats in Sydney due to 3 sets of cashed-up-baby-boomers chasing every desirable place as an investment.
As for property making losses, that’s just an accounting anomaly. Landlords move debt from their actual home to their investment…
show full comment
Philip Soos
(Researcher, School of International & Political Studies at Deakin University)
It appears that your example is wrong. NG is claimed on the difference between interest payments minus rent once all deductions have been factored in, for instance, property tax, rates, sewerage/water, insurance, depreciation and maintenance allowance, agent/body corporate fees, etc.
Now, it is possible for an "investor" to achieve positive gearing if, and only if, two conditions are met: they are high income earners, and the difference between interest payments and rental income (net of costs…
show full comment
Ben Stewart
all-round nice guy (logged in via email @hotmail.com)
Hi Phillip - I don't understand your comment that positive gearing can only be achieved if the investor is a high income earner? Whether an investment is positively or negatively geared is completely independent of your personal income.
Positively geared - TOTAL income from investment is more that the TOTAL of all expenses associated with holding the investment.
Negatively geared - opposite to Positively geared.
If your personal tax rate was 45%, then in Paul's example you would be 'saving' $225 in tax at a cost of $500 - i.e. still LOSING money
Philip Soos
(Researcher, School of International & Political Studies at Deakin University)
Yes, you are correct, my bad.
Ben Stewart
all-round nice guy (logged in via email @hotmail.com)
Paul Regis - your understanding of Negative Gearing is incorrect. It is the NET LOSS that is deductible, not the GROSS LOSS. So in you example, you would deduct $500 from your income, so maybe around $160 (depending on tax rate) would be saved. You still LOSE MONEY on a negatively geared property (i.e. you lose $500 per month on the property but only save ~$160 in tax).
That is why the whole negative gearing 'thing' doesn't work in a declining market, and once people realise that prices are declining over a longer period, there we be a mass exodus of negatively geared property owners.
Paul Regis
Business Analyst (logged in via email @live.com)
You're right for other countries, where it is the net loss written off. But not in Australia.
The ATO document on subject is http://www.ato.gov.au/content/downloads/IND00270214N17290611.pdf
It says "...you can claim expenditure such as interest on loans..."
and on page 24
"...is negatively geared... purchased with the assistance of borrowed funds and the net rental income... less than the interest on the borrowings. The overall taxation result... a net rental loss arises. In this case, you may be able to claim a deduction for the full amount of rental expenses against your rental and other income"
And look at the calculator sheet on page 22. That individual is writing off $11k against income!
Does this shock you? It shocked me. So, while this astonishing tax law continues, I suspect money will continue to be channeled into non-productive assets and the average Australian will hence continue in a lifetime of debt serfdom.
Philip Soos
(Researcher, School of International & Political Studies at Deakin University)
You still appear to be incorrect. The ATO document you quote says:
"A rental property is negatively geared if it is purchased with the assistance of borrowed funds and the net rental income, after deducting other expenses, is less than the
interest on the borrowings."
The ATO example you mention shows a net loss of $11,329. Even with a generous 45% marginal tax rate (earning over $180,000/year), that's still a loss of $6,231.
Ben Stewart
all-round nice guy (logged in via email @hotmail.com)
I have negatively geared a few properties over the past 15 years in Australia (thankfully have sold out of them now). I have an accounting/financial background and am quite familiar with how it all works. It is the net loss that is deductible, and if you lose money from an operational point of view there is no way to make up for it by tax saved on your personal income. When this hits home to everyone, watch the selling commence....
Paul Regis
Business Analyst (logged in via email @live.com)
You should have got a better accountant!
Ben Stewart
all-round nice guy (logged in via email @hotmail.com)
ask someone (preferably an accountant) to explain it to you, might be easier for you to understand....
Paul Regis
Business Analyst (logged in via email @live.com)
aha, thank you. I see my error now. Perhaps there's hope for us renters after all. I guess that if you do see a net cash outflow (even after tax benefits) then people are relying on capital gain for the difference. So far, that thought seems to have been reliable. But when capital gains starts to wobble then your last sentence of watching the selling commence will hit home.
But, until it happens then I guess prices will keep going up in a type of Ponzi scheme. A house of cards comes to mind...
