Negative Gearing Exposed

Australia’s housing bubble has been caused, to a large extent, by investors piling into housing on the back of overly generous tax concessions.

Given the interplay between investment housing and rental availability and affordability, I thought a detailed examination was warranted of the merits of investment property tax concessions, most notably negative gearing.

While it is clearly the case that Australia’s taxation system has artificially increased the demand for housing, thereby putting upward pressure on house prices, the proponents of these tax concessions contend that any tightening of existing tax rules would significantly reduce housing supply and increase rental costs. To quote the Minister for Housing (Unaffordability), Tanya Plibersek, on this matter:

“…any change in negative gearing would be a disaster for rental availability in this country….If we changed negative gearing we would see disastrous effects for renters in Australia.”

So is the Minister correct? Would changes to negative gearing reduce rental supply and affordability? Does negative gearing and its partner in crime, the 1999 halving of the capital gains tax (CGT) rate, increase the housing stock and reduce rents? Does society benefit from these tax concessions, despite their significant cost to Government revenue and their artificial stimulus to house prices?

Before we examine some of these issues, let’s first review some history.

A quick primer:

Negative gearing is a form of leveraged investment in which an investor borrows money to buy an asset, but the income generated by that asset does not cover the interest on the loan. A negative gearing strategy can only make a profit if the asset rises in value (capital gains) by enough to cover the shortfall between the income and interest that the investor suffers.

Under Australia’s taxation system, negative gearing rules allow investors in both property and shares to write-off the cost of borrowing used to acquire an asset as well as other holding costs against all income, not just the income generated by the asset. At the same time, following changes to CGT in 1999, capital gains earned on assets held for more than 12 months are taxed at half the rate of other income.

According to the Reserve Bank of Australia, "the taxation treatment [of residential investment property] in Australia is more favourable to investors than is the case in other countries". In Australia, there are no restrictions on the ability of taxpayers to negatively gear investment properties. That is, there are no limitations on the income of the taxpayer, on the size of losses, or the period over which losses can be deducted. By contrast, in the United States and Canada, there are limitations placed on negative gearing, whereas it is not permitted at all in the United Kingdom.

In July 1985, as part of a broader tax reform package, former Treasurer Paul Keating 'quarantined’ losses from negative gearing by stopping them from being deducted against other income. However, after intense lobbying  by the property industry, which claimed that the changes to negative gearing had caused investment in rental accommodation to dry up and rents to rise, Treasurer Keating restored the old rules in September 1987, thereby once again permitting the deduction of interest and other rental property costs from other income sources.

A costly policy reversal:

The reintroduction of negative gearing in 1987, in concert with the halving of the CGT rate in 1999, led to a surge in property investment in Australia. As shown in Chart 1, the number of property investors rose by 35% between 1999/00 and 2007/08, from 1.28 million to 1.73 million.

Of greater concern to taxpayers, total net rental income from investment properties has decreased from +$219m in 1999/00 to -$8,628m in 2007/08 (Chart 2). Further, the proportion of property investors declaring losses increased from 54% in 1999/00 to 69% in 2007/08. Assuming that the average marginal tax rate of property investors is 30%, negative gearing cost the Government around $2.6 billion in foregone tax revenue in 2007/08, meaning that average Australians are massively subsidising property investors.

The impact of the increase in property investment on Australia's house prices can be seen in Chart 3. Despite flat rental growth, house prices surged from 2000 as investors piled into investment property on the back of the new tax rules that enabled them to partly socialise income losses from holding investment properties (via negatively gearing), whilst privatising more of the gains achieved through capital appreciation (via the CGT concession).

This increase in property investment in Australia was also assisted by a significant increase in credit provision to property investors. From the mid-1990s, investors were permitted to purchase an investment property via accessing equity in their own home, without having to contribute any cash up front. Lending criteria on investment loans were also relaxed and became much the same as loans to owner occupiers, as did the interest rate charged. Lenders also began competing aggressively for investment loans and offered products specifically designed to attract investors, such as the split-purpose and interest only loan.

