As predicted by Christopher Joye early in 2013, house prices have been soaring. Across Australia’s eight capital cities, home values have surged 10.8 per cent over the 12 months to April 2014. Properties in Sydney and Melbourne have registered capital gains of 16.5 per cent and 11.0 per cent respectively.
Which raises the question: is the market getting overvalued? I think it’s time to admit that it is.
Benchmarked against the change in disposable household incomes, Australian home values look like they have overshot fair value by about 10 per cent. Unfortunately, this disconnect widens every day that prices outstrip incomes.
Most punters are far too fixed in their valuation views on the multitrillion-dollar residential property asset class, which is the single biggest source of household wealth.
House prices rise and, as we saw in 2008 and 2011-12, they can also fall. And like the equities market, property can be prone to periods when prices overshoot.
You should, therefore, attempt to form an educated position on the valuation integrity of the market and time your entry and exit accordingly.
Australia’s biggest housing bear, Dr Steve Keen, recently expressed surprise that I had developed concerns about the risk of a bubble after staunchly rejecting that proposition during the global financial crisis.
This change of view is doubtless frustrating for Keen, who forecast that Australian house prices would slump 40 per cent in nominal terms in 2008, only to watch them inflate 22 per cent above their pre-GFC peak today.
My view at the time was that any house price falls would likely be modest, which proved to be the case, and I anticipated the 2009-10 rebound, just as I did the present recovery.
The latter began in June 2012 and gathered pace in the second half of 2013 as the Reserve Bank of Australia slashed its target cash rate to a record 2.5 per cent low.
Mortgage rates have fallen in lockstep to never-before-seen levels.
Some banks are offering variable rates as cheap as 4.85 per cent, which is way below the average 7 per cent rate that has prevailed since the mid-1990s.
Change in valuation dynamics
Keen questions how I could have been comfortable with Australian property valuations in 2010 when I am worried about the direction of the fundamentals today.
He points, in particular, to the fact the current ratio of house prices to incomes, which is a valuation benchmark used by the RBA, is close to its level back in 2010.
I have actually made the same observation. So it is useful to explore why the housing dynamics in 2014 are different to what we saw in 2010.
It is because in 2010 Australia’s house-price-to-income ratio was falling – and it continued to taper to a decade-low trough until late 2011. Since the second half of 2013 and 2014, the ratio has been rapidly rising, and is approaching a new record high. As valuation dynamics vary during a cycle, my views adjust accordingly.
We have now witnessed house prices appreciating at three times the rate of incomes for a year. Right now, the market is overvalued by at least 10 per cent.
The price-to-income ratio is 10 per cent above its average since 2000, and 20 per cent beyond the average since the mid-1990s.
If the house price-to-income ratio continues its current climb, and the RBA gets around to normalising mortgage rates, house prices will fall, just like they did after the hikes in 2007-08 and 2009-10.
How much they deflate by is an open question, and depends on how high the cash rate goes.
A simple model of house prices, incomes and mortgage rates suggests, however, that Australian home values could fall by between 8 and 17 per cent if discounted variable mortgage rates rise as far as 7 to 8 per cent. I don’t see why this should give pundits conniptions.
Edited from “House Prices have hit the Roof” by Christopher Joye
17 April 2014 AFR Smart Investor
Original article here