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If the saying is true, what makes a market is that you have a buyer and a seller, who have a difference of opinion. Well, that’s certainly the case in the residential property market.

Residential real estate is almost the sacred cow of Australian investment. Over the last 80 years the trend rate of growth in real house prices has been about 3 per cent a year – consistent with long-term real GDP growth. Lately, that growth rate has been even higher. According to real estate advisory business Rismark, between December 2004 and December 2009 Australian house prices, Australian house prices grew by 6.2 per cent real a year.

The RP Data-Rismark Hedonic Index for national city dwelling values rose another 1.4 per cent in February, making the annual gain for the 12 months 12.7 per cent.

Melbourne rose 2 per cent on the month, to be up 19 per cent on the year; while Sydney jumped 2.6 per cent to be up 12 per cent for the year.

Steve Keen, associate professor of economics and finance at the University of Western Sydney, says growth rates such as these cannot last. Keen says that Australian house prices are overvalued, and will fall by 40 per cent over the next ten to fifteen years.

Christopher Joye, chief executive of Rismark, scoffs at this view. He says prices will continue to rise – although he does not discount the possibility of volatility – for the simple reason that housing is an under-supplied commodity in Australia.

It’s worth pointing out here that, contrary to a prevailing belief in many Australian investors, there is nothing intrinsically magical about residential real estate that makes it always rise in price. If it is over-supplied, it will fall – as in the USA at present.

But that is not the case in Australia. According to the Housing Industry Association (HIA), Australia presently builds 109,000 fewer dwellings a year than it needs. On present population projections, HIA economist Ben Phillips says that shortfall will reach 466,000 dwellings by 2020.

Joye says the shortfall is being magnified by Australian’s booming population. “Australia has got the strongest population growth in the stgeloped world. It’s currently running at 2.1 per cent a year. We have 22 million people presently, it’s forecast to go to 36 million people by 2050, we think that’s actually more likely to be 40 million people.”

The widening gap between demand and supply “categorically” stands as an underpinning factor for house prices, says Joye. “The fact of the matter is that asset prices are determined by supply and demand. To have a view on asset prices – on house prices – you have to have a view on demand and supply, because that’s the way that prices are formed.

“This is a market, and the way that markets work is that the price signal communicates to the economy as to where it should allocate its scarce capital. The house price signal is rising, which is effectively saying to builders and stgelopers is ‘you should be investing in new housing’ – because we have a housing shortage.”

The only way that more supply will come online is if the investment case for housing is a “solid and credible case,” says Joye. “Rising prices are a clear signal to the market from the supply side that there are reasonable economic returns to be earned from investing in new housing – and that’s a very positive thing for the market.”

Keen disputes the supply/demand argument. “The way to analyse that is to ask: how many people per house do we normally have, what is the flow of new people turning up in the country and what’s the flow of new houses being built. When you do that comparison, you find that the average occupancy is 1.9 people per house, we therefore needed to build one house roughly per two new people arriving in the country – whether they’re born or immigrants. But until 2005, we were building about one house per 1.5 people.

“So until then, the flow of demand versus the flow of supply was such that we should have seen a falling occupancy rate: that means an excess supply. If demand/supply is what causes everything, we should have seen falling prices for the previous 25 years, and they should have just turned around in the last three years. So the argument is spurious.”

Keen’s explanation for the house price growth since the 1990s is mostly leverage – that people have progressively been allowed to borrow more, and government policy in the form of assistance to first home buyers.

“What has really driven house prices is leverage: that’s the most significant factor. If you go back to the 1960s, the highest loan-to-value ratio (LVR) you would have got from a bank would be 70 per cent. But before the global financial crisis (GFC) hit, Australian borrowers were offered up to 95 per cent LVRs. That means that somebody with $50,000 can bid $1 million on a house.

“Banks have started to wind those LVRs back. Firstly, they went to a 92 per cent LVR: to make a bid on that $1 million house, you needed an $80,000 deposit. Now some of the banks will only give you an 87 per cent LVR: now, you would need a $130,000 to make that bid.”