By contrast, prior to the mid-1990s, investors typically had considerable difficulty obtaining finance for an investment property, often having to rely on both their own savings and funding from non-bank sources. Investors were also typically charged a significantly higher interest rate than for owner occupiers.

This increase in credit provision for property investment is evident in Chart 4, which shows borrowings for investment properties growing at a faster rate (17% per year) than borrowings for owner occupied properties (12% per year). Accordingly, the share of investment loans has grown from around 14% in 1990 to around 30% currently.


According to the RBA, the terms at which investors can access finance in Australia are also more generous than in comparable countries. Typically, interest rates are higher for investors than for owner occupiers in these countries, and stricter lending criteria applies. Not surprisingly then, the share of investor mortgages in comparable countries is in the single digits, compared to the 30% share in Australia.

Impact on the rental market:

So having established that tax-fuelled property investment has been a key contributor to Australia's inflated house prices and costs the Government (taxpayer) billions of dollars in foregone tax revenue, the question remains as to whether these tax concessions increase the availability of rental properties and reduces rental costs?

To answer this question, let's first examine the claim by the property industry that the 'abolition' of negative gearing by the Hawke/Keating Government in July 1985 caused investment in rental accommodation to dry up and rents to rise. Chart 6 uses Australian Bureau of Statistics (ABS) data to plot real (inflation-adjusted) rents for the Australian mainland capital cities. The first vertical dotted black line shows the beginning of the ban on negative gearing (July 1985), whereas the second vertical dotted black line shows its re-introduction in September 1987.

According to the ABS data, following negative gearing's abolition, rents rose in both Sydney and Perth, were flat in Melbourne and Adelaide, and fell in Brisbane. But if it was true that the abolition of negative gearing caused rents to rise, shouldn't rents have risen Australia-wide since negative gearing affects all rental markets? Clearly, based on this evidence, the properties industry's claim about the impact of negative gearing on rents are false.

My conclusion is supported by Saul Eslake, former Chief Economist at the ANZ, using different rental data. According to Mr Eslake:  "It's true, according to Real Estate Institute data, that rents went up in Sydney and Perth. But the same data doesn't show any discernable increase in the other State capitals. I would say that, if negative gearing had been responsible for a surge in rents, then you should have observed it everywhere, not just two capitals."

So having debunked the link between negative gearing and rental costs, what about the claim that negative gearing increases the supply and availability of rental accommodation? If this claim was correct, we would expect to see a high proportion of investor borrowings being channelled into new housing construction. Investors who buy existing homes do not increase rental availability since they do not add to overall housing supply and merely turn homes for sale into homes to let. They also do not address the shortage of rental accommodation, because the reduction in the supply of homes for sale throws potential owner-occupants onto the rental market.

In order to examine the effect of property investment on the rental market, Chart 6 uses RBA data to plot the percentage of investor mortgages going to existing dwellings versus new construction.

   
As you can see, the share of investment in new construction has fallen for the past 25 years, from around 60% in the mid-1980s to around 5% currently. So despite the favourable tax treatment provided to property investors in Australia, for every 20 investment homes purchased in 2010, only one is a new dwelling that has actually added to housing supply and rental availability.

The data on new home construction by investors is even more damning. As shown in Chart 7, there was a surge in investor loans for second-hand properties from around 2000 onwards, coincident with the reduction in CGT. By contrast, loans for new construction have remained relatively flat for the past 25 years. As a comparison, the ratio of investor lending for existing dwellings to new dwellings was around 2:3 in 1985; 7:1 in 2000; and 15:1 in 2010.

A failed policy:

Based on the above evidence, there is clearly little merit in Australia's tax concessions for property investment. Negative gearing and the CGT concession do not provided any incentive to invest in new housing because they are available for both existing homes as well as new ones. And since these concessions do not increase housing supply, they also do not put downward pressure on rents.

