By contrast, a six-month, government-guaranteed term deposit pays you 2.5 per cent gross. For someone on a 37 per cent tax rate that’s 1.6 per cent net, with no other costs to worry about.
When an asset is yielding less than what’s called the “risk free rate” (and you don’t get much more risk-free than government-guaranteed), the only way you can justify investing in it is making a capital gain. By definition, that makes it a speculative asset.
Commercial property on the east coast yields about 5.5 per cent – that’s a 50 per cent premium to the residential average. Don’t fall into the trap of saying: “But commercial property prices don’t go up as fast as residential.” Remember we’re talking about investing here, not speculating.
The other classic growth asset is, of course, shares. The most common valuation measure for shares is the price to earnings (PE) ratio, which is simply the price you pay divided by the net earnings you receive. At the moment the S&P/ASX 200 is on a PE of 16.5, but if a rental property is getting a 1 per cent net yield that’s a PE of 100.
The only way you can explain that difference is debt, which always lies at the heart of every property boom, and that’s where the Australian residential property market looks really risky.
Too much debt
According to the Bank of International Settlements, at 120 per cent, the ratio of Australia’s household debt to GDP is second only to Switzerland’s and compares with the average for developed economies of 72 per cent. For context, to look at three other recent debt-driven housing booms, the same ratio for the US at the peak of its pre-GFC property boom was 99 per cent (it’s now 76 per cent), Ireland’s was 117 per cent (now 44 per cent), and Spain’s was 85 per cent (now 60 per cent).
The RBA reports Australian household debt to disposable income is 190 per cent, up from 160 per cent in 2012 (and about 110 per cent 20 years ago), yet only 37 per cent of homes have a mortgage. Underlying that, in Sydney and Melbourne the loan to income multiple went from the old rule of thumb of three times to about six.
Again, for some perspective, Sydney’s house prices rose 80 per cent between 2012 and the 2017 peak and Melbourne’s went up by 56 per cent. By comparison, US house prices rose 78 per cent over the five years to their peak in 2006, Ireland’s prices went up 100 per cent in three years and Spain’s by 50 per cent in four years.
Now, about 18 months after they peaked, Sydney property prices are down 15 per cent and Melbourne’s by 11 per cent. From their peak to trough US prices fell 34 per cent, Ireland’s 55 per cent and Spain’s 35 per cent and the average time from top to bottom was just short of six years.
Banks and incentives
To understand what’s going on in the housing market, it helps to understand how we got here.
In 1988 the first Basel banking accord was released, which halved the capital banks had to keep on their balance sheet against residential mortgages. That meant the banks’ return on equity, or profitability, doubled overnight. In other words, if a bank has to retain $20,000 of capital on its balance sheet against a $100,000 loan, on which it charges an interest rate of 5 per cent a year, its return on equity (ROE) is $5000 (interest) on $20,000 (capital), so 25 per cent. If the capital buffer is halved, it’s $5000 on $10,000, so 50 per cent. Bingo, the ROE doubles overnight.
The Australian banks, coming off a crisis after over-lending to 1980s’ entrepreneurs like Alan Bond and Christopher Skase, jumped on this newfound source of profitability so enthusiastically that our “commercial banks” have swung from housing being one-third of their loan books to two-thirds. That has required a 30-year, industrial-scale campaign of shoving as much debt as they can into the sector, aided by tailwinds of declining interest rates, tweaking the tenure of loans from 20 years to 25 and now 30, and the rocket fuel of interest-only loans.
Why? Because it kept their profits high.
And the upshot? Over the past 10 years, mortgage debt has grown at 7 per cent a year, while real wage growth has been 2.5 per cent. In Melbourne, between 1960 and 1988 the multiple of average wages required to buy the median-priced home went from 2.8 to 3.9; but then between 1988 and 2018 it went from 3.9 to 10.3.
More debt in an over-indebted sector
The cheerleaders for the property market are back in force, but their assertion we’ve seen the bottom in house price declines is based entirely on more debt being taken on. That response is very much level one, or knee-jerk, thinking: just because you’re able to buy a house doesn’t make it good value.
Clearly the RBA is worried about the effects of falling house prices on the broader economy: assistant governor Michele Bullock gave a speech chastising the banks for being “stingy”; the RBA leaned on APRA to quietly reopen the interest-only lending taps just before Christmas last year; it’s openly signalling lower interest rates; and APRA is easing up on the lending benchmarks the banks have to use. Every one of those actions is designed to throw more debt into an already over-indebted sector.
The cries of relief that negative gearing won’t be abolished also breaks another rule of sound investing: you never invest in an asset based on tax breaks. It should always stand on its own feet.
After 30 years of debt-fuelled rising property prices, the “anchoring bias”, where peoples’ expectations are shaped by past experience, will be hard to shake. But behavioural economics tells us as investors, our best decisions are made when we engage second-level thinking and look beyond our biases.
James Weir is a director of Steward Wealth.