Monday, November 15, 2010

Have You Ever Seen Sydney From an A380 at Night?

Not another boring housing blog, you say. Believe me, I would rather be discussing Collingwood’s chances of going back to back in 2011, but it’s a practical matter. See, I have been living in the US for the past 5 years and am contemplating a return to Australia early next year. I’m coming up against the “rent vs buy” conundrum, and the more research I do on the Australian housing market, the more horrified I am. I have seen the carnage unfolding from California to Nevada to New York, and it ain’t pretty.

I first started to get worried on a recent flight back to Melbourne in a brand spanking new A380 with perfectly functioning engines. I was having a great chat with an Australian woman from Sydney sitting next to me… until the topic turned to housing. Here’s a snippet of our conversation.

Her: We just bought a place. It’s crazy. You can’t find anything nice for under a million.
Me: Wow. Weren’t you tempted to just rent?
Her: It’s only going to get more expensive if we wait. Anyway, housing prices in Australia double every 7 years so we think it’s a good investment.
Me: Some people in California said that and prices have fallen 40%.
Her: That would never happen in Australia. There’s a shortage of houses.
Me: They said that in California too.
Her: Are you getting the chicken or the beef?

This was followed by an awkward silence that persisted the rest of the 14 hour flight. And when I got to Australia, it was even worse. When it came to the topic of house prices everybody I spoke to seemed to be living in some kind of delusional fantasyland.

“We’ve got a fast growing population…”
“The banks have been much more responsible with their lending here...”
“There’s a massive shortage of housing supply…”
“The government wouldn’t let that happen here…”

And so on and so on.

Australians like to think Australia is different. But here’s the thing. Holding a belief that “house prices double every 7 years” as if it’s a gospel truth is a little bit like denying the existence of gravity or insisting that Sarah Palin is well educated because she went to four different universities over 5 years to get her bachelor degree.

Let’s step back for a minute and look at the big picture. Most studies show that in the very long term, house prices basically don’t grow much faster than inflation. For example, Robert Shiller has shown that in the US, real house prices (prices after accounting for inflation) grew at an average of just 0.4% a year between 1890 and 2004. 

Now you may argue that Australia is different. But one thing is for certain: in the long term, housing prices are constrained by the growth rate of household incomes. They MUST be. If housing prices are consistently rising at a faster rate than incomes (as we have seen in Australia for two decades now), this implies that households are taking on more and more debt. The only way that prices can continue to rise in such a situation is for banks to extend more and more credit and borrowers to become more and more indebted.

Logically, since there are limits to the amount of mortgage debt that it is prudent or possible to take on relative to one's income, this situation is totally unsustainable. At some point—as we have seen in countless housing crashes around the world over the past century—housing prices will either have to fall sharply, or remain stagnant for a long period while incomes catch up. This is an insight that is so basic most people seem to have forgotten it. And in my view, we are very close to a tipping point. Just look at all the kafuffle over the recent RBA rise and subsequent mortgage rate hikes.

According to Demographia, Australia’s median house price to income ratio is currently 6.8, by far the highest in the developed world. In Sydney, this ratio is 9.1, making it the second most unaffordable city in the world. Let’s take a brief trip to FantasyLand and assume that prices will continue to grow at 8% a year over the next decade. If we assume an average annual growth of 4% in household incomes over the same period, this implies that the price/income ratio in Sydney would rise to 13 by 2020. In other words, if you put every cent of your salary into mortgage repayments, it would still take you 13 years to pay back the principal. In fact, it would be much longer than that because we haven't even taken into account the interest payments.

Extrapolate out another decade at the same growth rates and you’ll get a price/income ratio for Sydney of 19. This would be equivalent to a person on a $60,000 salary today buying a $1.14 million house. Clearly these figures are ludicrous. With apologies to the author of this excellent blog, I would even say “delusional”. And yet there are still seemingly intelligent people out there saying things like “housing prices in Australia double every 7 years” as if it’s the most uncontroversial statement in the world.  I don’t know whether to laugh or cry.

Now, let’s take a look what would have to happen for the price/income ratio to merely get back to 5, which Demographia still sees as the borderline between “seriously unaffordable” and “severely unaffordable”. This would require a 44% price decline. Think that can’t happen? Look at the USA, Japan, Ireland, Spain, and countless other examples throughout financial history.

But let’s assume again that Australia is part of a different galaxy where it is impossible for prices to fall, and that we somehow manage to engineer a “soft landing”. If we again assume that incomes continue to grow at 4%, housing prices would have to stay flat (ie ZERO capital gains) for 13 years in order to get back to this level of (un)affordability.

Still think it’s a better decision to buy than rent? Let’s explore that one next time. 
In the meantime…
It’s the end of the world as we know it, and I feel fine…


  1. Welcome back to Oz, the land of denial and kangeroos !!

    How was the A380 ?? Haven't been on one yet.

  2. I'm not quite back yet, and a cheaper Aussie dollar would help me out a lot at this point!
    The A380 is great -- very smooth ride and a bit more space than usual in the cabin.