The current housing bubble is a global phenomenon. Most OECD countries have seen rapid rises in house asset prices in the past decade. Before we look at the Australian market, Yale economist and author of Irrational Exuberance, Robert J Shiller, has probably the best picture of the current house asset boom, albeit in the US.

Shiller has created a real house price index for existing dwellings dating back to the 1890s. As you can see from his data below, once the effects of inflation are removed, house prices never really deviated much more than 30 percent from the baseline in the 110 years from 1890 to 2000.

This is what you would expect. If house prices were to go up faster than inflation, this would mean houses would become un-affordable. Who would have guessed? The next generation would struggle to buy property, and the generation after that would struggle further.

But in the last decade there has been a tremendous, and in keeping with the Shiller theme, irrational growth spurt in housing asset prices. Ignoring the effects of inflation, house prices have doubled in 10 short years. It should be enough for anyone to question if it is sustainable at present levels? or worst, will it burst?

US Real Home Price Index, Robert J Shiller.

Looking at the Australian market, we are in no better position. From 1986 house prices have gone up more than 400%, and when the effects of inflation are removed we have seen prices more than double.

AUS & US Real Home Price Index

2nd October 2002 – “Housing real estate building bubble, Costello Howard fly high”

While house prices have spiraled upwards, over the same period rents have not increased greater than inflation. So while housing investors have been getting tidy capital gains, the rental yield has been falling. This has prompted the industry lobby groups such as the HIA to suggest rents will rise by 20% this year. It would appear for greedy investors that getting rapid rises in capital gains is not good enough anymore, they now want to raise rents to match those gains.

While the real problem is that rents are not too low, but asset prices are too high, for investors entering the market now, they are faced with the prospect of possibly stagnant or falling asset prices while at the same time having a poor rental yield. If there is no incentive for investors, then the rent crisis would get worse. However, historically, the market has never seen such a large increase in rents. In fact, in some states such as the ACT, any landlord that excessively increases rent greater than 120% of CPI can be answerable to the Tendencies Tribunal.

  • Through the roof: rents to soar 20% – Sydney Morning Herald, 9th January 2007.
    RENTS in Sydney are set to rise by as much as 20 per cent this year as investors sell property and pour money into superannuation.

Australian House Price & Rent Index.

Residential housing has limitations different to shares and other investments. If you brought $1000 Westfield when the listed in 1960, they would be worth in-excess of $109 million. The reason why people can still buy Westfield today, is simply, they buy fewer shares or a smaller portion of the company.

However with housing, if it becomes un-affordable, if prices increase more than inflation or wage growth, then you just can’t buy one brick instead of 100,000 bricks to live in. Houses are not indivisible.

The housing market is a supply and demand market. Many so called real estate experts have a perception that houses can continue to appreciate in value, some even predicting the next boom that will see prices further double over the next decade.

What they are failing to observe is an equilibrium point somewhere where the costs to service the debt on a house brought at exorbitant prices simply outstrip wages. That is, if house prices continue to rise faster than wage growth there will be a point where the house buyer will need to spend 100% of their wages to service the debt. Clearly this is not sustainable, although there are in fact some individuals trying their best in this situation.

We are already witnessing foreclosures on Mortgages steadily increasing. The event of “easy credit” has also provided some home owners with loans they would have never been able to access 10-15 years ago and perhaps they can’t afford. These sub prime or Alt-A loans have been at the center of the collapse of many home lenders in the USA, some 50 or more at last count.

The price-to-income and price-to-rent ratios have been used as a measure of the value of housing. The price-to-income ratio, in some regards, is an affordability measure for housing. Housing can double in price and still be value for money, provided over the same period Income also doubles. This is not a true measure of affordability, as it doesn’t take in the effect of interest rates, but is a good yardstick.

The price-to-rent ratio is similar to the PE ratio for shares. The bigger the ratio, the more overvalued the asset is and the smaller rate of return obtained for investors.

Price-to-Income and Price-to-Rent Ratios for Australian housing.

If you consider the end of 1995 as period of fair value prior to the current housing asset boom, you will observe both price-to-rent and price-to-income measures indicate housing is overvalued. During the period, rents have followed CPI. Due to a skills shortage, possibly fueled by the mining boom, wage growth has accelerated faster than CPI and has helped slow the effects of the price to income ratio.