Rather, the increase of investment in existing dwellings has merely significantly added to housing demand, reduced housing affordability, and displaced potential owner-occupiers, forcing them onto the rental market. While the cost to the taxpayer is immense, the costs to younger Australians, in particular, from reduced housing affordability and increased debt levels is even greater.

The situation that has arisen in Australia, where a substantial part of the population never own their own home or have to go deep into debt to achieve home ownership, makes a complete mockery of claims about 'rising living standards' and Australia having a 'strong economy'. Successive governments have allowed an appalling situation to develop in Australian society, and new approaches are desperately needed.

A better approach:

Australia's current system of negative gearing is a key factor behind the housing affordability problem in Australia. It has encouraged a flood of investors into the established housing market, it has not contributed to housing supply or rental availability or affordability, and it costs the Government billions of dollars of foregone tax revenue each year. Housing affordability will never be properly addressed in Australia until significant changes are made to negative gearing.  

Negative gearing's cost to the Government and impact on house prices would be greatly reduced if, from a certain date in the future, it was retained on newly constructed dwellings but abolished where an investor purchases an existing ('second hand') dwelling. In this way, pre-existing investment property owners would not be disadvantaged and, over time, tax deductible interest would begin to fulfil its economic purpose of encouraging real investment - the production of new housing supply - as new investors enter the housing market. Such an approach, once understood, would likely be supported by the home building and property development industry because it promotes higher building levels. Further, the increased housing supply would be likely to increase the availability of rental properties and lower rents. Of course, those groups with a direct interest in long-term house price appreciation would strongly object to such an approach including, perhaps, many current Australian home owners who (wrongly) perceive that their wealth is increased when their home value rises.

Tax purists might also disagree with such a change to negative gearing on the basis that it is wrong to discriminate among financial assets. My response is that housing is an entirely different type of asset from other financial assets, like shares. Firstly, housing is a social asset and shelter is a basic human need. Second, those buying other financial assets are bidding against other investors that can also access interest deductibility. However, with housing, the main other bidders are owner-occupiers that do not have access to this advantage (interest deductibility). So we are not comparing 'apples with apples' with regards to housing versus other financial assets.

Change ain't easy:

Of course, discussions about changing negative gearing are for now academic, since the Rudd Government recently announced, in response to the Henry Tax Review, that it would never change Australia's negative gearing or CGT rules.

While it won't admit it publicly, the Government is concerned that changes to tax concessions could lead to a stampede from property by investors and cause a bursting of Australia's housing bubble. Finance Minister, Lindsay Tanner, said as much in a recent interview on Lateline:

" The key reason why governments of both persuasions have not interfered with negative gearing is of course that that any dramatic change in the overall investment framework could lead to a stampede of people out of property, which could lead therefore to dramatic drops in prices which of course you’re seeing in other economies around the world and you see the economic devastation that flows from that."

So, despite the Government and many mainstream economists arguing that Australia's high house prices have been caused by a 'lack of supply' (housing shortages), the truth is that prices have risen largely because of speculation from housing investors combined with easy credit from Australia's lenders. And no government wants to spoil the party or have the bubble burst on their watch, despite pretending to be concerned about housing affordability.

Instead, I am left wishing that I could buy a time machine, travel back in time, and reverse those two fateful policy blunders - the reintroduction of negative gearing in 1987 and the CGT reduction in 1999. Then, maybe, Australia's house prices would still be affordable, households would be less indebted, and a large chunk of the population currently stuck in rental accommodation would be home owners instead. If only...

Debunking the Australian Housing Shortage

The argument that Australia is experiencing a chronic housing shortage has been used consistently by mainstream Australian economists, the property industry, and the government to justify Australia’s high house prices and to counter claims that we are experiencing a house price bubble. According to this argument, house prices will continue to be pushed higher in Australia by the growing gap between supply and demand as a result of a rapidly growing population.