Keen says that even though the RBA’s rate cuts have reduced the cost substantially from its peak, interest payments on mortgages in Australia today consume 7.5 per cent of household disposable income – or 1.65 times the average from 1976 to now.

“The primary driver behind this extreme rise in debt servicing costs is the ratio of mortgage debt to income. This is more than five times larger today than it was in 1990 – 130 per cent of household disposable income versus 25 per cent in 1990.

This growth was exacerbated by the First Home Owners’ Grant (FHOG), he says. “About 250,000 people took out the Rudd grant. Because it was $7000, which was increased to $14,000 and there were all the state amounts were there as well, that 250,000 people put about $2.5 billion of government money into the housing market.

“But then, people would go and lever that, borrow more money, and the people who sold the house who were upgrading would do the same again. You had leverage cascading upwards, and the end result was equivalent to about $100 billion of borrowed money that would not have been borrowed otherwise. Quite simply, the grant triggered a bubble, and that has to come out of house prices,” says Keen.

But Joye says house prices have simply tracked incomes for the last five years. “Between December 2004 and December 2009, Australian house prices – all areas dwelling prices – grew by 6.2 per cent a year, whereas disposable incomes grew by 6.0 per cent a year.

“But we actually strip out the 40 per cent of homes that are not in capital cities: they grew by 5.1 per cent a year. So on that basis, 40 per cent of the market has actually under-performed income, whereas 60 per cent of the market has tracked incomes. Disposable incomes is what mortgages are paid from, so we dispute that house prices have got away from people’s ability to service the debt.”

Joye argues that Australia has currently among the lowest mortgage default rates in the world. “On Reserve Bank of Australia statistics, the current 90-day default rate is 0.6 per cent. That is less than one-tenth of the US default rate, which is 8 per cent. But our mortgage rates are much higher than almost other stgeloped economies around the world. That tells you a simple story: that the ability of Australian households to service that housing debt is extremely strong.”

Joye also disputes the contention that the FHOG caused a housing bubble. “That is simply not true. The strongest-performing market over the last 12 months has been the top 20 per cent of suburbs, ranked by price. In other words, the most expensive suburbs in Australia have significantly outperformed the cheaper suburbs. That doesn’t reconcile well with the purported FHOG being the reason for price growth in 2009.”

The volume of mortgage lending is also an important indicator of the health of the market. Here, the most recent statistics show that new home loans fell for the seventh time in eight months in February, down by 1.8 per cent to the lowest level in 16 months. The proportion of first-home buyers hit a 20-month low.

“If there ever was an emerging housing bubble – and there wasn’t – it has been successfully deflated,” says Craig James, chief economist at CommSec. “Home lending has fallen in seven of the past eight months and further weakness may lie ahead in response to rate hikes in March and April. It is not just first-home buyers in retreat.

“The number of second and subsequent home buyers in February was the lowest for any February month in nine years. It’s clear that both higher interest rates and higher home prices are causing more budding home buyers to cool their heels on the sidelines,” says James.

And then there is affordability: that shifting combination of house prices, interest rates and incomes. House prices rise, as they did in 2009, when affordability improves. Here, the most important factor at present is interest rates – particularly in light of the five interest rate rises in the current cycle, from 3 per cent to 4.25 per cent.

According to the Fujitsu Mortgage Stress-O-Meter report for March, interest rate rises and cost of living increases pushed up the number of severely stressed households by 1.6 per cent to 222,225 in March, from 218,765 in February. And Fujitsu executive director Martin North says it is the newer entrants to the market that are coming under more pressure

“We estimate that by December 2010, 469,000 households will be in some degree of discomfort and those in severe stress perhaps as high as 267,000,” says North.

“The consequence of this is that stress is becoming more isolated to specific household segments, with first time buyers with young growing families feeling the pain most strongly.”

However, the rise in severe mortgage stress comes as the total number of households under mortgage stress eased by 3.5 per cent in March to 561,000 from 581,000 in February, on improving job prospects.

This means that the resources boom will also play its part in the health of the Australian housing market. One thing is for certain, it is not a straightforward market – as the marked differences of opinion on it tell you.

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