Will the property bubble burst or simply deflate?

As Aussie housing prices have risen dramatically in recent years and LVRs have skyrocketed, leading economists and investment advisers have weighed in on the issue of whether Australia is experiencing a “housing bubble” and, if so, whether it will eventually “pop” or quietly deflate. Today we summarise several perspectives:

1.    Jeremy Grantham, Chairman, GMO

Australians violently object to the idea that their houses, which have doubled in value in 8 years and quadrupled in 21, are in a bubble. Bubbles always need two catalysts: a near-perfect economic situation and accommodating monetary conditions. The problem is that we live in a mean-reverting world where all of these things eventually change. The key question to ask is: Can a new cohort of young buyers afford to buy starter houses at normal mortgage rates and normal down payment conditions? In Australia’s case, the timing and speed of the decline of the housing market is very uncertain, but the outcome is inevitable.

2.    Steve Keen, Associate Professor in Economics & Finance, University of Western Sydney

Though history would imply that there is a very large downside to bank shares now, it’s also obvious that bank shares fell a great deal in 2007-09, so that much of the downside may already have been factored in. However, on every metric: on the ratio of debt to GDP, on how much that ratio rose from the start of the bubble to its end, on how big the house price bubble was, and on how much bank shares rose, this bubble dwarfs them all.

3.    David Llewellyn-Smith, co-founder of The Diplomat magazine and co-author of The Great Crash of 2008 (sourced from Steve Keen’s Debtwatch website)

In fact, conditions are not yet ripe for the reckoning of the great Australian housing bubble. It would have happened in 2008 when global markets closed to wholesale Australian bank debt, but was postponed by a strong Federal Budget that supported both the asset and liability side of the banks’ balance sheets. The willingness of the Federal government to support the bubble means the reckoning can only come when the Budget also finds itself under pressure from a more serious and long-term correction in commodity prices or, as Grantham has hypothesised, from a burst of serious inflation.

4.    Ange Montalti, Senior Economist, ANZ Banking Group

The proponents of the housing ‘bubble’ story argue elevated ‘house price to income’ ratios must revert to their long term historical average in order to return housing ‘affordability to sustainable levels.

However, the predominant reason for the jump in the ‘house price to income’ ratio is the structural (read permanent) reduction in interest rates. Mortgage interest rates in Australia in the 1980s averaged around 14%; since 2000, the average has been close to 7%. This fall in mortgage interest rates has, quite reasonably, been capitalised into house prices, and measured housing affordability remains broadly equivalent to average 1980s levels.

There are no real grounds for any significant correction in house prices in the foreseeable future.

5.    Brian Johnson, Banks Analyst, Australia CLSA

Banks say that there is no housing bubble, as you would expect. However, Aussie housing affordability is stretched compared to other countries. When you have a look at the volume of lending that was done when interest rates were at a low point, 30% of that was going to first-time homebuyers. As interest rates rise, the ability to service those loans must be problematic. It’s naïve not to entertain the idea that we may be at risk for a crisis in the housing market.

6.    Shane Oliver, Chief Economist, AMP Capital

Australian housing is not in a bubble, but it is very overvalued. A lack of supply should prevent a sharp drop in prices, but prices will probably weaken slightly over the next year. There is little evidence Australians are struggling with their mortgages; non-performing housing loans are less than 1%, compared to 8% in the US.

7.    Alan Oster, Group Chief Economist, National Australia Bank:

National house price expectations have now turned negative. In December 2010, the Bank’s Residential Property Index dropped from 44 to 27 points, suggesting that housing market conditions will weaken considerably over the next 12 months. Furthermore, the most recent property survey was conducted prior to the Queensland floods, and next month’s survey will be worse. (Note: following the NAB’s previous Monthly Business Survey in November 2010, Oster stated, “There is no bubble,” predicting that housing prices wouldn’t collapse unless unemployment rises above 8%.)

8.    Christopher Joye, Managing Director, Rismark International

Jeremy Grantham continues to peddle the line that the dwelling price to income ratio is 7.5 times or higher, when many experts, including Australia’s central bank, the RBA, have repeatedly demonstrated that this is wrong: the right ratio is about 4-5 times if you compare national dwelling prices with national incomes, or capital city dwelling prices with capital city incomes. This estimate has been independently verified by the Reserve Bank of Australia, Goldman Sachs, Westpac, CBA, ANZ, HSBC and other third-parties. Grantham also makes the loose claim that Australia has “accommodating monetary conditions”, when, in fact, mortgage rates (at 7.4%) are exactly in line with the long-term averages, and amongst the highest in the stgeloped world.

9.     Gerard Minack, Chief Economist, Morgan Stanley

Most measures suggest that house prices are around 40% above fair value.  There’s a word for a financial asset that’s over-valued by 40%, so let’s use it: housing is a bubble.   Buying an asset that’s over-priced never ends well.  The real return on residential property over the next decade is likely to be negative, in my view.

10.    Ric Battelino, Deputy Governor, Reserve Bank of Australia:

Australia’s housing market isn’t headed for a US-style collapse – Australian unemployment rates are considerably lower than in the US, and mortgage markets are strictly regulated. Prices are high because of the competition for desirable coastal locations.  Households have been more inclined to trade up to bigger or better located houses, and to buy investment properties. Households under 35 years of age (i.e. the group that would typically encompass first-home owners), in contrast, have seen a fall in the proportion with debt.

If we look at the way the increase in household debt has been distributed, what households have done with the money, and the arrears rates on loans, it is reasonable to conclude that the household sector has the capacity to support the current level of debt. Having said that, the higher the level of debt the more vulnerable households are to shocks that might affect the economy. We at the Reserve Bank therefore welcome the fact that the household debt ratio has flattened out in recent years .

So who is right? We wish we knew. However, the trend definitely seems toward acknowledging the weaknesses in the Aussie housing market. While the “doomsday” predictions of economists such as Steve Keen have not  played out, an increasing number of respected experts are recognising the legitimacy of his concerns. A cautious approach to property investment is therefore justified. As Shane Oliver observes, even if Australia does not have a “housing bubble,” shares are probably the better investment at this time.