Are we headed for a property crash?

Is the property glass half-full or half-empty? Opinions vary so much that JAMES THOMSON has had to talk to a comprehensive range of experts to get some answers.

By James Thomson

Property Outlook

Is the property glass half-full or half-empty? Opinions vary so much that SmartCompany has had to talk to a comprehensive range of experts to get some answers.

Australia’s property market is balanced on a knife edge.

Some economists believe the debt-fuelled bubble is about to burst, sending house prices plunging by up to 50%. Others believe the undersupply of housing means the market will hold up well, even if Australia enters a recession.

What happens to the property sector is of vital importance to entrepreneurs. According to accounting firm PricewaterhouseCoppers, 65% of private businesses use their family homes as security to obtain business finance.

If property prices plunge, the capacity of businesses owners to take on further debt to grow or even save their business will be severely limited.

Predicting where house prices will go in the next two years is difficult given the extraordinarily volatile economic conditions. Besides, opinions (even here in the SmartComapny office) are so varied that to favour one point of view would mean not presenting the whole picture.

So let’s explore the outlook with a SmartCompany Q&A.

How strong have house prices actually been over the last few years?

Extremely strong. Between June 2002 (the end of the last slowdown) and June 2008, the median house price in every city bar Sydney and Melbourne more than doubled (Melbourne jumped by 57%, while Sydney increased by 37%). Here’s a graph from the HIA which shows the rapid acceleration.

Property in the downturn

While auction clearance rates have fallen sharply in the last six months, prices have remained relatively strong, with the exception of a few pockets such as western Sydney, where the stalling economy of that region has put borrowers under pressure to sell.

We’ve had a good run. But what’s next? Just how different are the predictions for house prices?

Economists fall into two clear camps on this one – the optimists, who believe that property prices will only fall moderately by 10% at the most; and the merchants of doom, who believe property prices are about to crash by 40% to 50% as Australia plunges into a lengthy recession.

I’m a glass-half-full type of person. Take me through the optimistic scenario

There are number of experts who support the more optimistic view on house prices, including ANZ chief economist Saul Eslake and the chief economist at the Housing Industry Association, Harley Dale.

Central to their argument is that demand for housing continues to outstrip supply.

Strong growth in Australia’s population (which grew by 1.61% in the 12 months to March, the fastest rate of growth in almost 19 years) has been fuelled by a sharp increase in migration (almost 200,000 migrants in the last 12 months). This has helped boost the underlying demand for housing – calculated by looking at population growth, the rate of demolition and current housing stock – to an estimated 190,000 homes.

But for the last five years, the building industry has been under pressure, with the high costs of land, raw materials and labour pricing many would-be home buyers out of the market and holding back growth in house starts to around 145,300. The graph from the HIA shows the gap between supply and demand.

Property in the downturn

If demand outweighs supply, that should provide plenty of support to house prices, shouldn’t it?

That’s the theory. Certainly the IMF supports this view that the fundamentals are strong. In its World Economic Outlook, released in early October, the IMF specifically said that its study of the extent to which house price growth could be explained by “fundamentals” (that is, supply and demand) “does not produce evidence of a significant overvaluation of Australian house prices”.

Well if the IMF is satisfied our house prices are not overvalued, how can these doomsayers disagree? And who are they, anyway?

The chief proponents of the “house prices to crash” theory are Morgan Stanley economist Gerard Minack and Steve Keen, associate professor in economics and finance at the University of Western Sydney.

They argue that house prices are wildly overvalued when compared with incomes. Australian house prices are running at seven times the median income, when Keen says the affordable level is about three times.

To put that in context, US house prices – which have crashed so badly in the last 12 months, sparking the sub-prime crisis – are currently three-and-a-half times median income level.

Minack and Keen argue that prices are simply unsustainable at this level and must come down as the economy slows.

But what about the supply and demand argument?

While both men agree the Australian property market is not oversupplied, they disagree with the notion that supply and demand drives house prices. They argue that it is the willingness of Australians to borrow extraordinary amounts of money to buy houses in recent years that has pushed prices up so sharply.

“I think that the major reason Australia now has one of the world’s most expensive housing stocks is because we’ve seen a dramatic increase in household debt, which reflects both the willingness of lenders to lend and – because we’ve gone 17 years without a recession – borrowers to borrow,” Minack wrote in a recent research note.

Here’s a graph from the Reserve Bank of Australia that shows the ratio of household debt to household income. It shows that for every $100 we earn, we owe $158. Back in 1991, in the midst of the last recession, we only owed $48 for every $100 we earned.

