Deleveraging and Australian Property Prices

by Stubborn Mule on 22 July 2009 · 60 comments

car-smallA few weeks ago, I had a preliminary look at Australian property prices. That post focused on rental yields and argued that the fact that property prices have consisently outpaced inflation over the last 10-15 years can be associated with a steady decline in rental yields which has been matched by a decline in real yields in other asset classes. What I did not address was the argument that debt deleveraging will lead to a collapse in property prices just as it has done in the US. That is the subject of today’s post.

The Bubble

The bubble argument is a compelling one. The chart below shows the growth in Sydney property prices over the last 24 years. Prices rose fairly consistently over this period at an annualised rate of almost 7%. Over this period, inflation averaged around 3% per annum, so property prices grew at a rate of approximately 4%. This means since 1985, the cost of a typical house has risen by a disconcerting 123% over and above inflation. Little wonder that many people see the property market as a bubble waiting to burst.

sydney-recent

Sydney Property Prices (1985-2009)*

The fuel driving the property market has been the rapid growth in household debt, most of which has been in the form of mortgage debt.  The next chart is taken from Park the Debt Truck!, a post which looks at trends in Government and household debt in Australia. The highlighted regions show the periods of Labor federal governments. Household debt began its upward trajectory during the Hawke and Keating years, but really gathered pace during the Howard years. With the help of continually extended first-time home-buyer grants, growth is yet to slow now that Rudd has come to power.

Govt and Household Debt

Government and Household Debt in Australia

This expansion of debt has been a key factor driving up property prices. Without the easy access to money, the pool of potential home-buyers would be far smaller and with less demand pressure, prices would not have risen so fast. A very similar pattern was evident in the US, but in late 2006 the process began to lose steam. Property prices faltered, debt became harder to obtain, borrowers began to default on their loans leading to foreclosure sales which put further downward pressure on prices. The bubble was bursting.

So far I am in agreement with the property bubble school of thought. Where I part ways is concluding that Australia will inevitably experience the same fate, resuting in a collapse in property prices, possibly in the range of 30 to 40%.

Deleveraging

Words can be powerful. Once you use the word “bubble” to describe price rises, it seems almost inevitable that the bubble must burst. Similarly, “reducing debt” sounds like a good thing, while “deleveraging” sounds like a far more ominous destructive process. But all deleveraging really means is debt reduction and it can happen in a number of ways:

  • borrowers use savings to gradually pay down debt
  • borrowers sell assets to pay down debt
  • borrowers default on their loan

When it comes to borrowers selling assets, in some cases this may be voluntary. But it may be that they are forced to sell. A good example is in the case of margin loans to purchase shares. If the share price falls, the lender will make “margin call”, requiring the borrower to repay some of the loan. Selling some or all of the shares may be the only way to raise the money required. When borrowers default on a secured loan (such as a mortgage), the lender will usually sell the asset securing the loan in an attempt to recover some of the money lent. In this situation the emphasis is usually on ensuring a speedy sale rather than maximising the sale price.

Forced sales are the ideal conditions for a price collapse, particularly if lenders have become reluctant to finance new borrowers. If debt reduction takes the form of gradual repayment, the pressure on prices is far less. There will certainly be less demand for assets than during a period of rapid debt increase, but this can simply result in neglible growth in asset prices for an extended period of time rather than a price collapse.

To understand what form debt reduction will take, it is not enough to consider the amount of debt. The form of the debt is very important. Some of the key characteristics that will influence the outcome include:

  • the term of the loan (the length of time before it must be repaid)
  • repayment triggers (such as margin calls)
  • interest rates

Short-term loans can be very dangerous. In 2007, the non-bank lender RAMS learned this the hard way. It had relied heavily on very short-term funding (known as “extendible asset-backed commercial”) and back when the global financial crisis was simply known as a liquidity crisis, RAMS found itself unable to refinance this debt. It’s business collapsed and it was purchased by Westpac for a fraction of the price at which the company had been listed only months before.

The most common type of loan with repayment trigger is a margin loan. There is no doubt that a significant factor in the dramatic falls in the Australian sharemarket over 2008 was forced selling by investors who had used margin loans to purchase their shares. There are also other sorts of loan features than can be problematic for borrowers. Another one of the corporate victims of the financial crisis was Allco Finance. It turned out that they had a “market capitalisation clause” attached to their bank debt. This was like a margin call on the value of their own company and was an important factor in the collapse of the company.

Even if borrowers have long-term loans and are not forced to repay early, if they are unable to meet interest payments, they will be in trouble. A common feature of the US “sub-prime” mortgages at the root of the financial crisis was that interest rates were initially low but then “stepped up” a couple of years after the mortgage was originated. While the market was strong, this was not a problem due to the popular practice of “flipping” the property: selling it for a higher price before the interest rate increased. Once prices began to fall, the step-ups became a problem and mortgage delinquencies (falling behind in payments) and defaults began to rise. In some states, the phenomenon was exacerbated by laws that allowed borrowers to simply walk away from their property, leaving it to the lender, who had no further recourse to pursue the borrower for losses. On top of all this, rapidly rising unemployment put further stress on borrowers’ ability to service their mortgages.

