Description

Australian Housing Market Bubble

Australians have long thought of their nation as the ‘lucky country’ and the performance of their economy over the last few decades has seen it live up to that moniker, with the country not having experienced a recession in over thirty years. 

Unlike the economies of many of its OECD peers, the country did not fall into a recession during the GFC and resumed a path to trend growth more quickly. In the lead up to the crisis, the IMF proclaimed in their World Economic Outlook that housing bubbles in Australia, UK, US and Ireland would burst. Whilst those comments proved prescient in the case of the other three countries, Australia managed to avoid a prolonged fall in housing prices during this period, largely thanks to Chinese demand for commodities (mainly iron ore). 

Since the year 2000, Australian housing prices have risen at an extraordinary clip of around 5% per annum in real terms.  

Most bubbles have their genesis in a kernel of truth and whilst their are partially valid reasons for the rise in house prices (the previously mentioned economic performance, population growth - largely driven by immigration based on Australia being seen as a desirable place to live), a combination of loose monetary policy, misguided government policies and pro-cyclicality of thought, as well as the original sin of the US housing bubble (thinking housing prices never go down) has elevated housing prices to a level well above what fundamentals would dictate as fair and reasonable. 

Fundamentally overvalued 

In Demographia’s most recent International Housing Affordability survey, they deemed ALL major cities in Australia as having ‘severely unaffordable’ housing. Demographia examined the median multiple (Median House Price/Median Household Income) to assess housing affordability and noted that Australia’s national average of 8x was well above the ‘affordable’ range of 3.0x under (for comparison the USA is currently at 5x). Notably, Australia’s two most populous cities Sydney and Melbourne rank as the 91st and 88th most affordable cities in the survey of 92 housing markets.  

The results of the Demographia survey are symptomatic of a housing market where prices have massively eclipsed wage growth.  

The below graph also demonstrates how out of line Australia is relative to global peers (the graph is a bit dated, but given house price growth since 2018 the conclusion stands).

Meanwhile, CBA released some graphs on housing affordability in Melbourne and Sydney, showing that with the recent interest rate increases (and noting that in Australia the majority of households are on a variable mortgage), mortgage payments are now consuming between 35-45% of income (and this is before the coming mortgage cliff which I discuss later).

The massive amounts of mortgage debt associated with nosebleeds housing valuations has resulted in Australia having one of the highest household debt to GDP ratios on the planet, at a staggering 130% (second only to Switzerland, and well above the 75% typical of most advanced economies)

Meanwhile, a recent report from the IMF described the Australian housing market as one of the most misaligned in the region, citing rapidly declining housing affordability and rising interest rates.

Negative gearing

Whilst there have been several tax breaks and government policies that have severely distorted the Australian housing market, I believe the primary one has been the prevalence of investors negatively gearing properties.

Negative gearing is a peculiar feature of the taxation system, particularly unique to Australia amongst its OECD peers. This is where individuals rent investment properties for less than their interest payments, and subsequently claim the rental losses against the marginal tax rate of their labour income. Coupled with an environment of persistently rising housing prices, this has created an army of Ponzi landlords. According to the Australian Tax Office, of the over 2mn landlords in Australia, there are over 1.3mn Australians who own loss-making rental properties (noting that Australia’s total population is around 25mn).

Clearly investors who engage in negative gearing have an expectation that the capital appreciation of their investment property will more than offset the rental loss they are incurring. With the benefit of hindsight, this approach would have been a highly successful one if applied historically, given the strong past capital appreciation. However, proponents of economist Hyman Minsky’s financial instability hypothesis will recognize this phase as the final phase of a bubble – where investors no longer purchase an asset with the expectation of income, but purely for speculative capital gains. 

This poses the scary question of what would happen if these loss-making landlords stopped experiencing housing price appreciation and decided to sell their investment properties en-masse. Furthermore, combined with an economic slowdown could be potentially disastrous given that unemployed individuals would have no use for the tax loss shields created through negative gearing. 

