The Ponzi in practice
In 2002, Andrew Oswald, a Professor of Economics specialising in housing markets at Warwick University, predicted a great housing crash would spread outwards from London across Britain, and advised all Britons to sell their homes:
“We are about to go through the great housing crash of 2003-2005. This crash will feel worse, in my opinion, than the one at the end of the 1980s. I advise you to sell your house, and move into rented accommodation. I am serious. In late Spring of 2003, it will begin to be recognised that house prices have stopped rising. People will cease being such enthusiastic purchasers. Those who rushed into buy-to-let properties will begin to sell them. House prices will crumble, just a little. Then by late summer of 2003, confidence in housing will go. Prices will crumble more. At that point, newspapers will take up the cause. Headlines will appear: house prices fell 8% last year.”
Roll forward to 2003 and, quoted in national newspaper articles, Oswald continued:
“‘It’s only when these figures come in next week that we’ll be able to see clearly how badly house prices are really falling in London.’ The key indicator of the stability of the housing market, Prof Oswald claims, is a person’s earnings compared with the price of their property, which should be a ratio of 1:4.‘Average earnings are £25,000, so the property value should be £100,000, but we are far above that ratio now – just as we were at the end of the Eighties,’ he said. ‘The whole of modern history tells us the prices are bound to fall. It will start with a wave that engulfs London then ripples across the country. Nowhere will escape.”
Stating that something is “bound” to happen, rather than it may occur or could eventuate, is certainly to take a bold position.
In the event, prices continue to roar upwards to unprecedented levels for more than half a decade before finally peaking in most parts of Britain in 2008.
London housing 1998-2014
Here’s how the issue played out in London:
A dozen years on we are still seeing articles about a “Tokyo style housing crash” and the average London house price has long since passed £500,000.
Even today, London house price to income ratios remain off the charts and a long, long way from four times incomes, with Knight Frank reporting today that London prices have increased by 68% in the last 5 years alone.
The point of all this is merely to note that whether you are discussing housing markets, share markets or indeed any markets, predictions are devilishly “difficult to make, especially about the future”.And further, what represents sound advice for one person may be poor advice for another, which is why, for example, stock buy recommendations should always come with lengthy disclaimers attached.
And remember, Oswald is no random blogger, he was and is a Professor of Economics who specialises in housing markets at one of the very highest ranking British Universities.
[sam id=43 codes=’true’] It’s perhaps worth noting quickly here, that property markets are necessarily granular. In a diverse country such as Australia, what is happening in Perth or Port Hedland may not be in any way reflective of what is happening in Palmerston or Pyrmont.
Even within cities, some suburbs and regions can remain relatively affordable as compared to incomes, while others can be wildly unaffordable on any metric you care to mention.
For this reason, national measures of averages dwelling prices to average disposable income, while useful indicators up to a point, are necessarily limited in their ability to assess affordability for individual households.
In Australia too, of course, academics have for many years predicted a crash based upon Irving Fisher’s theory of debt deflation.
The basic premise was simple enough, often described with emotive or sometimes even vitriolic language thrown in for good measure: dwelling prices would stagnate then rapidly fall as assets are unloaded en masse onto the market.
With demand falling in the housing sector – coupled with an inevitable increase in unemployment – a vicious deflationary spiral would occur and economy activity would grind to a halt.
The academics dismissed out of hand any argument that higher prices are in any way explained or justified by lower interest rates by stating that the 1960s should have prompted an even greater household debt ratio as rates were the lowest on record throughout that decade.Now, from what I’ve read, the 1960s was an interesting decade. I always head to Homebush when Townshend, Daltrey or Jagger visit Sydney.
The moon landings were also pretty cool. And I’m as avid a reader of academic theory as the next dude.But when the boffins start drawing analogies between today’s debt markets/lending standards and those of more than half a century hence (or worse, household debt ratios drawn from the 1861 Census) then it’s probably a good time to pull up the ladder and watch the footie instead.
The work of Hyman Minsky was cited by the academics years ago as proof of a coming property market crash in Australia, noting that bubbles occur when markets reach a stage of Ponzi finance: income flows cover neither principal nor interest charges, and owners become completely reliant on escalating sale prices (capital gains) to make a profit and meet the cost of the debt.
Anyway, the point of this post is not yet another tedious “will there/won’t there be a housing crash?” discussion.
Lord knows that particular debate has well and truly been done to death in both London and Sydney over the past decade.
Instead, today I’d just like to shed a little more light on the nature of the “Ponzi finance” in this era of low interest rates, and particularly, in Australia’s prevailing tax environment. In other words, what might the numbers relating to property investments actually look like in practice?
While the cost of capital remains so low, property investors for whom cashflow is a significant concern may easily source property investments which do not entail significant holding costs.
Take the below scenario of an off-the-plan property in Sydney around 11km from the CBD, bought by a middle-income earner, which gives rise to decent depreciation or on-paper losses.
Generally, rental yields have slipped markedly in Sydney over the last couple of years as dwelling prices have increased.
Significantly higher gross yields than this can be found in western or outer Sydney suburbs (or regional centres) for those who demand stronger cashflows, but let’s use the example of a new apartment which generates a moderate 4.5% yield.