So, how do Australian mortgages look on these criteria? The standard Australian mortgage is a 25-30 year mortgage with no repayment triggers. Most mortgages are variable rate and, despite the banks not passing through all the central bank rate cuts, mortgage rates are at historically low levels. In part due to the regulatory framework of the Uniform Consumer Credit Code (UCCC), lending standards in Australia have been fairly conservative compared to the US and elsewhere. The Australian equivalent of the sub-prime mortgages, so-called “low doc” or “non-conforming” mortgages, represent a much smaller proportion of the market. Many lenders cap loan-to-value ratios (LVR) at 95% and require the borrower to pay mortgage insurance for LVRs over 80%, which encourages many borrowers to keep their loans below 80% of the value of the property. Interest step-ups are rare. Mortgages are all full recourse.

The result is that while US mortgage foreclosure and delinquency rates have accelerated rapidly, they have only drifted up slightly in Australia. It is not easy to obtain consistent, comparable statistics. For example, deliquency data may be reported in terms of payments that are 30 days or more past due, 60 days or more or 90 days or more. Of course, figures for 30 days or more will always be higher than 90 days or more. Nevertheless, the difference in trends is clear in the chart below which shows recent delinquency rates for a variety of Australian and US mortgages both prime and otherwise. The highest delinquency rates for Australia are for the CBA 30 days+ low doc mortgages. Even so, delinquencies are lower even than for US prime agency mortgages 60 days+ past due.

Delinquency Rates (III)Delinquency Rates in Australia and the US**

All of this means that the foreclosure rate remains far lower in Australia than in the US. Combined with the fact that mortgage finance is still increasing, due largely to the ongoing first-time home-buyers grant, there has still been little pressure on Australian property prices. In fact, reports from RP Data-Rismark suggest prices are on the rise once more (although I will give more credence to the data from the Australian Bureau of Statistics which is to be released in August).

Once the support of the first-time home-buyers grant is removed, I do expect the property market to weaken. Prices are even likely to fall once more with the resulting reduction in demand. However, without a sustained rise in mortgage default rates, I expect deleveraging to take the form of an extended lacklustre period for the property market. Turnover is likely to be low as home-owners are reluctant to crystallise losses, in many cases convincing themselves that their house is “really” worth more. Even investors may content themselves reducing the size of their debt, continuing to earn rent and claim tax deductions on their interest payments.

The biggest risk that I see to the Australian property market is a sharp increase in unemployment which could trigger an increase in mortgage defaults. To date, forecasters have continued to be confounded by the slow increases in unemployment and now the Reserve Bank is even showing signs of optimism for the Australian economy.

Australian property prices have certainly grown rapidly over recent years. Driven by rapid debt expansion, prices have probably risen too far too fast. But, calling it a bubble does not mean it will burst, nor does using the term “deleveraging” mean that prices will inevitably follow the same pattern as the US. In the early 1990s, Australia fell into recession and the commercial property market almost brought down one of our major banks. Meanwhile, house prices in the United Kingdom collapsed. Despite all of this, in Australia, residential prices simply slowed their growth for a number of years. I strongly suspect we will see the same thing happen over the next few years.

* Source: Stapledon

** Source: Westpac, CBA, Fannie Mae, Bloomberg.

By the way, notice anything unusual in the picture at the top?

UPDATE: Thanks to Damien and mobastik for drawing my attention to this paper by Glenn Stevens of the Reserve Bank of Australia. It includes a chart comparing delinquency data for the US, UK, Canada and Australia. The data is attributed to APRA, the Canadian Bankers’ Association, Council of Mortgage Lenders (UK) and the FDIC. Since these bodies do not appear to make the data readily available, I have pinched the data from the chart and uploaded it to Swivel. It paints a very similar picture to the chart above.

Delinquency: US, UK, Canada and AustraliaMortgage Delinquency Rates

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{ 9 comments… read them below or add one }

1 Wade February 6, 2010 at 10:01 pm

The “low” rental vacancy rate is a myth peddled by Real Estate Agents. I have been successful in every rental application I have ever made. And if demand was so far in excess of supply, why is it that rents are yielding only 50% of the respective mortgage commitment (see the chart, and read the last par here http://www.bit.ly/cdgjc2)?

It really just goes to the poor quality of the data available in Australia where the primary sources (RP Data, Australian Property Monitors) are just thinly veiled industry marketing tools, while even the ABS has significant flaws in its data collection (doesn’t count units, doesn’t assess capital works).

2 Hookah March 7, 2010 at 5:38 pm

seems like australia property prices are on par with the US. They both have the same delevaraging problems. dang government always messing stuff up.