Australia’s housing situation is also said to be in direct contrast to the experience of the United States, which many observers characterise as having been subject to significant overbuilding during their recent housing boom, and whose house prices have fallen over 30% since the end of 2006 (see chart 1).

Take, for example, the following press release from the Australian Housing Industry Association (HIA) on 18 March 2010, which discusses the findings of its Housing to 2010 report:

“The report finds that if current building trends persist, then Australia’s cumulated housing shortage would reach 466,000 dwellings by 2020…Housing to 2020, which focuses on future housing demand and the number of dwellings required in meeting this demand, highlights a current housing shortage that already numbers 109,000 dwellings”.

And what will be the impact of such a shortage? The HIA press release goes on to say:

“If we don’t get a comprehensive supply response to the accumulated housing shortage then the lack of affordable and appropriately located rental properties will only increase…”

The HIA’s report was followed in April 2010 with the release of the Government’s Housing Supply Council State of Supply Report 2010, which makes similar predictions of a chronic housing shortage in Australia. Some of the key findings of this report are:

• There was an estimate cumulative shortage of dwellings of 178,000 in June 2009; 
• Over the five years to 2014, the overall shortage is projected to grow to 308,000 dwellings;
• By 2029, the shortage is projected to reach around 640,000 dwellings; and
• The lack of affordable housing in Australia is the “direct result of the ways in which housing supply shortages play out in the market”.

So there you have it, Australia is apparently not building enough houses and, as many commentators claim, this so called housing shortage will continue to put upward pressure on house prices and prevent Australia from experiencing the same house price deflation undergone in the United States and elsewhere.

The housing shortage claim is not supported by evidence 

So if Australia was experiencing a chronic housing shortage, then you would expect the number of people per household to have been increasing sharply, since there are not enough houses to go around and people are forced into share accommodation. Well let’s look at the Australian Bureau of Statistics (ABS) data on average persons per dwelling (Chart 2):

Doh! According to the ABS, the average number of people per dwelling has fallen significantly, while dwelling size, as measured by the average number of rooms per dwelling, has been increasing.

In fact, the number of people per dwelling in Australia has fallen steadily for the past 50 years, from 3.6 in 1960, 2.75 in 1990, 2.62 in 2000, and 2.56 in 2008. So the growth in the number of dwellings has actually outstripped the increase in the population and, therefore, the average number of occupants per dwelling has fallen considerably. Only in the past year or so has the rate of new building fallen behind population growth, as evidenced by a small increase in people per dwelling in 2008.

What if we, instead, examine the rate of population growth versus new dwelling construction? Well Steve Keen, Associate Professor of Economics and Finance at the University of Western Sydney, has done so (click here). Professor Keen found that:

“Over the period 1985 to 2009, an average of one residential dwelling was built per 1.75 new Australians…This build rate is well in excess of the current ABS ratio of 2.55 persons per occupied dwelling”.

Australia’s housing utilisation is below the United States!

Chart 3 compares the average number of people per household in Australia against that of the United States, Canada, and England. All information has been sourced from the relevant government statistical bureaus using data for 2006, which is the latest available international data and just happens to be the period immediately prior to the recent global house price crash.

So in 2006, at the height of the US Housing Bubble, Australia’s housing utilisation level, as measured by the number of people per dwelling, was well below that of the United States (and roughly equivalent to Canada). This data suggests that the housing shortage in the United States was actually more acute than in Australia!

Why then is there universal agreement that there has been significant overbuilding in the United States, resulting in a large quantity of homes now sitting vacant?

Interestingly, the common consensus prior to the onset of the Global Financial Crisis (GFC) was that the United States was experiencing an acute housing shortage, similar to the claimed shortage currently being experienced in Australia. Consider, for example, the following article on the California housing crisis, written in February 2006 just as prices in Southern California peaked. Prices have since fallen around 40%:

"The California Building Industry Association (CBIA) continues to express alarm over what it calls an ongoing housing crisis in Southern California. Alan Nevin, the association’s chief economist, projected in a 2006 CBIA Housing Forecast that only 185,000 to 205,000 building permits will be granted this year, far short of the 240,000 new homes needed each year.”

