Three is not the magic number

About a week ago, Demographia published their 7th Annual International Housing Affordability Survey. They picked up some press for finding that Sydney was the least affordable major housing market outside of Hong Kong, and Melbourne wasn’t that much better. Both were labelled “severely unaffordable”.

And while there is some irony in using the term “unaffordable” to describe the prices at which actual sales occurred (in any case, I agree that Australian capital city houses are expensive), it is the methodology of the survey that I want to nit-pick. It is based on a ratio that Demographia call the “Median Multiple”, which is calculated by dividing the median house (i.e. not apartment) sale price in that market for that period by the median household income for that market at that point in time. Apparently, such a measure is endorsed by such august bodies as the UN, the World Bank and Harvard.

I have previously talked about the mistakes that can be made in comparing two different medians, and it should be clear that there is no reason to assume any particular relationship between (say) today’s median Melbourne household income and the median sale price of a house in Melbourne over the last quarter. Ideally, the median should be calculated on the set of individual house affordability ratios, rather than a ratio calculated from the medians of two somewhat independent sets.

But the major issue I have with the report is that it picks, seemingly out of the air, the value “3.0” as value that separates unaffordable markets from affordable markets, as if it is some kind of universal constant. In fact, the value seems to be chosen principally because, in the past, affordability ratios were less than 3.0:

As Anthony Richards of the Reserve Bank of Australia has shown, the price to income ratio was at or below 3.0 in Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States until the late 1980s or late 1990s, depending on the nation.

In fact, it should be clear that in a country like Australia, and specifically in cities like Melbourne, you would expect their Median Multiple figure to generally increase over time. Hence, there is no constant value that can be used for this ratio to indicate whether the housing market is out of whack.

For the Median Multiple to increase, basically median property values need to grow faster than median income. From my point of view, there are two obvious drivers for this growth to occur.

1. Gentrification

The Australian Housing and Urban Research Institute (AHURI) recently published a report on the gentrification of Melbourne and Sydney. (Essentially, this is when the existing residents of an area are displaced by a wealthier demographic.) For Melbourne, the regions of Maribyrnong and Northcote were identified as undergoing gentrification.

In such cases, property prices rise because people with higher incomes move into the neighbourhood. Actual incomes don’t necessarily rise at all – it’s just people moving around.

When an area has little ability to accommodate the displaced, e.g. through supporting greater housing density from subdividing lots or building apartment blocks, they need to find somewhere else to live. According to AHURI, displaced residents commonly relocate to an adjoining suburb (e.g. in 44% of cases of employed renters or 38% of owners). As they note, this in turn creates a “rippling effect” of gentrifying another region, and then another.

2. Trading Up

A major constraint to purchasing property is the ability to borrow money. First Home Buyers feel this pain worst of all, because (unless a significant deposit has been saved) they typically borrow between 80-90% of the  purchase price.

However, everyone else in the market (by definition) has already purchased a home. So, when trading up, any additional amount to be borrowed will depend on the difference between the value of the current property and the value of the next.

Since banks limit the amount they lend based on a household’s income levels, clearly if a purchase relies principally on borrowing, it will be constrained by income level. But, if a purchase makes use of the equity in an existing home, it can go beyond income level.

Admittedly, this requires property values to grow, in order for the home owner to build up equity. So, it’s somewhat circular to argue that growth in property depends on growing property values. However, the growth in equity is typically much faster than the growth in the underlying property value, which is why subsequent properties can be purchased at a level equivalent to growth faster than income.

For example, a property purchased on a 10% deposit will, after five years, have had its equity grow the equivalent of about 30% per year, if the underlying property value grows just 5% per year for that period (assuming the mortgage isn’t paid down at all). Or more specifically, a $400k property on a $360k mortgage will end up as a $510k property with $150k of equity under those conditions. If the household income has also grown during that period, then the mortgage that could be serviced at the same level (as the mortgage at time of purchase) will have grown at the same rate. Putting that together with the increased equity is how the purchase price of the next home grows faster than income, while keeping the portion of income used to service the loans at about the same.

Australia has a large proportion of home owners as possessors of property. The recent AHURI policy bulletin on Australia’s changing patterns of home ownership noted that the home ownership level continued to remain around 70% of the population. Together with tax treatment that allows home owners to sell their property without any tax implications (versus, say, investors who would be up for GST), this creates an environment where trading up is encouraged.