Property in the downturn

Keen explains further. “The old supply and demand argument, the favourite harbinger of every economist except me,” he said in a recent interview on the ABC.

“To me where the demand comes from is people’s willingness to borrow money to buy an asset. And that reflects their expectation that the price of the asset will rise. When they no longer expect that to happen, the debt finance demand for housing will evaporate and the prices will fall with it.”

But we’ve lived with a huge pile of debt for the best part of a decade? Why should that change now?

Because of the credit crisis and looming global recession. Minack and Keen are extremely bearish on the global economy and expect deleveraging of the global financial system – the process we are seeing right now, by which banks try to reduce the massive amounts of debt they are carrying – will lead to a deep recession. Unemployment will rise sharply (Keen’s worst-case scenario sees unemployment hitting 20%), mortgagees won’t be able to meet repayments and more houses will need to be sold.

Of course, a flood of homes on to the market will push prices down. But Keen further argues that because home buyers will no longer be prepared borrow the huge amounts needed to buy houses at the current inflated prices, house prices will drop even more sharply.

“The only way you can get your house to be sold for a higher price than you bought it for is that if somebody takes out more debt than you did,” Keen said recently. “And that’s got to the point where it’s simply unsustainable.”

Hmm, these gloom-and-doom economists have a pretty good point. There’s no way I’d be borrowing big amounts in the current environment. How do the optimists respond to those arguments?

It really gets down to how bad the slowdown might get, and particularly how high unemployment might rise.

The HIA’s Harley Dale concedes that the sharp run-up in house prices and the heavy debt load many Australians are carrying does make the outlook for property more fragile.

“But we don’t think we are going to go from an unemployment rate of 4.4 % to the double-digit unemployment rates that we saw in the recession of the early 1990s.”

There are two reasons for this. First, Australia’s ageing population means skills shortages are still chronic across many sectors of the economy, so demand for workers should hold up.

Second, businesses are not under the same pressure from high debt, interest rates and labour costs as they were in the previous downturns and shouldn’t have to sack staff at the same rate. “Businesses in Australia are in far better shape than they were going into the early 1980s and early 1990s recession,” Dale says.

So basically, the outlook for housing depends on the outlook for unemployment. What are the projections for the economic growth and the unemployment rate?

NAB is forecasting economic growth to slow to 1.25% by the middle of next year, with unemployment rising to 6%. Westpac is tipping economic growth of 2% next year and unemployment rate of 5.3% while ANZ is also tipping GDP growth of 2% and an unemployment rate of 5.3%.

So we are not actually headed for a recession?

Not on those forecasts.

So house prices shouldn’t fall as dramatically as Keen and Minack expect?

That’s certainly the hypothesis of economists like Saul Eslake from ANZ and the HIA’s Harley Dale.

“You could, in some markets in Australia, be seeing falls in the order of 5% to 10%, but there will be markets where you see steady prices and you will see some pockets of moderate growth,” Dale says.

Eslake is also optimistic, but does point to three areas where prices are likely to fall:

  • Areas where non-traditional mortgage lenders made large amounts of low-doc loans, which are more likely to go into default. This is already happening in western Sydney.
  • Prestige property in Australia’s most expensive suburbs. Homebuyers just won’t throw money around like they used to.
  • Areas that have a high concentration of investment properties, as mum and dad investors decide to exit the market.

Sounds like I don’t have too much to worry about then

Hopefully not, but don’t go celebrating just yet.

Minack and Keen’s concerns about Australia’s unsustainable house prices and the danger of a sharp drop in prices if people stop borrowing such large amounts for housing should sound a cautious note.

It’s particularly worth noting growth in borrowing for housing is already dropping quickly, as this graph shows. Keen’s nightmare scenario might not be that impossible after all.

Property in the downturn

OK, so I need to be cautious. What should I be doing?

Well, Keen is currently trying to sell his Sydney apartment, which gives you some indication of what his advice might be.

If you’d still like to live in your home, the best advice is to reduce debt if at all possible and buy yourself some flexibility. Then, if the slowdown is severe and the worst happens and you lose your business or your job, you should be able to keep paying your mortgage and hold on to your house.

This is crucial. Even if house prices tank in the next few years, holding on to your house and not being forced to sell will mean you can ride out the property downturn until prices rebound, as they always do.

Remember, the housing market is fragile and caution is crucial for the next 12 to 18 months.


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