Other distorting government policies

The First Home Owners Grant (‘FHOG’) has its history in the Howard Government Years and coincided with the introduction of the GST in 2000, whereby $7,000 was given to individuals who had never purchased an owner-occupier house before. There had been various amendments to the grant since inception to coincide with the macroeconomic cycle. Notably, during the GFC the Australian government doubled the size of the grant (amongst other measures, such as relaxing the restrictions on foreign purchases of housing), in order to provide stimulus to the housing market. 

The policy has been a controversial one in both market and policy circles. Respected Australian economist Saul Eslake notes that despite the stated goal of the FHOG to increase the level of home ownership in the country, according to census data it has never increased and the stable trend actually masked a decline in home ownership amongst the ‘Below 50’ population, noting that in aggregate, first home-buyers are simply using the funds to increase their borrowing power and bid up the price of the assets even further and price future generations of prospective home buyers out, whilst mainly benefitting vendors. 

More recently, was the HomeBuilder grant, introduced during the peak of COVID to stimulate the moribund construction industry following lockdowns. The grant provided eligible owner occupiers $25k grants to either build a new home or renovate an existing one. Australia’s Treasury Department initially forecasted 27k grants would be given, but after a number of extensions over 100k grants were issued, with public think tank Grattan Institute stating it over-stimulated residential construction, contributing to the level of inflation we’re seeing today. 

Other ways the system benefits/inflates property ownership is not including the value of primary residence when means testing pension payments, whilst having no capital gains tax on someone’s primary residence.

Availability of credit / funding

The positive experience of housing prices in Australia has also resulted in an overall increase in tolerance amongst households for increasing their overall level of indebtedness. The Productivity Commission (a public economic think tank) was tasked with looking into policies to alleviate strains on housing affordability for first home buyers and found cheaper access to finance had clearly played a role in housing price appreciation. This was achieved via a number of means include i) lower ‘real’ interest rates as a result of financial deregulation that took place during the 90s (increase competitiveness of mortgage sector), ii) increased popularity of mortgage insurance, which allowed households will low deposits the ability to purchase a home, iii) innovation of non-conforming loans (similar to US subprime borrowers, although the market was much smaller) and iv) higher LVR loans. 

These tailwinds, along with the benign performance of the Australian economy over a multi-decade period has seen Australian Banks increase the proportion of their lending origination to the retail side of the business, through mortgages. I remember when starting as a graduate trainee in one of the Big Four Australian Banks that the retail side of the business just seemed to be an easier business to make money, resulting in greater capital being allocated to that side of the bank. One senior business banking executive, Joesph Healy, was so frustrated at the lack of attention to the business side of lending, given the tougher capital requirements (capital risk weightings being much lower to home mortgages) and greater competitiveness, that he ended up leaving to starting his own bank (Judo) to cater to this side of the market. Currently, the Australian banks have ~60% of their lending book in mortgages, a rate around double that of US and European peers.

In a radio interview in 2016, then Prime Minister Malcolm Turnbull in responding to radio host Jon Faine stating his children were locked out of the housing market, due to affordability issues half-jokingly replied “Well, you should shell out and support them, a wealthy man like you … you can provide a bit of intergenerational equity in the Faine family.” Whilst the PM was criticised in some circles for the tone deafness of his comments, it turns out that has been exactly what is happening, with the Bank of Mum and Dad now the ninth largest mortgage lender in the nation ($35bn book, with typical $90,000 average payment). Ironically, many parents are using the vast equity built up in their own homes over the decades as collateral to access what has historically been a cheap source of funding with record low interest rates. Going forward, lower house prices and higher interest rates (both received as a depositor and paid as a lender) may strain this vein of funding. 

Mortgage Fraud also appears to be rampant, with UBS in 2017 reporting that up to one-third of mortgages based on factually incorrect information (the primary one being understating living expenses to optically improve debt serviceability, followed by overstating assets/understating liabilities), with borrowers likely being in a much weaker position than banks and/or regulators currently believe. 

