The great delevering begins?

The great delivering begins?

Plenty of financial commentators were on hand to forecast a "housing bust" after the last great property boom in Australia. They were wrong and have incorrectly continued to make those predictions for years now.

But while there has been no major crash in capital city house prices, the aggregate weakness of the current property market upturn to date may represent compelling evidence that Australians could be slowly beginning to delever and are once again saving more.

Household Saving Ratio graph

Ultimately when dwelling prices-to-income ratios become high there are only really three ways in which affordability can improve without assistance from cheap borrowing rates.

Firstly there can be a major real estate market crash, as was seen in countries such as Ireland. Major crashes are often preceded by irrational market speculation until the market turns and a crash is triggered.

Secondly, there could be a mini-crash which is followed by weak markets and a slow recovery. This happened in parts of England situated away from London around half a decade ago, and prices are yet to fully recover in many regions such as in the north-east of the country.

And thirdly, prices can flatline or continue to rise but only in a weak fashion and slower than the rate of household income growth. There is a good argument to say that this is what has been playing out in Australia’s major capital cities, although, as is its way, Darwin has the potential to be an outlier.

Phase 1 – leveraging up (1993-2005)

Between 1993 and 2005, as interest rates fell and lending standards were deregulated, households geared up like never before. As noted recently by Luci Ellis of the RBA, household debt levels have broadly plateaued since 2005.

Household Finances graph

Phase 2 – slow melt begins? (2006-2009)

While prices in some areas remained strong, on a nationwide basis Australians stopped gearing up and price-to-income ratios eased a little.

Phase 3 – financial crisis and intervention (2009-2010)

As the subprime crisis took hold in the US and Lehman Brothers collapsed, a number of global real estate markets fell into turmoil. Australia avoided this, in part through intervention, as low interest rates stimulated the markets and other manipulative tools such as First Home Owners Grants were implemented. Prices jumped across Australia in a short but quite powerful mini-cycle.

Phase 4 – slow delevering continues? (2011-)

Property prices fell on a nationwide basis by around 7-8% through 2011 and the first part of 2012. But interest rates have been dropped to record lows and a property market recovery is well underway over a period of more than 12 months now, which is clearly evident in the increase in housing loan approvals.

Housing Loan Approvals graph

However, price gains to date have been significantly weaker than has been seen in previous cycles, which reflects the higher levels of household debt Australians are now carrying, and thus prices may fall in real terms over time.

The future downside of property markets (for example, when recessions hit, unemployment increases or when interest rates move higher) will likely be protected by the use of loose monetary policy where appropriate and perhaps the relaxing of foreign investor rules, although this will favour certain capital city markets disproportionately. Booming population growth in some cities will also underpin these same markets to some extent.

New trends

One of the trends which has been playing out globally is the increased impact of property investors on major real estate markets. Certainly in Australia, over the past two decades the level of investment mortgage debt has increased more than double the rate than that of the growth of mortgage debt for principal places of residence.

The proliferation of investors in part explains the strength of the Sydney and Melbourne markets in recent years.

The Brisbane and Adelaide markets have been significantly weaker over the past 5 years, and may be representative of the gradual delevering. Brisbane has very strong population growth which should keep the market buoyant enough. Notes the ABS:

"Between 2011 and 2012, the population of Greater Brisbane increased by 2.0% (43,300 people), which was the second fastest growth rate of the capital cities, behind Greater Perth (3.6%)."

Some commentators have been tipping Adelaide to outperform for the last 5 years, but it has not happened as the chart below shows. While the short-term is inherently uncertain, over the long run I believe Adelaide will be a weaker city market than, say, Sydney, due to Adelaide's weaker long-term population growth and dwelling supply meeting demand. Notes the ABS:

"At 30 June 2011, the estimated resident population of South Australia was 1.64 million people, which represented 7.3% of the total Australian population. In the ten years to June 2011, the state's population increased by 126,500 people, or 8.4%. This was the slowest growth of all states and territories, equal with Tasmania."

Dwelling Prices graph

The current property cycle continues, with all capital cities showing price gains, but Adelaide has been the worst performer of all the capital cities over the past 12 months. Prices in Adelaide remain all but flat in spite of record low interest rates. In contrast, Sydney has shown price gains of more than 8% and Perth more than 9% in this cycle, and Sydney's price gains look likely to continue. 

In summary, if you are expecting to benefit from households gearing up on mortgage debt ahead of the rate of income growth you are likely to be disappointed, because the great leveraging up took place years ago.

You may, however, move ahead, if you can anticipate the property markets and dwelling types which will be favoured by investors as well as homebuyers in the future. Broadly speaking, established medium-density dwellings and well-located houses in supply-constrained suburbs of the four major capital cities will likely be the best bet. 

These markets will be better protected in downturns too as as foreign investment rules are relaxed, with investors surging back to these markets each time a property market recovery is demonstrably underway.

Some say that promoting investing in suburbs close to the capital city centres is old-fashioned advice. Far from it - if you want to outperform the market in the future you need to be in the markets which will attract flows of domestic and international investment capital, because this may be one of the greatest drivers of future property price growth.

Why would price growth be stronger in remote regional centres, fringe/outer suburbs or small cities when the great leveraging up began two decades ago and finished in 2005? (it won't).

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