Housing Bubbles

There is growing concern that a bubble is developing in the residential property market in Australia. Prices have certainly zoomed up in Melbourne, and especially Sydney, over the last two years; see the chart below of Australian residential property prices.

The problem with bubbles is that until they burst there is no way to know for sure whether a bubble even exists. A steep run up in prices could be a rational response to changes in demand and supply. But, we should remember that property is more vulnerable to the formation of bubbles than other asset classes, so the possibility of a bubble in the Sydney property market should not be dismissed out of hand.

Figure 1: Australian housing prices 2007- 2015 (from RBA chart pack)

Why are most asset price bubbles property bubbles?

The answer to this question lies in a key difference between property markets and other asset markets such as share markets.

In the share market bulls and bears can both act on their views of where the market is headed. Investors who think that BHP shares are under-priced can buy them. Investors who think BHP shares are over-priced can sell them and wait until the price falls to buy back in. Or, if they don’t own any shares then they can borrow BHP shares and then sell them (short-sell the shares).

The key point is that in the share market bulls and bears can both act on their convictions. Consequently, the BHP share price cannot get too far from its fundamental value without invoking either buying or selling that brings it back to its fundamental value. Bubbles cannot easily form.

The property market is different. An investor who thinks property in Sydney is under-priced can always buy property, but what if they think it is over-priced? If they own property they might sell the property and buy back into the market once prices have fallen; however, the round-trip cost of selling and then later buying property (stamp duty + broker fee + legals = 8%) makes this a very expensive proposition.

If they don’t own property then there is nothing they can do. Investors can short sell shares but there is no way to short sell property.

In any market where positive sentiment can be acted on through buying but negative sentiment cannot be acted on there is a danger of a bubble forming. If the channel for the expression of positive opinions is open but the channel for expression of negative opinions is closed, then prices can move substantially above fundamental values without invoking selling that restores the price to fundamental value.

That is the main reason that property markets are vulnerable to bubbles, and most bubbles in asset prices are in property markets: think of Japan in 1991, or Ireland or Spain in 2007.

Booms followed by long flat periods

The graph below shows real housing prices in six countries since 1900. It is striking how much more property has risen in value in Australia than some similar countries.

Figure 2: Long series of international housing prices

Also noticeable in the Australian data is a pattern of property prices zooming up and then staying flat for long periods of time. This pattern can be explained in terms of property market liquidity

In the share market a fall in demand for shares combines combines with a steady supply of shares for sale to cause a fall in prices - sometimes falls of 50% or more as occurred most recently in 2008/9 and 1974/5.

In contrast, in the housing market a fall in the price of houses causes a fall in the supply of houses for sale. Rather than accept a capital loss, sellers of houses will withdraw from the market in the face of lower prices. The lower supply prevents prices from falling further. The result is that booms in house prices in Australia are followed by long periods of flat prices rather than a big declines. If prices in Sydney continue to rise substantially then a long flat period, rather than a big fall in prices, would be the historical norm.

Quality of property indexes

Indexes or share prices, such as the ASX200 or the S&P500, are much more accurate than property market indexes for the following reasons.

  1. Most stock market listed shares trade every day, so the daily closing price of every share is ‘fresh’. Whereas residential properties, on average, trade only every 9 years, so the price of the great majority of houses - even measured on a yearly basis - are ‘stale’.
  2. The dividend income generated by publically traded shares is known precisely, whereas property rental income is the private information of owners.
  3. Injection of new equity capital into companies - by issuing new shares - is known precisely. In contrast, the injection of new capital into properties - through renovations, is often not even recorded. For example, if a property is sold in 1995 for $150,000 and then sold again in 2015 for $1.6 million, but a $200,000 renovation in 2007 is not considered then the capital gain will be overstated. Spending on renovations is large and typically under-recorded, so capital gains in residential property are over-stated.

Property index data, such as appears in the graphs above, should not be given the same credence as stock market index data.