Cultural attitudes + Pro-Cyclicality of thought

Given Australia’s high rate of home ownership (~70%), discussion around housing prices fluctuations stir the passion of the nation. Chief Investment Officer of GMO Jeremy Grantham explained his experiences first-hand, stating “Tell a European you think there’s a housing bubble and you’ll have a reasonable discussion. Tell an Australian and you’ll have World War III.” 

The relatively successful economic growth of Australia, combined with multi-decade rise of house prices has created a positive feedback loop whereby:

• People are willing to bear greater debt loads, because they see how well this worked out for generations past, and this has also created a real sense of FOMO for each new generation of first home buyers that if they don’t get a foot in the market, it will only get harder and harder

• Banks have been willing to allocate more capital to mortgage lending, based on its historical success

• People are willing to sustain negative cashflow on an investment property, in the belief that housing price capital gains will more than compensate them

• Whilst Australian house prices remained relatively strong compared to global peers during the GFC, the share market dived like the rest of the world. This further reinforced in the minds of a generation of Australians that only housing is a safe haven

• People have been conditioned to believe that the government will always step in and provide support, whenever there is a wobble in the housing market

It would seem that the majority of Australians are not well equipped to deal with any macroeconomic turbulence, given an extended period of favourable and benign conditions. 

Why this time is different

The thesis that there is a large housing bubble in Australia ready to burst is not an original one. Dman wrote this up on VIC in 2016, and there have been several calls over the past decade for a large housing crash, only for house prices to march continually higher, making the trade to date a perennial widow-maker.

However, this time is different. Perhaps the biggest factor that has driven the rise in Australian house prices for the last decade, has been accommodative monetary policy by the RBA over the past decade.

This is particularly stimulative of the housing market, as unlike the US, the majority of mortgages originated in Australia are variable rate (with only an option to fix a rate for the first few years). In the debate amongst the bears versus the bulls, one thing that the bulls would always point to was actual mortgage payments, rather than simply incomes versus house prices. Implicit in this, was the assumption that interest rates were structurally lower, which did play out over the past decade and seems to have supported the bull thesis.

However, recent global inflation woes have seen rates rise, with the RBA cash rate now at 3.6% and rising, and no near-term reprieve in sight.

Furthermore, there appears to be a near-term catalyst in sight - a looming mortgage interest rate reset cliff. At the onset of COVID, as usual the authorities came to the rescue to allay any fears of shakiness to housing prices. The RBA established a term-funding facility to offer low cost fixed-rate funding to the major banks for three years. In total, $188bn (!) was lent to Australian Banks, and this facility allowed banks to offer temporary fixed rates at under 2% to borrowers. However, two-thirds of that fixed rate debt is set to expire this year, and given the rise in the cash rate, this could see mortgage rates on those fixed rate loans re-price from less than 2% to around 6%.

This will cause massive stress for a number of households and if combined with any shocks to the economy, a resultant increase in unemployment may see a significant rise in distressed property sales, pressuring housing prices and ultimately the banking system.

Housing prices are currently down nationally around 10% from their April 2022 peak, since the RBA started raising rates. People here seem relatively sanguine about it, given prices are still above pre-covid levels and its more just been seen as blowing some necessary froth off those valuations …. However if rates remain sustained, Australia remains very fragile to further falls from here.

Best way to play

The clearest way to play the over-valuation of Australian housing is to short the domestic banking sector. Any stress here would dramatically impact mortgage books, and see a massive hit to earnings via loan loss provisions and asset write-downs, whilst also likely necessitating dividend cuts.

Of the big four domestic banks, Commonwealth Bank of Australia (CBA) has the largest mortgage book (and was also the biggest beneficiary of the RBA’s term funding facility) and currently trades at Price/TBV of over 2.5x, so a lot of potential downside from here.

Catalyst

Mortgage cliff

Sustained higher rates / global recession