Slump in Australian house prices an outside risk

Real Estate Institute of Australia data shows rental yields are averaging about 2.5 per cent in Sydney. Photo / Mark Mitchell

Australia's economic recovery will probably not be derailed by a slump in the housing market.

Most likely, 2011 will turn out to be the third year of steady recovery from the global financial crisis (GFC) that caused the economy to stagger backwards for a single quarter in 2008.

Or will it? It is all too easy to forget a key lesson from the crisis that came to a head in late 2008.

It was the same lesson taught by the bursting of the South Sea Bubble in 1720, the panic of 1873, the October 1987 sharemarket crash and the collapse of the "dot com" boom in 2000, and any number of financial crises through the ages.

And there are oh so many ways that things might go wrong.

China's commercial property market might slump, like Australia's did in the late 1980s, succumbing to years of incremental tightening of monetary conditions.

Farther afield, financial turmoil afflicting debt-burdened Ireland could spread through Europe, plunging the world's financial markets into Mark II. Or maybe GFC Mark I isn't over yet.

More aftershocks could emerge with the US economy slowing and putting downwards pressure on share prices in New York, which still sets the tone for equities worldwide. And global equity markets are a key driver of economic activity in Australia.

The sabre-rattling on the Korean peninsula could escalate into all-out war. It's happened before.

But it does not take much imagination to see what could happen if Australia's housing market goes into a tailspin.

There are few domestic industries not intimately bound up with the housing market - transport, retailing, manufacturing, you name it.

Perhaps the most important is the finance sector.

In October, according to Reserve Bank of Australia (RBA) data, there was A$1968 billion ($2.6 trillion), or A$1.968 trillion, of credit outstanding in Australia.

Of that, A$1148 billion - more than half - comprised housing loans.

As the sub-prime crisis in the US showed, banking systems and slumping property markets can make an explosive combination.

"Despite being more indebted, households' debt-servicing ability is currently strong, supported by ongoing income growth," the RBA said in its half-yearly review of the finance system in September.

There are two potential flies in the ointment here. One is housing prices, and the other is income growth.

There has been a lot of discussion about prices recently. Some argue there is a "bubble".

Prominent among them are Steve Keen, associate professor of economics and finance at the University of Western Sydney, and a prominent figure in the funds management game, Jeremy Grantham, co-founder of pioneering "strategic asset allocation" investment firm GMO.

Their view is housing prices can be driven above their historical norms by borrowing, creating a bubble that can be sustained only as long as debt continues to rise.

Shortly before Christmas, the Housing Industry Association of Australia's senior economist, Andrew Harvey, argued that "in the longer term Australia's housing market is underpinned by the immutable forces of insufficient supply and robust underlying demand".

Westpac's economists, in a report titled "Australia Housing: The Bubble Myth", argued along similar lines.

What's more, comparing house prices with incomes as a gauge of fair value is an odd way to measure the value of a financial asset.

A financial analyst attempting to value shares or bonds in this way in a presentation to a client would generate, at best, embarrassed snickers.

But more rational means of valuing housing also suggest overvaluation.

Real Estate Institute of Australia (REIA) data suggest rental yields - rents, net of estimated costs but before income tax, as a percentage of price - are averaging only a little over 3 per cent in the capital cities.

For Sydney and Melbourne yields average around 2.5 per cent.

At those rental yields it is difficult to come up with a plausible outlook for prices and rents that could justify investing in housing.

That is if investors are hoping for the returns had in recent decades - in double digits per year in much of the 1980s and 1990s and early 2000s.

Either rents and prices must rise to unaffordable levels or, if rents are to stay affordable, prices must rise even faster.

If prices rise faster than rents, yields will fall further, making investment on the expectation of big returns even less rational than it is now.

Two International Monetary Fund economists, Patrizia Tumbarello and Shengzu Wang, published a paper in December asking "What Drives House Prices in Australia?".

Their econometric analysis suggested an overvaluation of 5 to 10 per cent.

But based on trends in price-to-rent ratios (the inverse of rental yields), their analyses showed Australian housing prices were 16.5 per cent above the norm.

But that was based on the average for the past 10 years, when prices were high and yields were low.

Based on the REIA's yield data, housing prices would have to fall by 25 per cent to pull rental yields back up into line with even the modest 4.3 per cent average of the past two decades.

So the argument that housing prices are expensive has merit, and means that at some point there could be an adjustment.

And that adjustment could be prompted by one of those unlikely-but-still-plausible catastrophes listed earlier.

Catastrophes undermine income, the demand side of the equation that gives comfort to the proponents of the no-bubble thesis.

But because those events are unlikely, it means a slump in housing prices is also unlikely.

So relax. 2011 will turn out to be one of those normal years of economic growth and rising prosperity. Probably.

- AAP