Is the Australian property market really a time bomb?

Over the last few weeks I have noticed increasing nervousness among the property investors I speak with, and it’s not just first time investors wondering whether they should get into the market. I’m also noticing concern from some investors with substantial existing property portfolios.

Only yesterday I got a phone call from a professional colleague who has been investing for years, but now has the jitters after reading that Jeremy Grantham, a legendary US investor, warned that Australia had “an unmistakable housing bubble and that prices would need to come down by 42% to return to the long-term trend.”

Is he right? Are our property markets going to crash?

Well, before I give my thoughts (for what they are worth) let me share some other concerns I’ve heard over the last few weeks.

Some investors are concerned that property prices have risen too high too quickly, particularly in Melbourne and Sydney and that they may now drop. While others are concerned that they have been priced out of the market and it’s too late to get in.

Yet others are worried that interest rates will rise further and if they purchase a property today they won’t be able to hold onto their property.

It’s understandable why so many investors are nervous…

Last year while the rest of the world suffered and Australia avoided going into recession, we felt confident, in fact a little smug and thought the worst was behind us. With all the good news in the media buyers were out in force and set some of our property markets on fire.

But now the messages are changing.

It’s no longer just good news – there is bad news, followed by good news, followed by some mixed messages. Most people, even some experts, don’t know exactly what’s happening or, more importantly, what’s coming next. No wonder most investors don’t know what to do.

While Australia’s economy has performed well and is likely to continue to do so, we don’t operate in a vacuum. We are part of a global economy, one that is still having lots of problems. While America is slowly working its way out of its problems (but has a long way further to go) the extent of the problems in Europe are just coming to light. If history repeats itself, there will be plenty more surprises – maybe some shocks – and these may have a negative impact on the Australian markets and in particular finance markets.

Rolf Schaefer, director of Metropole Finance, is concerned that if the Australian banks have difficulty raising money overseas and if they follow the trend already evident in England and Canada, they may lower the available loan to value ratios for investment properties.

I see our housing markets softening in coming months. By this I mean price growth will slow – it doesn’t mean prices will fall, but they may in some areas. Particularly at the bottom-end of the market if interest rates rise again too soon.

It is more likely that the market will eventually get back into equilibrium in contrast to a sudden sharp fall as some of the doomsayers are predicting.

It is unlikely the government or the RBA would allow such a correction to occur.

What about all the talk about unaffordability?

In his recent newsletter, property analyst Michael Matusik says that while it’s true that residential property is more expensive, relative to household incomes, than it once was, this imbalance is not as drastic as the doomsayers think.

Matusik suggests a better measure of affordability is mortgage size versus household income, which is around a ratio of three across Australia, up from two a decade ago. He explains that when looking at the middle to upper end of the Australian market – which holds three quarters of our residential property – this ratio is just two.

Matusik says that on average, Australians hold 80% equity in their dwellings – even higher for their principal place of residence. He goes on to explain that when looking at Australian’s leveraging – when playing mortgage size against household income – this has declined over the last five years.

He makes the insightful comment that unless we see our banking system collapse, he can’t see how house prices across Australia will lose close to half their current value in a short, sharp crash. And even over the longer term, such deflation seems very unlikely.

RBA Deputy Governor Ric Battellino also recently commented that house prices in Australia, relative to income, were reasonable.

“People feel that house prices in Australia are quite high and that’s quite often because the ratio of house prices to income that are published for Australia tend to focus mainly on prices in the cities, and they are quite elevated,” Battellino said. “But, if you look across the whole country, the ratio of house prices to income is not that different from most other countries.”

This should give comfort to those worried by the many predictions of economic disaster. If you pit the headline-seeking doomsday brigade against the RBA, I’ll believe the Reserve Bank any day.

David Airey, president of the Real Estate Institute of Australia (REIA), also slammed the comments by Grantham, saying:

“What we are experiencing in the housing market is normal growth for house prices. If Australia was in the midst of a so-called housing bubble, then we have been there for some time. REIA’s data highlights that historically, median prices, compared to income, have been relatively stable for the past 10 years, taking into account normal fluctuations,” said Airey.

“It is important to note that the price/income ratio doesn’t entirely explain the state of houses prices. Demand fundamentals, such as interest rates and stock returns also need to be considered. As well as these fundamentals, we need to look at structural factors, such as population growth and the current undersupply of housing.”

“What is evident from the data recorded by REIA is that we are not seeing a bubble developing which will implode, but rather, the cyclical changes of the Australian housing market,” concluded Airey.

So what should property investors do?

Firstly it is worth remembering that the fundamentals that started this property cycle are still there and there is no doubt the property values will continue to increase but now more slowly and selectively.

We still have a strongly rising population, yet at the same time a shortage of supply of properties to meet this strong demand that shows itself as rising prices and low vacancy rates. We are just not building enough new properties and those we are building are coming on stream at a much higher building cost. Plus we still have relatively low interest rates.

But one factor that boosted the market – consumer confidence – is now faltering.

The growth of the markets in Melbourne and Sydney in particular was unsustainable. In some ways the property markets have gotten ahead of themselves. They are now taking a breather. This is normal. Property prices don’t increase in a straight line. They go up in little booms then catch their breath and sometimes even drop a little bit, but then they move up again.

But not all properties will increase in value equally.

Property values in regional Australia, and in the outer and working class suburbs will be more interest rate sensitive. This is where homeowners (who drive the market) are more sensitive to interest rate rises and affordability issues.

On the other hand homeowners in the inner more affluent suburbs generally have more disposable income. Further, their income is not as dependent upon rises in the CPI but people in these suburbs tend to have a share portfolio, businesses, property investments or get bonuses and have more disposable income and are more likely to be able to afford higher property values.

This will create a two-tier property market, with properties rising in some areas and not in others. Values will increase in the inner more affluent suburbs and not as much in the outer working class areas.

As property investment is a long-term play, get into the market now by purchasing the right type of property – one that will be in continuous strong demand by owner-occupiers (who drive up prices) and with an element of scarcity. If possible buy one to which you can add value which will increase your capital growth at a time when general capital growth will be lower.

Then sit back and allow the magic of time, leverage and compounding to work its magic!

Michael Yardney is the director of Metropole Property Investment Strategists, a best-selling author and one of Australia’s leading experts in wealth creation through property. For more information about Michael visit www.metropole.com.au and www.PropertyUpdate.com.au.