Concluding remarks

So, if you’ve read this far, you’ll hopefully now agree that the Median Multiple price-to-income ratio is likely to increase over time in Australia, and hence there is no constant level of affordability that relates to it. 3.0 is not the magic number of affordability.

To conclude, I will leave you with a graph from an RBA speech on housing costs showing how, as you’d expect, the  price-to-income ratio for Australian property has fluctuated, but trended up over the last 15 years (blue line).

Lies, Damn Lies and Medians

When I first got involved in property investing, I wrote a little program that scoured the real estate websites for details of properties that were in areas interesting to me. One of the stats that it tried to calculate was the average rental yield (the rent divided by the purchase price) for different areas. Unfortunately, the values I was getting back were utter rubbish.

After looking closer at the data, I realised that I’d fallen for a classic beginner’s mistake: I had tried to compare median values.

The median is an “average” measure of a set of values where there are just as many values smaller than it as there are larger than it. If there are five houses worth $100k, $120k, $125k, $190k and $250k, then the median house value is $125k (the middle one).

Medians are widely used by real estate agents because they are easy to calculate, aren’t skewed by the effect of a really expensive or really cheap property coming onto the market, and provide a simple message to buyers. They state how affordable an area is – if you can afford the median, then you can afford the majority of homes for sale in an area.

However, my mistake was comparing two median values in an area: 1) the median rent  and 2) the median sales price. The set of properties available for rent was composed of completely different dwellings to the set of properties available for sale. For example, the median rent might have come from a 2 bedroom unit, while the median sale might have come from a 3 bedroom unit. As a result, the yields being calculated were much too low.

My mistake in comparing medians is repeated by many in the media every week in calculating property growth by comparing the median from one period with the median from another period. To be fair, it’s not entirely their fault, as they get their data from real estate agents.

Statisticians are aware of the problems with using the median for calculating growth rates and have come up with three improvements. Christopher Joye has written a detailed overview, but I’ll provide my potted summary.

Stratified Median

The Australian Bureau of Statistics (ABS) and Australian Property Monitors (APM) both use an approach of grouping properties into related sets (stratifying the data) prior to computing medians. If the groupings are done properly, then any skewing in one group will not affect another group too much, so data from different periods should be more comparable. However, it doesn’t eliminate the problem that properties sold in different periods might not be comparable in the first place.

Repeat Sales

The main approach used by Residex is based on calculating the growth rate of properties sold in a given period based on how much they sold for last time. Comparing a property with itself clearly doesn’t have the same level of issue as comparing medians. However, a property might have been renovated (or even completely demolished and rebuilt) since its last sale, which adds a wrinkle to the calculation. Also, sales of new buildings cannot be included since there isn’t a prior sale to compare them with.

Hedonic Method

The hedonic method is less interesting than it sounds, but is the main approach used by RP Data. In this method, sale data is combined with data on the nature of each property, e.g. precise location, land size, number of bedrooms, number of bathrooms, etc. In this way, like can really be compared with like, and more accurate growth rates can be calculated for properties in different areas. However, this approach is only as good as its data, and we need to trust that the statisticians at RP Data have gotten the good stuff. Also, historical data for all of these additional details are hard to find, so it’s not possible to do comparisons as far back as with the other approaches.

In conclusion, it is clear that the three improved approaches all have their strengths and weaknesses, but all are superior to the plain median. I was never able to update my little property stats program to collect enough data to make proper comparisons, but at least I learned the pitfalls of comparing medians.

Housing Boom or Blame Boom?

There’s talk again of the house price boom (or even bubble). I know people who are looking to buy at the moment, and I feel so lucky that I’m not having to find a first home in the current market.

However, stories I read in the media suggest to me that we’re also in the midst of a blame game, where various bogeymen are out there pushing up prices to the detriment of everyone else. If you believe everything you read, we can blame:

  • First-home buyers – whose free cash from the government in the form of the FHOG (First Home Owners Grant) is making it hard for others to compete.
  • Overseas investors – who are apparently making the most of relaxed rules from the FIRB (Foreign Investment Review Board) to invest in Australia when other international markets are looking shaky and depressed.
  • Local investors (in particular Baby Boomers and Gen X) – whose access to the tax deduction of negative gearing enables them to sustain larger holding costs of property than non-investors.
  • Developers – who have been slowly releasing lots from their land banks rather than supplying enough to the market to meet the demand
  • Immigrants – who have been coming here in increasing numbers because it has a promising way of life but are now competing with the locals for somewhere to stay.
  • Governments – for allowing all of the above to occur.