Ben Stewart
all-round nice guy (logged in via email @hotmail.com)
it is definitely a massive Ponzi scheme.
We rent now as well as we believe that is the smart thing to be doing - SOOO much cheaper.
We live in QLD, near Noosa, and prices are falling quickly here (~30% already locally), as in most of the state, except the mining regions. Around here the bubble has popped, but sounds like a lot of the rest of the country is yet to experience that.
Jim Wright
Retired Civil/Structural Engineer, IT Consultant/Contractor (logged in via email @acslink.net.au)
Your article discusses housing finance as a standalone process in its own right. However, negative gearing links the economics of buying property to external income flows and tax liabilities. Thus, while the returns on the property itself may be negative, the investor may have a positive outcome because the tax not paid exceeds the loss on the property. Would you like to comment on what impact, if any, negative gearing has had on the movements in housing prices.
Reinhard Dekter
(logged in via Facebook)
Thanks for another good article, Philip. As I understand it this is largely due to interest rates being too low. The situation makes returns on lending money so bad that anyone with cash is forced to invest in some real asset to avoid losing much of their wealth. Capital flows into the housing market as a result and produces constant price rises that themselves justify highly leveraged purchases, resulting in a bubble. I think you are right in saying that RGR has little to do with the bubble except the policy of the Grant which is probably the worst thing they could have done. When house prices were getting "out of reach" that was the signal that there was a serious bubble that needed an interest rate hike to combat rather than the time to divert capital from profitable parts of the economy.
Philip Soos
(Researcher, School of International & Political Studies at Deakin University)
Interest rates are only a small factor in the building up of a bubble. Speculators care not for interest rates because they will flip the properties in short order - days, weeks, months, couple of years - to make a capital gain to pay down the entire loan regardless of what the prevailing interest rates are. There was an interesting study by the Federal Reserve recently about this.
Asset bubbles have less to do with external interventions e.g. central bank setting rates and far more to do with the natural instabilities and inefficiencies of financial markets misallocating credit. Hyman Minsky and Steve Keen are the ones to read on this matter.
Bruce Moon
Bystander! (logged in via email @imap.cc)
Ho Hum.....
Currently, stock market analysts are saying that the fundamentals are great for a bull market; yields are right, the economy is OK, China is still buying. But, it is still a bear market. Why???
Market players are not rational. They are not irrational, rather, most players go with the herd. Thus, we can say emotional sentiment plays a big part in the decision-making process (of whether to 'play').
The same applies to other investment sectors.
On a purely rational basis, there may be merit in saying the domestic housing market is about to crash. But, will home owners with an emotional quotient play the game?
We'll wait and see.
Cheers
Paul Regis
Business Analyst (logged in via email @live.com)
Exactly right. That's what they said in Ireland too. I read that "the bull market will end when it ends". It was the most accurate prediction that I saw.
Nonetheless, the Australian government is certainly doing its bit to keep the bubble inflating.
Thomas Kline
(logged in via Facebook)
We have to acknowledge negative gearing has a psychological effect. In the long run, it must have an impact on people's willingness to buy property that is loss-making and thus pushes up the price point at which demand for property will fall, thus raising the price (assuming that finance is available to those wanting to buy loss-making property).
Negative gearing is available in many countries ( source: http://australianpropertyforum.com/topic/8489333 ) and this will of course be a factor with…
show full comment
Michael Burrows
Mr (logged in via email @gmail.com)
Agreed, First Home Owners allayed some fear and allowed the Real Estate industry to boost prices $30k - $40k. This in turn raising the value of property in general. Recent $10k amounts are behaving similarly.
Various studies have alluded to Australian property being some of the most expensive in the world; over-valued to as much as 60%.
Property lives in the Australian 'psyche' and accounts for a sizeable amount of one's perceived wealth. Deduct 0 - 60% of say a $450k home - potential loss or…
show full comment
Bryan Kavanagh
Research Associate, Land Values Research Group (logged in via email @lvrg.org.au)
Anyway, excellent article, Mr Soos. Where does this leave former Treasury people who having argued shortage of supply of suitably zoned land have acted as spivs for the Australian real estate market? Watch for the denouement, folks, because these and others have made some big statements about our residential market being different. Different? Yes, our bubble was bigger than almost anywhere else!