When did property become an asset for speculating with? Property rising 5-10% year, after year, after year, is NOT normal. This attracts speculators and when this happens, you have to start asking some questions? The number one question being, “is it a bubble?”
In 2007/2008, America had a sub-prime lending bubble. This has been well publicised. After a sharp increase in home prices, which lead to a flood of new inventory (all based on loose credit), peaked in early 2006 and began to decline in 2006/2007. Prices finally bottomed out in 2012.
During the same time period, Ireland also suffered through a real estate bubble. Home prices nearly doubled from 2001 to 2006, in the middle of a period that has been known as the “Celtic Tiger” (Celtic Tiger actually ran from 1990’s to 2007). The correction was epitomised by “ghost estates”. (“Ghost estates” refer to housing estates/blocks that were built in rural areas, with little infrastructure in place. These estates were eventually abandoned during the crisis in 2008, many unfinished and unsold, leading to the term “ghost” estates.)
The Spanish property bubble was similar to the Irish bubble and occurred around the same time.
I believe the Australian property market is in a bubble that could possibly be greater than any of the previous three mentioned.
Throughout the following blog I will show you why I believe that there is an inflated house market and give some thoughts on the possible catalysts that could cause a reset in property prices.
The common term here is “bubble”. So firstly let’s have a look at the definition of what a bubble actually is.
Fig. 1 Bubble
The chart above is a well-known image that depicts the common cycle of manias that have occurred throughout the ages, time and time again. This chart depicts the cycle of all the major previous bubbles.
- The Tulip mania bubble of 1634-1637
- South Sea Bubble of 1719-1721
- Wall Street Crash of 1929 leading to the Depression in the 1930’s.
- Japanese economic bubble 1991 (real estate and stock market).
- Dot-com bubble 1994-2002. Collapse of technology bubble.
- Financial Crisis of 2006-2009
- US/Irish/Spanish Property bubbles of 2006-2009
As we can see from the “bubble” chart, emotion plays a major part in all manias. Enthusiasm, delusion, greed, denial, fear and despair are the emotions that people go through in the cycle. This pattern has repeated time over time and not only in severe manias. This can be the model for many commodity cycles, stock cycles and even currency cycles!
Regarding the Australian “bubble” I believe we are somewhere in the greed/delusion phase.
So why do I believe Australia has a property bubble? Let’s have a look at some of the facts.
After the global financial crisis (GFC) in 2007/2008 and the eventual implementation of quantitative easing (QE), interest rates were pushed down throughout the world to extremely low levels. As many countries eventually had their economies begin to expand again, central banks opted to keep these interest rates at low levels.
Low interest rates fostered an appetite for risk and alternative investment. People began to seek yield. Much of this investment was through property. What other investment was as “safe” and offered such a good return? (Unless you were living in USA, Ireland or Spain!)
This led to investors accounting for 32% of total mortgage lending in Australia. This is even higher than in Ireland during their 2007/2008 crisis. In Ireland, 27% of mortgage lending was by investors! The majority of these “investments” in Ireland were cash flow negative as rents did not cover mortgage costs. The Irish were banking on capital appreciation. Property prices always go up, right?
In Australia negative cash flow from investment properties is known as “negative gearing”. This is where investors use an investment loss to offset the other income they earn, allowing them to pay less tax. The assumption on this type of investment is that the price of property always rises and in the interim they can benefit from a lower tax bill. This encourages investors to buy property even when the figures do not add up! This sounds a little familiar.
Most home loans are ‘principal and interest’ loans, which means the repayments reduce the principal (amount borrowed) and cover the interest for the period. With an interest-only loan, you are only paying the interest on the amount you have borrowed.
After a set time the mortgage resets and you then have to pay the principle (the amount you actually borrowed) back along with the interest! This means that some people will see a significant jump in their mortgage payments when the loans reset.
In Australia 2017, 35% of new loans had been interest only (IO).
At the end of this initial period, many of these mortgages will see payments due, rise 30-60%. A large number of these mortgages will reset in 2019.
