Since 2008 until the current period, realhousing credit has more than doubled whilst real income per GDP has gone nowhere in Australia. House prices in Sydney and Melbourne have also doubled in the meantime. Yields are atrocious which means investors were betting on perpetual capital growth (which can’t occur forever). Credit growth has outpaced income growth, GDP, and inflation.
We saw the exact same thing with US in mid 2000s, Ireland, Spain and to a small extent, UK. In every scenario, the primary ingredient that leads to collapse in prices is negative credit growth. When this occurs, demand for housing crashes and leads to oversupplied housing market. A feedback loop occurs and feeds on itself. It only gets rectified when there is a reason to buy 2-3 properties for speculation (primarily when yields make economic sense or the economics of property are very attractive, i.e location).
NSW median household income is about $100k per annum, so using historical price to income ratios of 4-5x, median dwelling price in Sydney should be around $400-$500k, but this measure doesn’t take into account interest rates.
Given mortgage rates are lowest they’ve ever been in Australia, let’s say 6x is the new normal. That takes fair median dwelling price in Sydney to $600k. Using the average of ABS and Corelogic, current median price is around $850k. To reach fair value of $600k, prices would have to drop by 30%. This of course assumes median household income remains the same. But given Covid will smash aggregate demand (after lower stimulus sets in), it’s within the realm of possibility to see a median dwelling price of $500-$550k in Sydney and around $450k in Melbourne. Don’t forget, asset markets often undershoot and overshoot. There is no orderly decline when credit expansion was out of control in the preceding years.
At 500k median dwelling price, house prices will go back to mid 2000s level. They’d still be high for specific low income groups but for majority they’ll be very affordable. This will also have severe ramifications for the economy given many small business loans are backed by residential real estate. But this adjustment is necessary to wean the economy off excess credit we’ve added in the last 12 years.
What is the probability of necessary price adjustment not occurring? Well, state and Federal government would have to introduce massive incentives to make the bubble even bigger. I’m talking about $100k home owner grants, massive incentives from state governments and relaxed lending by the financial institutions. However, it’s highly unlikely this will happen. Banks will have to tighten up their lending to reduce risk as many loans will go bad. Some banks have already done this. Federal Government is also intent on reducing the stimulus. And state governments, unlike the Feds, can’t print unlimited electronic money, they don’t have that authority and they need to issue bonds to raise that money or make cuts elsewhere.
Credit growth has also turned negative, meaning deleveraging is occurring. This will lead to less credit being available in the banking system. With less credit floating around, house prices and other assets will take a massive hit. Many economists and analysts underestimate the power of this. Negative credit growth is disastrous for overleveraged banking system reliant on ever increasing house prices. Add small business loans going bust, it won’t be pretty. Imagine early 1990s recession but a bit worse, that’s what’s going to happen. Banks were also showing deteriorating in their balance sheets prior to Covid; earnings were already under pressure. Given the virus situation, banks should be cancelling dividends, hoarding cash and only lending to credit worthy individuals.
The price valuations in Sydney are extreme. Even outside CBD (as far as Jordan Springs, Marsden Park and surrounding areas) brand new houses are selling for $900k. Two bedroom apartments are selling for $600k in some areas as well. The overvaluation is without any historical precedent. For Sydney to become an environment with 5-6% yields, prices would have to halve. Sydney is yielding same as Central London, an area full of billionaire competing for real estate and increasing their value. In Sydney, there is no such phenomenon, it simply is/was a classic plain vanilla credit bubble (plain vanilla in this context means a simple financial instrument).
Given 1-2% net rental yields and dumb investors speculating purely on capital growth and land value extraction, the epicentre of the crash will be the outskirts of Sydney. It won’t be Strathfield or Inner Sydney, it’ll be outskirts of the city where the masses were fooled into borrowing insane amounts of money to bid up house prices and land lots. The responsibility solely rests on APRA, the banking regulator. They realised credit extension was out of control in 2015/2016 and introduced some lending constraints. This culminated in more controls in 2017-2018 as lending continued being out of control. When this occurs, interest rates aren’t relevant, it shows how hell bent banks were on lending credit – at the end, this generates fees, commissions and profits. APRA removed these limits in 2019 as government became unhappy about prices dropping (Sydney dropped 15% in 18 months). This resulted in 11% rise in house prices in 2019, however from the peak they were still down.
Then Covid came and smashed the lending bubble. My bet had always been an exogenous financial event however it took one tiny virus instead. Young families with savings and secure jobs should be rejoicing, over leveraged investors with negative cash flows should be very worried. It would take a stimulus of insane proportions to prevent this from collapsing (in excess of $1 trillion by my calculations, this includes bank lending). The fiscal stimulus was only $50-60b.
The bubble is very similar in Melbourne as well, only to a smaller extent. Everything here also applies to Melbourne housing market as well.
All the ingredients are in place for a significant house price correction in Sydney and Melbourne.