Is there anyone left?

What is good in this debate is the recognition that it is supply and demand that is driving the prices in the market. However, the purpose of this finger-pointing seems to be to blame everybody else for the problem. I’m not convinced that any of the above factors are at the heart of the matter:

  • First-home buyers – the demand from these guys doesn’t explain why an unrenovated house in Richmond sells for more than $2m (as I read in yesterday’s paper). The whole market is booming, not just the cheaper end.
  • Overseas investors – although they are active, they are still a minority. I don’t think they could underpin the entire boom.
  • Local investors – negative gearing also results in lower rents than would otherwise occur, which should in turn reduce the demand for home ownership.
  • Developers – their land is generally at the fringe, and there is heavy demand in the centre.
  • Immigrants – these are a net benefit to a society, since they generate taxes and jobs, but have always been an easy target.
  • Governments – there is some truth to the saying that in a democracy, we get the government that we deserve. If governments continue to follow policies that we don’t agree with, we can only blame ourselves for voting them in.

On the other hand, a factor that I don’t think has gotten enough attention is our culture. In particular, the “Australia dream” of owning a house on a block of land.

I worry that it is the pursuit of this goal, more than any single segment of society, that is driving the demand for houses in the suburbs of our capital cities. We need to give up on this dream if we are to achieve sufficient densities in the inner ring of suburbs where most people wish to live.

Rather than blaming other people, I can fess-up to being as guilty as everybody else on this one. A couple of years back, Kate and I bought a house together that would’ve housed a family of five when it was designed and built around 1900 in Kensington. This is a typical, gentrified, ex-working-class neighborhood of Melbourne that probably has lower densities now than when it was new. We moved out after we had our first child, because it was too small for us (!).

In the same way that governments around the world have influenced the cultural desires for a certain family size, it ought to be possible to embark on a campaign to change our cultural expectations and change this demand factor. Make living in high-density accommodation the trendy option. Guilt people out of their large houses with empty rooms and private back yards. (Other countries have a higher density of living than us, hence why many immigrants are willing to live in apartment blocks that locals would avoid; another reason why immigrants aren’t contributing as much to the problem.)

At the same time, there needs to be more direct incentive to motivate people to embark on such a change. Make subdivision easier. Make building apartments on new land easier. Ensure that apartment blocks are built well (good climate control and sound/smell proofing) and there is provision for common outdoor areas.

I’ve spent most of my years since I left home living in higher density accommodation such as apartments and townhouses. Although I’m currently living in a house, I think I’d be willing to share walls again.

Negative news for property

We know that prices move due to an imbalance in supply and demand. If supply is unchanged but demand increases, prices will rise.

Back in 2000, John Howard and the federal government introduced the GST. At the same time, he also introduced the $7,000 First Home Owners Grant (FHOG) with the aim of offsetting the effect of housing price rises due to GST being added to contruction costs. Understandably, the FHOG was rather popular.

State governments took note, and added in their own grants. For example, in 2004, The Victorian government began offering a $5,000 First Home Bonus. Then in October 2008, Kevin Rudd and his federal government sweeteed the pot further with a $7,000 First Home Owner Boost ($14,000 for new homes). Everyone’s been seen to offer first home owners a hand-out.

But it isn’t clear that it was actually helping first home owners. As these grants didn’t directly affect supply, but they did affect demand, the prices of housing for first home owners would naturally rise. It’s not immediately clear how much prices actually rose, but we might be able to take a guess.

There are two basic ratios that banks look at when deciding whether to grant a home loan: the LVR (loan to valuation ratio) and DSR (debt to service ratio). The LVR (amount of loan divided by value of property) is typically limited to between 90-95%. The DSR (periodic interest payments divided by periodic income) is typically limited to 30-40%. So, the more deposit you have, or the more income you have, the more you can borrow for a particular property.

According to this Fairfax article by Jessica Irvine, banks will require as much as 5% of your deposit to be real savings, but the rest can be government grant. So, for a Victorian first home owner, eligible for $26,000 in grants to build a new home, if the DSR is not limiting them, and they are taking out a 90% LVR loan, then the grants allow them to borrow an extra $260,000 than they would otherwise be able to receive.

In practice, the DSR would limit our hypothetical first home owner, even with the historically low interest rates on offer at the moment. But the above exercise does go to show how significantly the FHOG and its successors can move house prices.