In October 2017, UBS conducted a study which found that 33% of borrowers with IO loans may not even know they have them (fig. 2)!!
Fig.2 Source: http://www.afr.com/business/banking-and-finance/financial-services/one-in-3-interestonly-borrowers-dont-understand-their-loans-ubs-20171004-gyu2qh
When these loans reset it will obviously lead to a squeeze on consumer credit/consumer spending. The majority of these households may need to reduce spending drastically and possibly be forced to sell property.
If sub-prime was the main instigator of the property bubble in the USA in 2006-2008, interest only loans could be the ticking time-bomb that causes the Australian property bubble to implode. In the USA “teaser rates” were offered to lure in less than credit worthy clients. This was well publicised in the book/movie, “The Big Short.”
“Officially”APRA (AUSTRALIAN PRUDENTIAL REGULATION AUTHORITY) have asked that interest only loans are now limited to 30% of new residential mortgage loans. Banks are expected to “place strict internal limits on the volume the IO lending at LVR above 80%” and “ensure there is strong scrutiny and justification of any instances of interest-only lending at an LVR above 90 per cent.”
The big banks are reducing the amount of IO loans they put on their “books.” They have reduced this from 45% of new loans to 17% of new loans as you can read here – http://www.abc.net.au/news/2017-12-05/interest-only-lending-plunges-apra-crackdown-bank-rate-rises/9227906. However the fact remains that the original loans still exist and must be paid when the rates reset.
According to Brian Hartzer, Westpac CEO, 50% of the mortgage loans at Westpac (one of the big four banks) are interest only loans.
“Westpac chief executive Brian Hartzer has told MPs that about 50 per cent of the lender’s mortgages are still interest-only.”
“Half the home loans on Westpac’s mortgage book are interest-only but chief executive Brian Hartzer says that isn’t a problem.
Prudential regulator APRA told the major banks six months ago to limit higher risk interest-only loans to 30 per cent of new residential mortgages.
Mr Hartzer confirmed to MPs on Wednesday that Westpac will meet the requirement but said the lender remained comfortable with a much higher overall rate with older loans included.”
(Source : https://www.sbs.com.au/news/half-of-westpac-mortgages-still-interest-only)
Yes. That was 50%. Not a typo! I will let you decide if this could be a potential problem or not!
To begin understanding the Australian household financial situation let us look at a few charts. Numbers do not lie.
Fig.3 Source: www.tradingecomonics.com
From fig.3 we can see that the average Australian saving ratio has fallen dramatically in the past 5 years. It would be much better to see households with a constant or increasing savings ratio. Ireland showed a very similar trend from 2005-2007 where the saving ratio fell from 11 to 4.
From fig.4 we also know that wage growth has not been increasing during this time. In fact, from the following chart we know that wage growth has been slowing during the same period.
Fig.4 Source: www.tradingecomonics.com
So knowing these facts we can see that Australians wage growth and saving rate is slowing. This should hopefully mean that Australians are not increasing their debt but actually reducing it. Not quite!
In fig.5 we can see that the Australian household-debt-to-GDP ratio of 123%. This is currently the third highest in the world!
Fig.5 Source: www.tradingecomonics.com
Fig.6 Source: https://www.rba.gov.au
Fig.7 Source: https://www.rba.gov.au
From fig. 6 and fig. 7 we can determine that household debt has increased significantly along with house prices. The price to income ratio is the basic affordability measure for housing in a given country. It is generally the ratio of median house prices to median familial disposable income. The home price to income ratio is greater than 5, the highest level in recent history.
Fig.8 Source: https://www.rba.gov.au
Fig. 8 shows that disposable income growth has been falling since 2008/2009 and as we have seen, it is not because people are saving more, as this rate has also been falling since 2008/2009.
Fig.9 Source: https://www.rba.gov.au
From fig. 9 we can see that approximately 50% of mortgage holders have only sufficient savings to pay the mortgage for up to 6 months! A whopping 33% have only enough savings to pay one month’s mortgage payment!