I note in passing that much of this new stock demands a material “newness premium”. I’m trying to be polite here – what I really mean is, it’s way over-priced.
And therefore a capital growth rate of 4% could well be overtly optimistic
It’s been possible lately to fix mortgage rates at least 50bps lower than this, but let’s suppose a 20% deposit, a 5.00% mortgage rate and a flexible interest only loan, for the sake of argument.
Naturally, you can argue from now until the cows come home about whether wages and rents will grow and at what pace, whether inflation will hit the implied 2.50% target, whether property prices will stall or fall…or whatever.
And, of course, markets are at last pricing in rate hikes by Q2, 2015!These variables are all arguments for another day.
What I’m considering here is the possible cash flows of a property bought and financed in such a manner today:
…or not neutrally geared?
This is where the point on market granularity comes in.
Wealthier investors or high income earners may buy dwellings in the premium sector and incur significant cash outflows, being able to afford to soak up cash flow losses. Others are motivated simply by the lure of paying less income tax.
Let’s say a higher rate taxpayer buys an established $1 million apartment with painfully high strata fees by using only a 10% deposit, attaining relatively weaker depreciation and on-paper deductions, and achieving a dismal gross yield of under 4% .
Note that we’ve again stripped out the 1.5% Medicare Levy here, and in this scenario the buyer would likely be zinged for Lenders Mortgage Insurance (due to the use of a low deposit) in addition to around $55,000 in stamp duty and land transfer fees, and other acquisition costs such as legal or conveyancing fees.
This investor is sitting squarely in what the academics would classify as the “Ponzi finance” category.
Cashflows will likely be relatively poor for years to come and therefore some capital gains are required in order for this investor (speculator, whatever) to achieve a positive internal rate of return (IRR).
The concept of a market supported solely by Ponzi finance is fundamentally flawed in the current environment since it incorrectly assumes that every investor in Australia bought their property today (and airily ignores the role of homeowners in the housing market).
Many of us Generation X’ers, for example, own investment properties bought back in the 1990s for which the cashflows are so far in the black – more than double or even triple the mortgage repayments – that it’s hard to envisage any reason for ever selling the income-producing asset.
Rental incomes from well-located properties tend to increase over time so any rational investor who bought a few years ago would perhaps be unlikely to be suffering negative cashflows in the current environment.
It’s erroneous in the same way that some people argue that shares have been “a poor investment” by casually electing to ignore the ongoing tax-advantaged dividend flows and working on the unsound presumption that investors bought their entire portfolio precisely on the day of the 2007 stock market peak (exteremely unlikely).
By the same token, housing affordability arguments which argue that where first homebuyers can’t afford to buy a median-priced house in Sydney, then prices across the board must inevitably and immediately return to a certain pre-determined price/income ratio, may also be misguided.
Whether you desire that outcome to occur or not, this overlooks a huge number of variables such as the role of inheritances, mortgage rates, the large portion of housing stock which is owned unencumbered, the substantial role of equity, that investors can afford to hold property based upon rental incomes, and all manner of market distortions such as the prevailing tax regime and much more besides.
If you were to take the debt deflation theory to its illogical conclusion then nobody would ever buy a dwelling since they would always expect them to be cheaper in the future. Prices would fall to zero.
However, property markets are relatively illiquid and are not so straightforward.
Homeowners account for most of the housing stock and are not always inclined to sell in a downturn, even when instructed to do so by the talking heads in the press (2002, 2008…).
And if I had ten bucks for every time I’d heard someone say: “I’m going to wait and buy a property when prices fall by 10%” then I’d surely soon have enough moolah to give Gina Rinehart a call and fund the entire Roy Hill project.
In any event, the understanding of debt deflation has been around for so many decades now that governments and Central Banks are painfully aware of the potentially destructive effect of shrinking credit markets. Market interventions, while not always effective, are at least likely.
While moderate corrections in housing markets are periodically welcomed, a long, drawn out decline in house prices is considered to be poisonous to economies, and corrective action will be invoked.
Long, drawn out falls in dwelling prices also have a habit of killing off housing supply as we saw in Sydney from 2004.
And while academics sometimes argue that housing supply is irrelevant, I doubt you’d find anyone in the real world who would agree with that (how else would one explain the price of a detached dwelling in Hong Kong if supply is unimportant?).
I strongly agree on one point though, that being the fundamental importance of debt markets in the house price equation.
If there ever is to be a sharp property crash in Australia, it is as likely, in my opinion, to be caused by a short-circuit in the credit markets as anything else.
As noted at the beginning of the post, predictions about the near-term future are almost impossible to make.
Yet a salient reason that most people continue to be poor or average investors in all asset classes is that they spend far too much time concerning themselves with what might happen in the next 30 days and not nearly enough considering where we might be in 30 years.
Nothing is a sure bet in life, but I’d take a wildcard punt that housing affordability will still be a barbecue topic when I’m 65 as it was when I was 25.
Hopefully, all Aussies will be vegetarian by then too so I might be offered something to eat, though I’m not holding my breath on that one.