Thursday, July 23, 2015

Why Sydney real estate prices appear not to make medium term sense

I have become very fond of Australia's Reserve Bank. That may sound a dumb thing to say about an institution, but I do like the balanced if cautious commentary on economic matters.

Back at the start of June, Belshaw's prognostications on Australia's economic outlook provided a stocktake on the economic outlook as I saw it. Nothing profound, just a benchmark that I could assess later developments against. My view as an analyst is that on some issues you need to put down what you think is happening, why its happening, what it means. If you don't do that, how are you going to make a rational future assessment of your own views?

As I write, the median house price in Sydney has reached a million dollars. So half the houses are under a million, but half are over a million. Despite the arguments for and against, I have no doubt that there is a housing bubble in Sydney. 

I say this for two reasons. The first is that the ratio between median Sydney house prices and those in the rest of the country seem out of kilter in historical terms. The second is that even with high Sydney rents, the rental yield on Sydney properties is now very low. Low rental yield means that future returns on investment properties are more heavily dependent on the combination of future rent increases with capital gain. For the life of me, I cannot see how in terms of simple maths current Sydney real estate prices can hold.

In a useful and interesting speech yesterday, Reserve Bank Governor Glen Stevens explored some of the longer term issues facing the Australian economy. Here I want to pick up just a few points from that speech.

Mr Stevens suggested that the long term trend rate of growth in the Australian economy may have fallen. This is quite important, for things such as budget estimates are based on a return to trend growth. If the trend rate has fallen, then this will create problems not just for things such as budget surpluses, but will also place pressure on spend and tax collections.

Mr Stevens suggested that a fall in immigration may be one of the causes. The official economic projections are based in part on assumptions about population increase. If actual numbers are lower than projections, this feeds through into lower growth. This is a particular problem for Sydney as the largest entry point for migrants.

Mr Stevens also pointed to stagnant income growth. If people don't have increased income, then they can't increase their spending. Now you would expect income growth to be slow following the ending of a boom period. I would argue that some fall in Australian real incomes is almost inevitable as exchange rates adjust, as the economy restructures. Mr Stevens and the Reserve Bank want a lower Australian dollar to assist the adjustment process. That keeps cash incomes up, aids exports, but also means some reductions in real incomes as imports including overseas travel becomes more expensive. 

Turning now to the detail of his remarks, there is nothing there that conflicts with my own June prognostications. I can let those stand.

Finishing with Sydney real estate prices, here are just four reasons why I think that they will either crash or, as has happened in the past, enter into a long period of no real growth.

  1. Interest rates will rise, reducing real estate returns. If interest rates don't rise, it will be for economic factors that will, of themselves, act to reduce real estate prices. 
  2. Lower immigration, reducing Sydney's population growth.
  3. Better returns from other investment activities, including investment in real estate in other places.  
  4.  Low rental returns in Sydney with limited immediate capacity to increase rents given stagnant incomes. 


Winton Bates said...

Hi Jim
I think your last reason is the most persuasive. Lower expected growth in income implies lower present value for future rents. I don't think interest rates will rise by much, if at all, during the next year or so. It is possible that any increase in interest rates could put substantial numbers of people under mortgage stress. If so, that would have a dampening effect on housing prices. I guess lower income growth could be expected to reduce migration, but that will depend on what is happening in the rest of the world. Expect more Greeks!

Jim Belshaw said...

We already have more Greeks, Winton!

On interest rates, I do expect rates to rise. The issue is when. At the moment, my best guess is that rates will start to shift up over the second half of 2016. I don't have especially good reasons for saying this. I think US rates will start to shift up by the end of 2015. Europe is actually growing despite Greece. I think that there is likely to be some easing of QE there. The Ozzie will decline with capital flows. All this points to some upward movement.

Noted on rental yields. So many apartments are being built now with high starting rents but low rental yields that a glut seems inevitable.

Winton Bates said...

I agree with all that. I hope borrowers and lenders have already factored in the potential for gradual increases in interest rates.
This might be a good time for people to sell their houses. But few will. It is a lot easier to give that advice than to follow it particularly since it is not easy to find better alternative investment opportunities at the moment.

It is interesting that the decline in growth prospects probably reflects uncertainty in the world economy leading to high hurdle rates for investment. At the same time people buying houses (and shares) seem to have had fairly optimistic expectations of capital gains. At some point these conflicting expectations have to reconcile.

2 tanners said...

I'd probably throw in that a perception of a tendency towards austerity budgets might also affect willingness to invest and predictions of growth rates. I'm not aware, and I stand to be corrected, of growth under austerity budgets in times of low inflation (or at all). Austerity is generally most effective when growth is seen to be unsustainable (the 'soft landing' theory').

Jim Belshaw said...

Hi Winton. If I were to sell now, I'd reinvest in another market that has lagged behind Sydney! 2t, the concept of austerity budgets is, I think, very new. It's not that there haven't been austerity budgets, but I struggle to think of another period where austerity for its own sake has been an objective. Maybe Winton could advise!

2 tanners said...

Reagan. The period just before the recession we had to have. Thatcher. Razor gang. Sir Otton Niemeyer. Come on, Jim.

Jim Belshaw said...

Good morning, 2t. It was a genuine question. In the Depression case, you had a major crisis. The argument wasn't, I think, that austerity was good for its own sake, just that it was necessary. The other cases you give all fit into the changing attitude to Government services that began in the 1970s.