This might all seem pretty good: the government subsidises new home owners, and existing home owners and developers get more money for their properties. However, here’s the rub – the rumour is out that Kevin Rudd is going to rein in these grants, and perhaps even end them after this financial year. I didn’t think it would ever happen – it’s very hard to unwind these things once you’ve put them in. Anyway, he’s going to tell us in the budget announcement this month.

However much the FHOG has stimulated demand, removing the FHOG will undo it. If supply is unchanged but demand decreases, prices will fall.

Positive news for property

This year there have been a few claims that house values will fall significantly, including this one from Christopher Hire (20% fall) or this report on Steve Keen (40% fall). Such a drop in property seems credible on face value as we’ve had significant drops in values on the share market – why would property be immune? Well, as was recently explained in The Australian, it’s really apples and oranges. And, in fact, it turns out that residential property prices have actually increased each of the last two months.

Okay, the increases are very slight, but even a slight increase is a somewhat different reality to a significant fall. I think rumours of the death of the housing market have been exaggerated…

The moral of the storey

We’re all thankful for the RBA’s recent 1% cut in the cash rate. Hopefully it will help Australia avoid a recession. However, it seems that the Tenants Union of Victoria is trying to leverage this into improvements in rents for their members, using the argument of ethics. The claim is that landlords are morally obliged to reduce rents when their costs fall.

I am sympathetic to the plight of renters: I have been one for most of the time I’ve lived out of home, and it is possible I will be one again in the future. However, I am also a landlord and I speak from experience when I say that the price of rents is generally unrelated to the level of interest rates. The current rental crisis is more due to population pressures driving a level of demand beyond that of the existing supply. Market forces set rents, not the mercenary nature of landlords.

Over the last decade, up until the last two years, I have had to keep my rents more or less static, despite rising interest rates, since it was a renter’s market, and market forces meant I had to wear the increase in costs. In the last couple of years, it has swung around and it’s more of a landlord’s market in Melbourne (although less so than 12 months ago), so rents rose in line with demand. When more apartments are built, supply will increase, and things will balance out again. I know, this isn’t helpful to those renting today, but housing is a long term proposition. People renting can get a house of higher quality than if they bought, as they are paying off a historical mortgage (i.e. when the house was cheaper) rather than a current mortgage (assuming house prices have risen).

Another flaw to the proposition by the Tenants Union of Victoria is that if you extend their argument to its logical conclusion – that rents should be set at a fixed margin above costs – then you get absurd outcomes. For example, rents would be cheaper on properties where the owner had paid off more of their mortgage, and almost free when there was no mortgage left at all.

However, there are some ethically grey practices by landlords around rents that do deserve scrutiny and complaint. I am thinking here of when a property is advertised at a particular weekly rent but then the landlord expects prospective tenants to offer to pay above that level of rent, or selects tenants for the property based on offers of above-advertised rental payments. The issues here are transparency and fairness: all tenants should be given equal opportunity to apply for a property. If landlords wish to receive higher rent, then they simply need to advertise their property at that level of rent. There is no need for secret, above-advertised payments.

But even with such dodgey practices in the market, overall rents will respond to market forces. It’s simple supply and demand. No matter what the Tenants Union of Victoria demands.

That’s not a Housing Affordability Crisis

I won’t draw any conclusions here, but I will draw your attention to the following points:

  • There are 7.9 million households in Australia, and on average each household owns $298,000 in residential property, e.g. their own house and other rental properties (from ABS Household Wealth and Wealth Distribution, Australia, 2005-06).
  • This puts a total value on all residential property in Australia of something like $2,400 billion. However, the market cap for the entire Australian stock market is currently about $1,600 billion (from ASX Historical market statistics).
  • Australia is the “fourth-largest retirement savings market in the world” (from the Eureka Report) while superannuation funds are prevented from borrowing any money to buy assets, which is the main way that residential property is bought in Australia.
  • When it comes to shares though, the ATO has softened its stance on some types of gearing. Contracts for Difference (CFDs), when bought with cash, are apparently alright (in Interpretive Decision 2007/56), even though CFDs behave very much like borrowing to purchase a share.
  • Westpac has bought 441 houses from Defence Housing Australia (according to The Australian and a DHA media release) with the intent of launching Australia’s first residential real-estate investment trust.
  • House prices are driven by supply and demand. The superannuation industry has the potential to add a little bit of demand…