Vivek's blog: I do not understand Australian real estate one bit

Monday, July 27, 2009

I do not understand Australian real estate one bit

OK, so Australia might well avoid a recession. Huzzah!

I have to admit, though, that I'm still completely perplexed by Australian housing prices. After they experienced a slight dip in urban centers, apparently they've bounced back up.

This is great news for the millions of Australians who have invested in property. It's fabulous for people looking to sell out of the market. It's bad news for people who aren't in the market but want to be. And, although it's perceived as good news for those who own a house they live in, it's actually neutral news for them. (Why do you care how much your house is worth, unless you're selling it? And if you're selling it to buy another house, a rising market will mean that you're no better off.)

Now here's what I don't get. Housing in Australia is ludicrously expensive. I've heard several theories as to why this is. Most focus on 'supply and demand' (there's a shortage of housing in Australia, so there's upward pressure on prices) or Australia's high degree of urbanization (the more urbanized a country, the higher its average dwelling prices).

The supply-demand argument seems flawed. As with any asset, future events should be priced into current value. Therefore, if we know that the population of Australia is rising and that there's a housing shortage, that shortage should be factored into today's prices.

There should be no sustained upward pressure on prices, except if there are unforeseen circumstances that affect supply and demand (such as a massive influx of immigration). Without this exceptional circumstances, the appreciation in real terms of an asset such as property should correspond directly with the risk that that asset will fall in price. Riskier assets will command higher growth rates, all else being equal.

We are consistently told that property in Australia is one of the safest asset classes around, and that house prices 'double every 7 to 10 years'. This simply cannot be true. Guaranteed assets do not outperform inflation. If prices do double every 10 years (a 7% compound annual growth rate), then there is a high likelihood of that price falling. We are told that 'pent-up demand' has created a floor for house prices in Australia, so prices cannot fall dramatically or for a long period. Now I have to believe several things that just don't add up: house prices almost always go up, they'll never fall much or for long, and they will outperform inflation.

This smells extremely fishy. It stinks of market intervention. Clearly, the Australian government has a vested interest (votes) in propping up house prices. That's why it's giving cash handouts to first-time homebuyers. (Of course, the cash simply makes its way to the sellers.) The Reserve Bank of Australia, fearing recession, has supplemented the cash stimulus by lowering interest rates to the floor. Property prices have benefitted from this double whammy: a government subsidy and cheap finance. (If you're American or British, this should sound hauntingly familiar...and terrifying.)

Of course, I'm not a professional economist. The Australian property market has been skyrocketing this entire millennium with barely a pause. I just don't understand the fundamentals behind it or how it's sustainable.

Although I'm tempted to call 'bubble,' I'm not going to do anything drastic (like short real estate). I know that the market can stay irrational longer than I can stay solvent. And I'm not pretending to be prescient.

I just don't get it. Can anyone explain?