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.