3 Stubborn Mule March 7, 2010 at 7:20 pm

Hookah: and sometimes the Government messes up by not intervening when they should!

4 Lefty March 9, 2010 at 10:17 pm

A number of our neigbours have simply given up trying to sell and taken their houses off the market. One young couple who have gotten themselves in too deep are trying to sell for what seems like a ridiculous price to me. I ran it through an online mortgage calculator under a number of different scenarios – it turns out that if interest rates were to return to where ther were just before the outbreak of the GFC, on a variable rate, the repayments on this mortgage would be more our entire combined monthly income – no food, no clothing, no nothing, just mortgage payments.

Average household incomes in this resource boom town may be higher than the national average but such prices still seem ludicrous.

Even the “priced-to-sell” house next door would still consume three-quaters of our entire income at pre-GFC rates.

We thank our lucky stars that we built our house just before the real estate boom kicked off and are paying less than 20% of our monthly income in mortgage costs.

Nationwide though, prices seem to show no sign of heading any way other than up (and Steve Keen will be taking that mountain walk).

5 Big June 16, 2010 at 11:09 am

Your analysis does not include the governments “12 month Mortgage Repayment Holiday” which stipulated to the banks to give mortgagors reprieve for 12 months if they had lost their jobs and could not repay – Effectively with the “Repayment holiday” those mortgages would not appear on your data as delinquent as they would be considered on holiday – I would like to see the data well past the the 12 month holiday passing i.e. 12 months after October 2008 i.e. from October 2009 and onwards -you’ll probably find an interesting upswing of delinquencies

6 Jenny White June 12, 2011 at 3:39 pm

Every weekend, a range of real estate organisations publish auction results, which are rarely the same. There are several reasons for these differences in the results.
The organisations who collect auction data tend to adopt varying geographic definitions for each city that the auction results relate to. For example, city centre vs CBD.
Australian Property Forum’s auction results thread includes clearance rate data from APM, RPData and the Real Estate Institutes. These are published each Saturday evening
Auction Results Sydney
Auction Results Melbourne
It is very important to remember that there are many differences in the various methodologies used to calculate auction clearance rates by each auction results publisher.
Essentially, the auction clearance rate is intended to offer a snapshot of the balance between supply and demand in the auction market, which can be a leading indicator for the property market.

7 Stubborn Mule June 12, 2011 at 4:01 pm

Bit of a late reply to the comment, but here goes. The classification of borrowers who have been offered some form of “repayment holiday” or other hardship relief does complicate the issue. However, it does not simply understate the delinquencies as the treatment varies from bank to bank: some include these in their delinquency figures and some do not.

Delinquency figures have been rising over recent months but it is not the result of the end of repayment holidays (if anything, given the recent natural disasters, the number of people receiving hardship relief is higher than ever). Rather, we are seeing higher interest rates starting to bite and, in some cases, the effect of the multi-speed economy. Parts of Queensland where there had been oversupply of property (e.g. the Gold Coast) are presenting tough conditions for tradespeople and the high Australian dollar is not helping as it weighs on tourism and other dollar-sensitive sectors.

8 firsttimebuyer February 20, 2013 at 6:27 pm

I originally commented on this thread back in 2009 after we bought our first house. I was the guy hoping for capital growth to move my family up the property ladder. We have just last week sold that house and I thought I’d update the thread to let everyone know how we got on.

The short version is that we held the house for just under four years and sold it for exactly $100,000 more than we paid for it – on the face of it not a bad return.

The longer story however is that in the intervening time we had spent approximately $50,000 on maintenance and renovations – the house looked pretty nice when we left! Add in the stamp duty, the agents sales fees and the professional legal/moving fees and we’ll be lucky to have broken even on the whole deal.

So while the general strategy of buying for capital growth has proved sound we simply hadn’t factored in the frankly ridiculous cost of buying and selling real estate, nor the maintenance costs associated with holding an older property.

Although I have enjoyed the experience of owning my own home, from an investors point of view I have certainly come away from the experience jaded. I can’t help but think that the whole “property ladder” concept is probably nothing more than scheme concocted by real estate agents to help them get into their Porches sooner. If I had the last four years over again there is no doubt I’d be spending it renting.

My belief in owner occupied real estate as a solid investment remains, but only if the plan is to buy your “20 year” home so there is time for your asset to appreciate substantially vs the costs. Until then my advice would be to just sit on your cash – which is exactly what I will be doing in my newly leased, newly renovated, family sized home.

9 Stubborn Mule February 20, 2013 at 7:38 pm

@firsttimebuyer it sounds like you’ve done relatively well given the concerns some had at the time about a likely crash. But you do make a very good point about all the costs involved in transacting and maintaining a house. When people tell you how well they’ve done out of their real estate investments, they almost always just point to their purchase and sale prices, never all the other costs involved. I owned a flat myself for about seven years and I’d say that once I factored in stamp duty, strata levies, etc, etc, I basically just broke even.

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