From the ages of eleven to thirteen, I spent two days a week in Hebrew school. I absolutely hated it. Today, I joke that I had my Bar Mitzvah, made two grand, and retired on top. Although I can no longer read Hebrew, I can still remember the history lessons of the Holocaust. Every week, it was pounded into our brains that Germany was once a liberal, Western democracy before they turned to fascism. The mechanics of how a free republic went on to commit one of the worst acts of genocide were pounded into our heads on a weekly basis with the underlying message, it could happen here in the United States.
At the time, I thought this was crazy paranoia being taught to us and it could never happen in the United States. Now older and wiser, I still think it was absolutely crazy paranoia with a not so subtle pro-Israel agenda. Of course, this kind of social upheaval is not impossible and empires do come and go. At this moment in time though, I would put the odds of the United States creating concentration camps and systematically murdering its own citizens to be so improbable that it would be near zero.
I mention this story because I know a thing or two about crazy, wild paranoia stories with not so subtle undertones of “it can happen here”. Except I hope my message does not contain a subtle undertone, subtlety is not my strong suit and my message is not it can happen here. My message is it WILL happen here.
Ever since I became interested in the Australian property market, I have read every article in The Age (local and online newspaper). Within the same page, there are multiple contradictory titles. One article will claim that properties are rising and auction rates are going up - buy, buy, buy! The article immediately below the positive spin will then state that vendors (property sellers) are accepting lower prices and gloom and doom is in the property forecast. Even more amusing than the contradictory headlines are the hundred or so comments each article attracts.
My favorite comment so far in discussing Australian national treasure Steven Keen’s prediction that home prices would decline by 40% (http://www.brw.com.au/p/sections/features/keen_to_be_heard_ibhMdopX0E8Soh00ql3mPO) stated (loosely paraphrased):
“If someone bought a home for $500k, why would they sell it for $300k? It’s worth $500k and they will not accept anything less!”
In light of comments like this, I feel it necessary to talk a bit more about basic economics. Houses, like stocks, depend on matching a buyer to a seller. Unlike stocks, houses are not liquid - there are large transaction costs associated with a sale, home sales can take weeks to months to match buyer and seller, and no two houses are exactly the same. Whereas stocks (should) trade based on some multiple of their earnings and their prospect to grow said earnings, these metrics do not apply to residential property (except on the macro scale). What really drives home prices is - wait for it - comparables. A house of roughly the same size in the roughly the same geographic area with roughly the same amenities will be seen by a potential buyer to be fairly valued if it is reasonably close to a similar unit that had sold recently. If there are more buyers than sellers - house prices go up, driving comparables up, generating newspaper headlines about property booms, and drive house prices up even further.
But what happens when comparables start declining? As the housing markets of the US, UK, Ireland, and Spain have shown; it is possible for home values to fall. When properties that are similar sell for less, it makes every property less valuable. The cycle works the same as above, except in reverse.
Australians are proud of saying that there is no sub-prime mortgage market like the United States had (which may or may not be true) so there will not be massive amounts of foreclosures flooding the market if/when interest rates go up. However, an important part of the Aussie economy is being overlooked which inevitably will lead to a firesale on property - negative gearing.
The Australian Tax Office (ATO) reported that nearly 70% of landlords did not make ANY income in 2007-2008 (I would imagine that more recent data would look even worse). In fact, these negatively geared landlords lost a staggering $12.75 BILLION (with a B!) or
According to the late economist, Hyman Minsky (summarized nicely by Phillip Soos), there are three phases to 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.
Read the third one again. In Ponzi finance, owners rely on escalating sales prices. When prices stop going up, those 70% of landlords and property “investors” are screwed. There options are to keep pumping cash into what is now a rapidly depreciating asset or liquidate to get rid of the debt now that the dream of capital appreciation is long gone.
When “investment property” is dumped on the market by a million or so landlords (in a population of 23 million people), it will probably look an awful lot like the foreclosure waves that hit the United States when the sub-prime market blew up. With an increase of supply and not a lot of demand, prices go down. Economics 101.
As if this were not bad enough, there is some basic math to explore as well. It has been nearly six years since the housing bubble popped in my native United States. Although numerous economist and US national treasure Warren Buffet have now started calling real estate fairly valued or even under valued, a bottom has yet to be statistically proven.
Economists who have analyzed the Australian housing bubble have called it anywhere from 40-60% overvalued. For the sake of this exercise, I will split the difference and call it 50%. Based on the example in the United States, it may very well take up to six years to reach the bottom before house prices begin to appreciate. From there, house prices should rise with inflation, roughly 3% annually. How long will it take for house prices to get back to their peek prices? By the rule of 70 (http://en.wikipedia.org/wiki/Rule_of_70) assuming 3% appreciation plus six years to reach bottom, the answer is... 28 years. That is basic math.
In summary, when you look at the basic economics of supply and demand factoring in there are 1,000,000 landlords currently LOSING money every month on their “investments” in a country with only 23,000,000 people, there is a potential flood of property that can come into the market after a significant decline. As soon as more properties enter the market, it creates downward pressure and prices continue to lower until a bottom is reached. It may very well take up to 28 years for home values to reach their inflated peaks. In the current market, rental prices are 50% or less than the equivalent mortgage costs. The best thing to do right now is rent and hoard cash.
