Aussie Pride

It was almost 80 degrees here in NC this past weekend.  Perfect weather for a Friday in the local library reviewing the outlook for global housing markets.  We stumbled across the 7th Annual Demographia International Housing Affordability Survey last week, which offered some terrific insight into the scope of the bubble brewing Down Under, when we finally got around to reading it.  As defined in this study, all major markets in Australia and New Zealand are severely unaffordable.  With a Median Multiple (median house price divided by gross annual median household income) of 11.1, Sydney is the second most unaffordable market of the 325 markets included in the study, while Melbourne ranked 79th with a Median Multiple of 9.0.  For perspective, median house prices have historically averaged 3.0 or less times median household incomes.  Demographia summarizes the Australian market as follows:

Housing remains the most unaffordable in Australia, except for the single market in China (Hong Kong) included in this Survey. Australia is characterized by more restrictive land use policies. The Organization for Economic Co-operation and Development has recommended that Australia “ease” its housing supply constraints, which have driven up housing prices.

Australia’s major markets have a severely unaffordable Median Multiple of 7.1, nearly 2.4 times the 3.0 affordability standard. Each of the major markets, with the exception of Sydney had housing affordability within the 3.0 norm during the 1980s (Figure 2). Australia’s Median Multiple for all markets was also the highest outside China, at a severely unaffordable 6.1.

Sydney, which has had long-standing limits on housing development on the urban fringe, was the most unaffordable major market. Sydney had a Median Multiple of 9.6. Prices rose strongly in Melbourne, which had a Median Multiple of 9.0. Adelaide had a Median Multiple of 7.1, despite being the lowest demand major market in the nation. Brisbane (6.6) and Perth (6.3) were less unaffordable, but were still well above the threshold of severe unaffordability.

More troubling than price alone, is the conclusion that this house price escalation has occurred generally independent from varying demand levels.  In Sydney and Melbourne, the median priced house now costs a household at least $750,000 more than the historic housing affordability norm, ultimately retarding consumer spending.  Last year’s study showed that the median household would spend over half of its pre-tax income on mortgage payments.  We would note that these payments have only gotten larger with several RBA interest rate hikes since that study was published.  As we pointed out in our initial piece on the Troubles in Oz, the ratio of home prices to income has always fluctuated around a stagnant long term average, because income acts as an anchor limiting the price homeowners are able to pay and has always pulled price back to earth in every instance.

A similar ratio, calculated by the Economist puts the Australian housing market at the top of the charts.  In theory, the price of a home should reflect the value of the services it provides, so the Economist  calculates the ratio of prices to rents in 20 economies.  Using this measuring stick, the Land of Oz is 56% overvalued and inching toward fair value as prices fell 1.6% month over month.  But as Michael Lewis so eloquently described in a recent Vanity Fair article, When Irish Eyes Are Crying:

Real-estate bubbles never end with soft landings.  A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long-term investment real estate has become and flee the market, and the market will crash.  It was the nature of real-estate booms to end with crashes.

Their real-estate boom had the flavor of a family lie: it was sustainable so long as it went unquestioned, and it went unquestioned so long as it appeared sustainable.  After all, once the value of Irish real estate came untethered from rents there was no value for it that couldn’t be justified.

There is an iron law of house prices . . . The more house prices rise relative to income and rents, the more they subsequently fall.

Smart investors in the U.S. looked for a slow-down in the appreciation of home prices as an indication that momentum was waning and price increases were unstable.  Month over month declines also served as early warning sign that the bubble was beginning to deflate at home.  Perhaps we are nearing an inflection point Down Under as well.  Steve Keen, who has followed the Australian real estate market closer than anyone on the street, argues that the government-stimulated debt-driven boost to aggregate demand was the primary reason Australia got through the Great Financial Crisis (GFC) so well, and also why Australian real estate prices avoided anything but a hick-up in an upward trend.  But he shows (first chart below) that the most recent data for Australia indicate that this Credit Impulse has now peaked and is turning back towards zero.  With a ratio of Private Debt to GDP still in nose-bleed territory (second chart below), deleveraging in the household sector should have a significant impact on real estate prices.

The bulls hang onto the hope that demand for housing in Australia far outstrips supply.  Indeed, even the Demographia study highlighted “smart growth” with restrictions on development on the edge of the urban fringe, as a driver of higher prices in markets like Australia.  Maybe, but the skeptic in us wonders why such a large percentage of mortgages on bank balance sheets are loans to “investors.”  We hope these aren’t the same “investors” that were buying homes in Dublin or in California.  For what it’s worth, a 2005 paper by the OECD on Recent House Price Developments pointed to complex and inefficient local zoning regulations among the reasons for the rigidity of supply in Ireland.  According to this paper, heavy land-use regulations in some US metropolitan areas were also associated with considerably lower levels of new housing construction which restricted housing supply and increased home prices.  We would note that these “supply restrictions” didn’t exactly prevent prices from ultimately returning to earth in California (see chart below).

Perhaps Aussie Pride is enough to keep the bubble inflated and prevent folks from questioning the sustainability of ever-increasing housing prices.  Then again, we’re pretty sure our Irish friends would tell you they are a proud people as well.  The Australian banks tell investors that because their mortgages are non-recourse, they do not have to worry about the same types of risks and losses experienced by lenders in the U.S.  Then again, there’s no such thing as a non-recourse home mortgage in Ireland either, so perhaps the Irish banks are a better proxy for Australian bank investors. We wonder how the currency would react should Aussie officials be forced to recapitalize the banking system, given investors’ current optimism on the AUD.  We believe the Australian Dollar has begun a topping process and investors should position accordingly.  Options on lower Australian interest rates also provide investors with a cheap hedge against a bumpy Chinese landing, should policy makers continue to stomp on the brakes with the same delicate touch as my fiancé’s foot on the pedal.

Disclosure: At the time of publication, the author was short the Australian Dollar, Australian interest rates and various Australian financials via traditional and derivative investment vehicles, although positions may change at any time.