"Southern California has been experiencing a massive population boom in recent years and it's believed that 6 million new residents will be living in the region by 2020. The population increase, coupled with the housing shortage, has the CBIA worried that it will be increasingly difficult for first-time homebuyers to find a moderately priced unit."

Sound familiar? Read the article for yourself here.

So how can an acute housing shortage in the United States suddenly turn into a massive oversupply? The answer lies in the way economists measure housing demand.

Demand ain’t what it used to be
 
‘Underlying demand’ is the common methodology used in calculating whether there is a housing shortage. Put simply, underlying demand estimates what the demand for newly-built housing might be given the growth in population, trends in household size, demand for second (or holiday) homes, and economic conditions (e.g. employment, interest rates, etc). Underlying demand differs from ‘effective (actual) demand’, which is the quantity that owner-occupiers, investors and renters are actually able and willing to buy or rent in the housing market.

Underlying demand is an inherently flawed concept, since it is calculated by extrapolating earlier trends (i.e. reductions) in household size, and ignores the impact of higher housing prices on housing demand. Take, for example, the Housing Supply Council’s approach to measuring the level of housing shortage in its State of Supply report, which “implicitly assumes that household formation decisions are taken without regard to housing market conditions”. Yet, as house prices rise to unaffordable levels - as they have in Australia - you would naturally expect the number of people per house to increase as children stay at home longer and those living in shared accommodation rises. Put simply, while high house prices decreases effective (actual) demand, it does not affect the level of underlying demand.

Equally, general economic conditions can dramatically affect the level of housing demanded. For instance, as a country’s economy deteriorates, and unemployment rises, the number of people per dwelling will rise as they group together to reduce their housing costs. This most likely explains the current situation in the United States. Despite supposedly experiencing an acute housing shortage prior to the onset of the GFC (measured using underlying demand), there is now a large oversupply of housing brought about by a deep recession.

Vacant homes everywhere

The final nail in the coffin of the housing shortage argument lies in the number of vacant houses identified in the last two Australian Censuses. As shown in Chart 4, between 6 per cent and 8 per cent of homes in capital cities were identified as vacant on Census night in 2001 and 2006. To put this into context, the overall number of capital city vacant homes in 2006 (387,000) is equivalent to around 2½ years of total Australian housing supply (around 150,000 new dwellings per year)!

The reason behind this massive supply of vacant homes is unknown. However, it might be the case that because rental returns are so low (with net rental yields of around 2 ½ per cent), owners would rather keep their houses vacant and ‘collect’ the capital gain rather than deal with the drawbacks from renting, including potential property damage, having to deal with tenants, etc.

The risk is that if the expectation of future capital growth disappears, or there is a significant fall in house prices, then many owners that have kept their homes vacant might put these on the market, leading to a sudden oversupply of housing.

‘Undersupply’ is not a bullish indicator for the Australian housing market

The bottom line is that the argument that the housing shortage in Australia will continue to drive Australian house prices higher and prevent the kinds of house price falls experienced overseas is not credible. The economic reality is that the demand for housing is changeable depending, largely, on the prevailing economic conditions. A significant deterioration of the Australian economy is likely to significantly reduce the level of housing demanded and cause the number of persons per dwelling to rise as Australians group together in order to reduce their housing costs. When coupled with a potential flood of vacant properties onto the market as house prices begin to fall, then the perceived shortage of houses in Australia could easily turn into an oversupply, just as it has in the United States.

Housing Shortage Myth

Let put to bed the Myth that we are different because we have a housing shortage?