All these charts provide the evidence that Australians are saving less and have less disposable income. While at the same time, are carrying very large amounts of household debt. This cannot be a good combination. What will happen when all these IO loans reset? A lot of households will be under extreme financial stress! What will happen if the RBA begin to raise interest rates? This allows the banks to increase their mortgage rates. This could put some households under extreme stress!
We have basically showed that home prices in Australia, wage growth, income and household debt are out of sync. They have diverged to a dangerous level and at some point in the near future I believe that there will be a correction.
So what could be the catalyst that starts the correction or signal the peak of the bubble?
Recently there has been talk in Australia that the government may change the rules regarding negative gearing or even abolish it entirely. Negative gearing now produces annual losses in the $4-8B range! I’m sure the Australian government would love to get their hands on this every year! This could provide a large catalyst for some investors (probably baby boomers) to sell cash negative investments as they would no longer be sensible investments. The problem comes when the supply of property may not meet as much demand from over indebted 35-54 year olds. Millennial sentiment has changed and they seem less interested in large mortgage debt burdens to go with their large university debt!
So already we could have a slight supply demand issue.
A common bullish argument for the increase in property demand is due to the massive increase of immigrants. However, the population is not growing at a crazy rate, contrary to popular opinion. In fact the population growth rate has been falling since 2009 as we can see from fig.10!! Not many would have guessed that! It did rise dramatically from 2004 to 2009 and this can explained by the many European immigrants that flocked here during the global financial crisis (GFC), escaping the economic problems in Europe.
Maybe the current expected demand from immigrants will not be as much as expected. Spain’s population growth peaked in 2007 – just before their bubble popped so population growth cannot be used as a strong reason for increasing demand.
Fig. 10 https://www.rba.gov.au
At the time of writing Sydney has approximately 350 residential cranes in operation. For comparison the entire United States of America (where the economy is doing well) has a total of 175 residential cranes in operation!! Sydney has a population of 5.37m. America has a population of 327m!
Melbourne has a population of 4.82m and it has 150 residential cranes in operation. Nearly the entire amount in the USA!! (Source: Hedgeye Risk Management LLC c/o www.macrovoices.com)
Examining Australia’s population growth rates, I don’ think the demand will outstrip supply for much longer and these cranes will be forced to pack up.
As we have mentioned the GFC, we should mention why Australia avoided recession and has managed to avoid one for 26 years. China.
China is Australia’s main source for GDP and during the GFC China enabled an economic stimulus package that helped the global economy exit recession benefiting Australia along the way.
The top export destinations of Australia are China ($55.1B), Japan ($18.9B), South Korea ($11.2B), the United States ($8.26B) and the United Kingdom ($7.41B). Iron ore and Coal contribute to 40% of Australia’s GDP.
Fig. 11 Source: https://atlas.media.mit.edu/en/profile/country/aus/
Fig. 12 Source: https://atlas.media.mit.edu/en/profile/country/aus/
Critics of China’s stimulus package have blamed it for causing a surge in Chinese debt since 2009. Any interruption to the Chinese juggernaut will be trouble for the Australian economy. China imports 35% of Australian exports! This is a significant exposure to the Chinese economy and Chinese sentiment. Any slowdown in global (therefore China) growth, similar to the Global Financial Crisis (GFC) in 2008, will have a big drag on Australian growth. If China decide to purchase the majority of their iron ore from Brazil as recently cited, this could mean trouble for the Australian economy.
We also know that the Chinese are large investors in the Australian property market.
“Total Chinese property investment in Australia rose from around A$1 billion (US$752 million) in 2008/9 to almost A$32 billion (US$24.1 billion) in 2015/16.”
Source: http://www.atimes.com/article/china-still-loves-australian-property/
“Chinese companies bought 38 per cent of all the residential property development sites sold in Australia last year, spending $2.4 billion, according to a Knight Frank report this year.”
Source : http://www.smh.com.au/business/new-investment-rules-to-curb-chinas-foreign-acquisition-binge-20170820-gy033p.html
However, China are beginning to impose stricter capital outflows as they believe companies investing overseas in real estate could be harming China’s financial stability.
