best places to buy property in melbourne, page-25

In the News
Summing Up The Property Proposition
- 5/7/2005



Property should be part of any well-diversified portfolio but something tells me residential investors are about to receive a lesson in the relationship between risk and return that they haven’t anticipated. Some people have developed unrealistic expectations immediately following the explosive growth in the sector. It is prudent to put the last decade’s growth of residential prices into some sort of global and historical perspective.
Many people don’t stop to think about the reason some assets grow in value and question what drives long-term returns. Fixed Interest Investments have both duration risk and credit risk and investors are rewarded accordingly for taking on these risks. Share price growth is a function of a growing earnings stream as the purchase of a share of company is an entitlement to all future dividends of that particular business. The growth of earnings in a company is fundamentally achieved by the policy of retaining approximately 50% of earnings for reinvestment in income generating enterprises. The price of individual stocks will fluctuate above and below a valuation depending on sentiment and external factors but over the span of decades the market always reflects the steady rise of earnings reflected by the practice of retaining earnings for growth.
Property prices historically have been reflections of the fact that ownership of a property entitles the landlord to all future revenues from rent after expenses have been deducted. There are no retained earnings in the case of property investment but the income increases with inflation causing property growth. This is because rents increase as a result of wages growth that is in line with inflation. This is what allows the rent to be increased accordingly. Rental growth is the only thing that drives property prices in a sustainable manner over the very long term. Everything else is speculation. In the share market, anything other than earnings growth is inevitably speculation also.
Interest rate movements affect property prices in the short term but these adjustments are made by the Reserve Bank in response to inflation expectations. The last eight years have seen a break with the connection that property prices have had to inflation and this has added a speculative factor to residential property that most property owners are ignorant of. It is critical that we understand the reasons for the recent phenomena of abnormal growth.
When inflation was high during the 1970’s and 1980’s at a rate of approximately 10%pa, wages and therefore rents increased at the same rate and doubled approximately every seven years. This increasing earnings stream allowed property prices to grow at the same rate of increase so that a property valued at $50,000 in 1970 would have grown to $100,000 by 1977, $200,000 by 1984 and $400,000 by 1991 without growing at all in real (above inflation) terms. This inflation driven growth gave people an expectation that property always grows in value and there is very little risk in borrowing heavily to invest in something that seemed to only ever increase in value.
When the inflation dragon was finally slain in the 1990’s and wages and hence rents were no longer the safe catalyst to drive up prices and make residential property such an excellent hedge against inflation something else that will prove to be less benign came into play. As inflation fell from 10% to 3%, interest rates for residential property loans fell from 13% to 6.5% as they are typically set at 3% above the inflation rate to allow for banking margins. The consequence of this was that when a family approached the bank for a loan based on their income and ability to repay, instead of calculating they could borrow $400,000 over a 25 year period they were told they could afford twice this amount as they calculation was based on interest rates that had halved. The problem was that everyone else attending the auction on the sunny Saturday morning was told the same thing and they inevitably bid each other up to the affordability level and drove the property price up to $800,000.
Investors, real estate agents and the unlicensed promoters of property seminars saw a classic opportunity to sell something based on its immediate prior performance without purchasers questioning how those growth rates were achieved and whether they were sustainable. At an inflation rate of 3% and wages growth at the same level there is no way for rents to increase so income growth in the last cycle has not driven the asset growth. It was driven by a doubling of debt from a halving of interest rates. The only way for asset growth to continue in the same manner as the recent past is for interest rates to halve again to a level of 3% with inflation falling to zero that may or may not happen. In fact, inflation may pick up and hence drive up interest rates and herein lies the problem. Housing debt levels have been bid to unprecedented levels and household interest obligations compared to disposable income are approaching 10% for the first time in living memory. At current levels even a quarter of a percent increase in rates causes affordability problems for heavily indebted households.
According to the Economist magazine in the UK, house prices are at record levels in relation to rents in America, Britain, Australia, New Zealand, France, Spain, the Netherlands, Ireland and Belgium. America’s ratio of prices to rents is 32% above its average level during 1975-2000. By the same gauge, property is over valued by 60% or more in Britain, Australia and Spain, and by 46% in France. The ratio of prices to rents is like a price earnings ratio in the share market. The price of a house should reflect the future benefits of ownership, either as rent saved for the owner-occupier or as income for the investor. It is now cheaper to rent than to pay interest on a loan. Now that the prices are not rising anymore, there are a lot of highly geared investors that have bid prices up and are no longer making any money. A potential housing market collapse has to be considered in a rising interest rate environment that has the potential to unravel the speculative gains that were not achieved through income growth. These speculators may have looked clever a few years ago but the smiles seem to be vanishing from their faces. In such an environment it is incumbent on us to understand the dangers of debt, the long-term factors that drive return (income growth) and the relationship of risk. I hope we have well diversified, risk managed portfolios to see us through what ever happens in the next few years as the imbalances are inevitably corrected.
Kevin Bailey is the Executive Chairman of The Money Managers Ltd, a financial planning firm based in Melbourne.

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