In 2006 California Building Industry Association (CBIA) expressed alarm over what it called an ongoing housing crisis in Southern California. Alan Nevin, the associations chief economist, projected in a 2006 CBIA Housing Forecast that only 185,000 to 205,000 building permits will be granted in 2006r, far short of the 240,000 new homes needed each year. Southern California has been experiencing a massive population boom in recent years and its believed that 6 million new residents will be living in the region by 2020. The population increase, coupled with the housing shortage, has the CBIA worried that it will be increasingly difficult for first-time homebuyers to find a moderately priced unit. Los Angeles and Ventura counties are suffering from a housing crisis, said Holly Schroeder, chief executive officer of the Building Industry Association Greater Los Angeles Ventura Chapter. In 2006 the Median House Price in California was $275K today it is $175K this despite forecast of 6 million new residents all needing housing by 2020? Housing Demand did not save them. This example remind anyone of Australia?
(Oh yes the USA had SUB PRIME, but Australia has 45% of First home buyers Stressed at a time when interest rates are at 30 year lows? Imagine what will happen with a couple more rises)
Also a housing report in the UK in 2002 said Britain was heading for a property shortage of more than a MILLION homes by 2022 unless the current rate of house building is dramatically increased, according to reports from the Joseph Rowntree Foundation (JRF). The evidence, being presented at the Foundations Centenary Housing Conference in London, reveals that the supply of housing is already falling behind demand faster than previously recognised. House prices in the UK have fallen 15-45% depending on which area or sector you look at.
Again we are told Australia is different we wont crash we are UNIQUE in the world? Are we? Housing Demand forecasts in UK in 2002 & California were just like Australia in 2010 yet their prices crashed.
According to the ABS, 12,814 residential dwellings were approved in October  2009— that equates to about 150,000 constructed annually. Given that the average Australian household has 2.6 people, dwellings for about 400,000 Australian are being built each year. Last year, net migration to Australia was 213,461 (of which skilled migrants made up just over half). In short, there is substantially more housing than there are migrants. It appears that the housing shortage is two parts myth, zero parts reality. It is highly doubtful that migrants are even in a position to “bid up” the price of properties. The VAST MAJORITY migrants would not be in a position to pay $500,000 to purchase a property so they will have no impact on demand. According BIS Shrapnel, rents increased last year by only 3.5%, barely more than inflation. Not only are immigrants unlikely to cause property to rise they are having little effect on rental rates either.
Australian Population increases also occur organically, especially given Australia is in the midst of a baby boom. In 2008, 296,600 babies were born, the highest figure ever. However, last year 143,900 people died, meaning that actual population organic growth was only 152,700. So, even adding the net births to the net immigration levels (213K + 153K= 366K), it still appears that surplus housing is being built.(150K Houses built 2.6 people per house = Housing for 395K demand for addition shelter 366K SURPLUS= 29K) (FYI most babies born today aren’t in a position to enter the housing market for about 25 years so the recent baby boom is unlikely to be a cause of the recent price rises or demand). But PROPERTY SPRUIKERS put their stuff out you read it & don’t question its contents then PANIC like LEMMINGS & drive prices up , pay too much & wind up slaves to the Mortgage. But please don’t take my word for it look into it yourselves….Property is a commodity it is called SHELTER every commodity has a price SPRUIKERS talk it up to make their profits off you…

Australia A bubble About To Pop?

The following is an article that was published on Seeking Alpha - a leading North American investment blog that provides free investment market analysis primarily from money managers, investment newsletter writers, and the general public. 

Since this article brings together my previous posts on the Australian housing market, the information contained within does not cover new ground and will be familiar to regular readers. 

There is currently widespread debate in Australia and abroad about whether Australia is experiencing an unsustainable housing bubble, or asset inflation based upon sound fundamentals.

Recent analysis by the Economist, the IMF, Demographia, Morgan Stanley, and Jeremy Grantham of GMO argue that Australian house prices are severely overvalued and due for correction.

On the other hand, Australia’s banks, the property industry, and industry 'experts' claim that Australia’s housing market is different to other countries and underpinned by sound fundamentals, including a strong economy, high population growth and housing shortages, as well as a robust banking system.