The State Council said China will instead encourage companies to invest in projects that contribute infrastructure such as, the “One Belt, One Road” Initiative, which is seeking to build new rail and shipping links for trade.
Chinese outbound investment fell 44% in the first seven months of 2017 as the Chinese government began cracking down on capital flight, and criticised Chinese companies for buying trophy assets such as European football clubs, iconic hotels such as Club Med, and Hollywood studios.
This will also possibly have a negative effect on the demand side.
Fig. 13 http://www.scmp.com/news/china/economy/article/2126252/china-puts-us1500-daily-personal-cap-overseas-bank-card
On the 1st January 2018 China announced a new limit that people can withdraw from their Chinese bank accounts while overseas as you can see in fig. 13. Individuals will be allowed to withdraw a maximum of 100000 yuan (US$15,000) per year. This will have negative effect on the number of Chinese buyers looking for property in Australia.
And that negative effect may already be playing out. All these previous capital controls have already prevented Chinese investors making settlement on their Australian investments as we can see from this article: https://www.reuters.com/article/us-australia-property-china/chinese-capital-controls-send-tremor-through-australian-property-idUSKBN1E136S
Any other problem that China encounters will end up being a bigger problem for Australia.
According to many well-known fund managers, China faces extremely high debt, may possibly have to recapitalise their banks (possibly up to $3.5T) therefore printing RMB (devaluing) and obviously de-pegging from the USD. Just listen to Kyle Bass break it down here
https://www.youtube.com/watch?v=Mvwu6x7W0gM
Kyle Bass and all these other hedge fund managers are incredibly intelligent people. If they believe that China is in this kind of trouble and they are willing to risk a huge amount of their net worth on this trade, I would take this risk very seriously. This could end up being the largest threat to Australia’s recession free run of the past 23 years.
Out of all OECD nations, Australia is the most dependent on China by a huge margin, according to the IMF. Over one-third of all merchandise exports from Australia go to China including all physical products and natural resources.
Any interruption to this would be significant to Australian employment. The downstream effect would mean less employment opportunities, layoffs in many industries related to mining, industrial, services and so on. Obviously this would have a large negative effect on housing demand and mortgage repayments.
All this could lead to a negative feedback loop.
A drop in house prices -> less consumer spending -> less employment -> more mortgage defaults -> increased supply on the market -> drop in house prices……….. and repeat!
It is also worth noting that Australian GDP from construction is $32B. For comparison GDP from mining is $25.7B and GDP from manufacturing is $25.4B.
All of these examples of potential problems for the property market just provide a glimpse of some of the catalysts that could cause the Australian “bubble” to pop. Some of these may not materialise, but as a trader there is enough catalysts present for me to consider a trade.
If we examine Australian building approvals (permits) we can find the current appetite for building through property developers and the public.
Fig. 14 http://abs.gov.au
It is a great way to help us anticipate any change of trends in the market. This is commonly known as a leading indicator. As we can see from fig.14 the percentage of building approvals seems to have peaked around 2015-2016. From past experiences, building approvals indicators tend to lead the current market by many months, sometimes years. Housing starts also peaked in 2015 at 116,000 and are at around 96,000 today.
Auction clearance rates have been falling in Sydney, Melbourne and Brisbane from the end of 2016. (Homes can be sold by auction in Australia unlike other parts of the world where only properties under distress go to auction.)
This confirms that the demand for properties could have peaked and it could be time to place a starter position and profit from the property downturn.
In a later blog I will provide some ideas of how to profit from this thesis.
Note: Jonathan Tepper (twitter handle: @jtepper2) the founder of Variant Perception has been very public with his opinion on the Australian housing market and some of his interviews are fascinating. I strongly suggest you seek them out and listen to at least one of them. Jonathan successfully predicted the US, Irish and Spanish housing bubbles. He has also suggested in one of his interviews that the $AUD could fall to as low as 40c (versus $USD).*
Don’t Buy Now (twitter handle: @PopTheOzBubble) is another great source for people to find articles regarding Australian property madness.
DHCapital 
Enjoyed looking through this, very good stuff, regards.
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Thank you Christena
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