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Re-examining the housing market


Edmund Kemsley

By

April 10th, 2016


Edmund Kemsley breaks down housing bubbles and considers whether the various ingredients are present in Australian or if all the talk about an imminent crash is just hot air.


What is a housing bubble?
A housing bubble occurs when housing prices rise substantially faster than rental returns and median income. Because the price of the asset is rising faster than it should, the amount of credit will swell dramatically and home buyers and investors will become overextended. A bubble period is also extended by the construction industry, attempting to make the most of the mania, building in excess of demand.

So, what forces are at play during a housing bubble? Economics 101 will tell you that the market for any good is governed by the powers of supply and demand. A healthy economy is expected to have stable population and income growth which leads to a gradual increase of housing demand. Accordingly, the supply of housing should respond and provide new housing at a rate that is appropriate to demand, keeping prices at a stable “equilibrium” point (as long as no pesky regulators get in the way).

From Finland to Thailand, a quick look at the history of housing markets will reveal that prices have continually deviated from their theoretical “equilibrium” price, leading to abrupt readjustments. Simply relying on the basic assumptions of supply and demand doesn’t do enough to explain the reoccurring nature of housing bubbles and while attempting to solve this problem can be enigmatic for economists, it is understood that fluctuations in the housing market are strongly related to the business cycle. A study of 22 economic recessions found that in twenty instances housing prices fell by 10% or more.[1]

What elements are necessary for a bubble to form?
Human behaviour plays an undoubtable role in causing housing bubbles. It is important to recognize that homes are both a durable good and an asset. Homeowners might be more interested in a house’s features than portfolio investors, but all real estate buyers are concerned with the same thing: the future price of the asset. In reality, the real estate market has more in common with Wall Street than the market for used cars.

What’s more, studies have found that even in controlled simulations, asset prices continually deviate from those predicted by rational expectations market models, even when information about the future financial payout was provided to the test subjects.[2] One explanation is that asset markets, such as housing and equity markets, attract trend-based investors who buy and sell in relation to the amount an asset price is changing as opposed to trading in relation to intrinsic value.[3] In short, rising prices attract investor attention – from the financially savvy to the blue collar worker – and no one is immune to the flashing lights exhibited by a booming housing market. Consequently, this phenomenon creates a self-reinforcing loop that can be difficult to break until the seemingly foreseeable happens: bust.

Most market failure stories aren’t complete without a dash of government intervention for good measure, and housing is no exception. The housing market is unfortunately incredibly susceptible to ill-informed regulation. The US Taxpayer Relief Act of 1997 was designed to support homeownership by excluding housing assets from capital gains tax. Instead, it caused a larger percentage of investment to flow into housing, fuelling the US housing bubble that collapsed in 2005 and triggered the worst global economic crisis since the Great Depression. Introducing tax incentives can be a perilous endeavour, the same legislation also played a role in fuelling the 2003 Dot Com Bubble.[4] This isn’t to say that the government is the root of all market collapses but, generally speaking, all economists agree that ill-informed government intervention can have merciless consequences.

Does Australia have the elements needed to create a bubble?
Both basic elements are present in the Australian housing market. Since the late 1980s, Australia has experienced a sustained period of strong housing price growth, outstripping inflation and avoiding any significant decreases in price.[5] Regardless of the underlying causes of the price inflation, it is undeniable that this trend has facilitated the expectation of continual house-price inflation becoming well-entrenched. Furthermore, in response to price increases, the government has intervened in an effort to win votes from home owners and real estate investors. The Australia Institute argues that the capital gains tax exemption for main residences and the negative gearing tax deduction have distorted the housing market and driven up housing prices.[6]

To gauge the scope of the housing bubble, economists use house price-to-rental income as an indicator of how much the price has exceeded the asset’s intrinsic value. As it stands, the stats don’t calm any nerves; the OECD estimates that, relative to price-to-rent ratio, house prices are overvalued by an alarming 48%.[7] Furthermore, the dwelling price-to-income ratio has risen to the remarkably high level of five and half times, suggesting that owning a home is becoming out of reach for a growing proportion of society.[8]

Moreover, household debt has also soared to an unprecedented altitude. Between 1990 and 2014, the household debt-to-income ratio tripled from 47% to 154%. Much of this debt has gone into housing credit; mortgage debt has doubled in just 8 years.[9] Greater amounts of household debt leave households more vulnerable to a decline in housing prices and economic fluctuations. The former is known to lead to a household balance sheet crisis. As housing prices level off or begin to fall, interest repayments threaten a household’s balance sheet and can drive some into negative equity. Credit liquidity is also an important factor as low interest rates have contributed to an over-abundance of credit which is amplifying the price surge.

When there is smoke, is there fire?
Recently, Vanguard, an investment firm, calculated that a ’05 US-style housing crash would push Australia into recession.[10] But despite dire predictions, the Australian housing market isn’t in a state of complete disrepair. Firstly, home owners in Australia aren’t locked into the high fixed-rate mortgages that sent many US households into negative equity in 2005, so the death spiral of foreclosure and fire sales isn’t likely to occur in Australia (not to mention the huge loss of low and middle income wealth that goes with it). Furthermore, a mammoth oversupply of housing doesn’t look likely. In 2005, US housing construction sat at a whopping 6.5% of GDP, while Australia currently sits at between 3.5-4%.[11]

Some analysts have instead forecast that Australia will go through a cooling period over the next few years. At this stage, that outcome seems more likely than a crash. Nonetheless, the RBA will need to carefully monitor the effect that low interest rates are having on housing credit. Additionally, if the government backed off from demand-side regulation by removing the negative gearing and capital gains tax incentives it would discourage poor real estate investment and dampen the price surge. Instead, the federal and state-level governments should support a cooling period and focus on prudent supply-side policies in areas that are most at risk of an oversupply, like Melbourne CBD. If this happens, Australia can avoid the bubble bursting, for now.

 

[1] Reinhart, C. and Rogoff, K. (2009). The Aftermath of Financial Crises. American Economic Review, 99(2), pp.466-472.
[2] http://www.theatlantic.com/magazine/archive/2008/12/pop-psychology/307135/
[3] Gjerstad, S. and Smith, V. (2014). Rethinking Housing Bubbles. New York: Cambridge University Press.
[4] http://www.businessinsider.com.au/heres-why-the-dot-com-bubble-began-and-why-it-popped-2010-12?r=US&IR=T
[5] http://www.rba.gov.au/publications/bulletin/2015/sep/pdf/bu-0915-3.pdf
[6] http://www.tai.org.au/content/top-gears-how-negative-gearing-and-capital-gains-tax-discount-benefit-drive-house-prices
[7] http://www.oecd.org/eco/outlook/focusonhouseprices.htm
[8] http://www.smh.com.au/business/the-economy/housing-bust-now-the-greatest-recession-risk-say-investment-banks-20151012-gk6pjz.html
[9] http://www.abc.net.au/news/2016-02-29/verrender-housing-bubble-is-building/7206678
[10] https://static.vgcontent.info/crp/intl/auw/docs/literature/2016_VEMO_Australia.pdf?20160317|091500
[11] AI Group, (2015). Australia’s Construction Industry: Profile and Outlook. July 2015. Can be found at: http://www.aigroup.com.au/constructionoutlook

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

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