So which camp is right? Is Australia’s housing market a debt-fuelled time bomb underpinned by ‘Ponzi finance’ that requires the ‘greater fool’ and ever-increasing levels of debt to perpetuate it? Or are current valuations justified? Let’s examine the data.

One long boom:

The below chart plots Australia’s nominal house price growth against comparable countries. As you can see, Australia’s house prices growth has been nothing short of phenomenal, leaving the other countries in its wake.

Next I have plotted average Australian established house prices against average Household Disposable Incomes (HDI) and Average Full-Time Ordinary Earnings (AFTOE).

As you can see, the ratio of house prices to average earnings started at around 2.5 times HDI and 3.7 times AFTOE in 1986. This ratio increased slowly from the mid-1980s to 2000, rose rapidly from 2000 to around 2004 and then settled at around 6 times HDI and 7.7 times AFTOE in 2008/09. 

The increased cost of housing is also reflected in the amount of HDI required to service the average mortgage (see below chart).

As shown above, despite as significant reduction of mortgage interest rates over the past 20 years (shown below), the ratio of average mortgage interest payments to average HDI has increased from around 6 per cent in 2000 to 10 per cent currently (after peaking at around 11.5 per cent in 2008). Whilst this ratio may look benign on the surface, only 35 per cent of households in Australia have a mortgage. So the actual repayment burden on indebted households is much larger than implied by the average.

Whilst commentators can argue about the choice of house price data and income measures, the trends are clear – Australian housing has become far more expensive overtime and households are now required to dedicate a much larger proportion of their lifetime’s earnings to purchase a home.

Debt levels explode:

Since the growth of house prices has significantly outpaced the growth of incomes, it follows that rising debt levels have been the key contributor to rising house prices in Australia, since the only way to purchase something that you cannot afford through income (or savings) is to borrow the difference. The below chart uses RBA data to plot the level of mortgage debt against HDI and GDP.

As you can see, Australian mortgage debt has increased significantly from  32 per cent of HDI and 12 per cent of GDP in 1990 to 142 per cent and 92 per cent respectively as at June 2010.

Further, Australia’s household debt levels - which includes mortgage as well as other personal debt - compares poorly against other advanced nations (see below).

Based on the above data, we can confidently conclude that Australia’s house price growth has been debt-fuelled, thereby fulfilling one of the key ingredients of an asset bubble.

Ponzi buys a house:

What about the claim that Australia’s housing market is being underpinned by ‘Ponzi finance’, whereby the rental income (or imputed rent) from a property does not cover the debt expense incurred to purchase the asset, therefore, requiring perpetual capital growth, the ‘greater fool’ and ever-increasing levels of debt to perpetuate it?

To evaluate this claim, I have first plotted the growth in real (inflation-adjusted) house prices against the growth in real rents. This allows us to assess whether rents have increased at roughly the same pace as house prices such that rental incomes broadly cover the cost of debt repayments.

According to the Australian Bureau of Statistics (ABS), real rents have increased by around 15 per cent since 1987 whilst real house prices have risen by around 165 per cent over the same period. It is no surprise, then, that yields on rental houses have plummeted from around 8 per cent in 1987 to 3.5 per cent currently (see below).

Remember that the rental yields shown above are before deductions for property expenses such as rates, land tax, maintenance and agents fees. If you take these costs into account, then current net rental yields would likely track below 3 per cent - far below the current discount variable mortgage rate of around 7 per cent. Put another way, the average new housing investor would incur a pre-tax income loss of over 4 per cent on every dollar invested in housing.

Yet despite the worsening investment fundamentals, investors have piled into residential property at an astonishing rate. The below charts, which come from Morgan Stanley, shows that Australia has become a nation of landlords. In 1988/89, 608,000 taxpayers reported rental income to the Australian Taxation Office (ATO). But by 2007/08, 1,765,000 taxpayers did – 13 per cent of the total.

