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Bubble or boom

September 25th, 2003

My column in today’s Fin (Subscription required) is about the (putative) bubble in housing prices. After noting that virtually all economists think there is a bubble I observe

There is a paradox here. In a country with a longstanding suspicion of market forces, economists have normally been among the few defenders of the market. Even relative sceptics put more weight than the average Australian on seeking rational economic explanations of market outcomes. Yet in the case of the housing boom, ordinary Australians have shown a faith in the market that would put the most devout Chicago economist to shame….

A bad end to the current boom would mark the failure of the separation between monetary policy and prudential regulation introduced following the report of the Wallis Committee. The whole program of financial deregulation would be called into question.

The implications would be even more striking if the current putative bubble turned out to reflect a sustainable increase in underlying values. If the doubling of house prices over a few years is not a bubble, then it is clearly impossible for economists to recognise one when it is in progress. It would be hard to imagine a more triumphant vindication of the efficient markets hypothesis than this.

If anyone has a plausible story as to how the rise in asset prices is sustainable, I’m eager to hear it. Sustainable in this context means that the value of the flow of services from housing should equal the rental cost implied by current prices and reasonable real interest rates.

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  1. Observa
    September 27th, 2003 at 09:49 | #1

    Try this very poignant overview of property prices at http://www.russell.com/au/Institutional_Investors/Russell_Library/Investment_Articles_and_Updates/Russell_Perspectives_Dec_2002_Property.pdf

    It has a 10 year overview of property prices as well as comparisons with other investment forms. With property price to yield ratio at its highest level ever(and 35% above the average) the only conclusion you can draw is bust unless the ROW want to keep the game of musical chairs alive.

  2. PK
    September 30th, 2003 at 16:09 | #2

    Sorry Uncle Milton, but that is an incorrect comparison.

    A listed company has two main options with any profit: return a dividend, or reinvest in the company. Thus a listed company can be generating a quite generous yield, but return no dividend. Investors should hopefully realise that yield in future capital gains.

    I don’t think yields in Sydney rental properties are so low because landlords are reinvesting the vast majority of their profits back into their existing properties.

  3. September 25th, 2003 at 17:54 | #3

    Great column John.

  4. Uncle Milton
    September 25th, 2003 at 18:49 | #4

    *If anyone has a plausible story as to how the rise in asset prices is sustainable, I’m eager to hear it.*

    OK, how about this. Interest rates have halved and house prices have doubled. Isn’t this what you’d expect to happen to an asset price? (If bond rates are halved, then the price of bonds doubles almost by definition.) It’s true that borrowing cost for housing isn’t the same thing as the rate of return on the investment, but they should move closely together.

  5. September 26th, 2003 at 00:51 | #5

    It is interesting that the elite/mass disconnect was very evident during the last years of the Clinton Empire. In those faroff days, the masses:
    – enagaged in day trading, despite bubbling finance markets
    – ignored Clinton’s on the job dalliances, despites a manafactured politcal crisis
    The elites meanwhile, tut-tutted these goings on, with:
    – Greenspan calling the boom “irrational exuberance”
    – Republicans denouncing Clinton as a serial philandering draft dodger.
    It seems that the masses have a mind of their own.

  6. September 26th, 2003 at 02:56 | #6

    Uncle Milton is correct.
    Real Interest rates were close to 10% as late as the mid nineties.
    They are now closer to 5%.
    SO you can double your mortgage and still be up for the same cost in interest servicing.
    Further, the capital gains tax rate has been halved, from ~ 50% to 25%, and this applies to sales of residential investment properties. This automaticly increases the realised real capital gains from these sales by around 50%.
    So the basic cash flow of property investment has been massively improved over the nineties:
    interest costs have been halved
    capital revenue has been increased by 50%
    The annual rental rate should be the same as the annual real interest rate ~ 5%. But the rental income return on investment for rental properties has slumped, from about 5% to 2%.
    This would indicate that the prices have overshot the fair value of property, even given low interest rates.
    Property prices have slumped before, most notably after the eighties boom.
    A reduction in employment or increase in interest rates would take the air out of inflated asset markets.

  7. Homer Paxton
    September 26th, 2003 at 10:32 | #7

    here in Sydney if one buys a house or unit one is not investing because the nominal yield is 1.8% so taking out expenses it is possibly 1% or lower.
    Thus people in Sydney are engaged in speculation not investment in other words pass the parcel.

    I would call that a bubble.

  8. observa
    September 26th, 2003 at 10:56 | #8

    I pointed out previously, the classical analogy of real estate prices with the price of bonds and interest rates. Now what if you were an international RE investor with some US dollars sloshing around 12-18 months ago? You would have looked at Oz with its relatively high interest rates and low dollar and decided an investment in Oz RE was a one way bet. Q:How much OS money is in Oz RE now? Also increasingly sophisticated computer analysis programmes may have deduced that Oz RE was relatively low compared to ROW prices. Q:Could they analyse median RE prices in major centres around the world in terms of Big Mac prices? Did some of these types of analyses come up with further evidence of a one way bet? As a world investor you may also see Sydney RE as a safer haven than Djakarta or NY. I notice AFL GF tickets are selling at $1000 with lots of demand and limited supply. Some small recompense to Port supporters from Collingwood supporters I would suggest.

  9. September 26th, 2003 at 11:19 | #9

    yes, good sound common sense from Homer.
    Splendid work sir!

  10. Uncle Milton
    September 26th, 2003 at 11:57 | #10

    Homer, the fact that rental yields are close to zero proves nothing. Some companies, like News Ltd, pay no dividends, and investors get their returns through capital gains. That doesn’t make it pass the parcel for them. The same could go for property investors.

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