Part of this surge of housing investment can be explained by the Baby Boomer generation reaching peak earnings age (45 to 55 years) from 1990. As the Boomers and others realised that they had not saved enough for their retirement, they began buying investment properties en masse as a way of catching up in a hurry, helped along by a proliferation of tacky property investment seminars marketing slogans like: “THIS WEEKEND CAN MAKE YOU A MILLIONAIRE” and continuous segments on tabloid television showing every man and his dog making fortunes on the back of property.

But with house prices booming and rents remaining flat, the proportion of taxpayers where rental income does not cover costs increased from around 50 per cent in 1993/94 to 70 per cent in 2007/08:

Meanwhile, the aggregate level of net rental losses has ballooned from +$219m in 1999/00 to -$8,600m:

Finally, as shown by the below ATO table, the overwhelming majority of loss-making investors are middle income earners, with 77 per cent of these investors earning less than $75,000 per year in 2007/08. By comparison, only 5 per cent of loss-making investors earned over $150,000.

The data, therefore, strongly suggests that the Australian housing market is being underpinned by Ponzi finance, whereby investors and owner occupiers are leveraging up to buy property in the hope of achieving continued rapid capital growth (in the case of investors) or ‘getting in’ before prices increase further (in the case of owner occupiers). But with the significant negative income returns (or imputed rents) from holding residential property, the only way that house prices can continue to increase faster than incomes is if buyers believe that prices will continue rising and that large capital gains can be made by selling the same asset to other buyers (the ‘greater fool’ theory). Such a scenario also requires ever-increasing debt levels, which is clearly unsustainable.

This hypothesis is broadly supported by a recent investigation by the Economist, which found Australia’s housing market to be the most overvalued in a sample of 20 countries using an average price-to-rents methodology. Similarly, the IMF recently found the Australian housing market to be amongst the most overvalued in the OECD based on price-to-rents and price-to-incomes.

Risky finance:

While there are many factors that have increased the demand for housing – such as Australia's generous taxation system (explained here), subsidies paid to first-time buyers, and Baby Boomer demographics – the extra demand for housing could only have fed  into higher prices if credit was readily available, enabling buyers to borrow large sums and pay high prices. Put simply, the supply of credit is the crucial ingredient to Australia's booming housing market.

As explained in the book, The Great Crash of 2008, it was the rise of the non-bank lender in the mid- 1990s - raising funds via securitisation activities on the wholesale debt markets - that initially caused an intensification of competition amongst mortgage lenders. It was these non-bank lenders, whom have no formal regulator and no rules outside of regular trade practices and corporations law, which led the decline in Australian credit standards from the mid 1990s by introducing ‘innovative’ loan products like low-doc loans in 1997, then ‘no-doc’ loans in 1999, and more recently they were beginning to issue ‘non-conforming’ (sub-prime) loans just before the global recession intervened.

Faced with this new competitive threat, Australia's banks responded in kind by reducing their deposit requirements and tapping new sources of funding offshore. Gone were the days of requiring a minimum 20 per cent down payment and the banks funding their loan portfolios from domestically sourced funds (mostly deposits); instead, 5 per cent down payments became commonplace funded increasingly by the banks issuing bonds to foreigners.

As shown below, the percentage of bank liabilities funded from foreigners has increased from just over 5 per cent in 1989 to around 22 per cent currently, totalling over $500 billion! Over the same period, the banks increased the proportion of loans channelled into housing, with housing loans increasing from around 35 per cent of total lending in 1990 to 57 per cent currently.

Anyone seeking an answer as to why Australia owes so much money to foreigners only has to look to the banks' model of borrowing heavily offshore to pump-up housing:

With the banks awash with funds - sourced from both domestic and foreign sources - and with a higher proportion of bank assets (loans) being directed into housing, is it really a surprise that house prices and household debt levels have exploded over the past two decades?

The key risk is that Australia’s ability to sustain current house prices, let alone further price increases, rests with the willingness of other countries to continue lending Australia's banks money. But in times of crisis, such as when Lehman Brothers collapsed, foreigners tend to zip-up their wallets, leaving our banks, house prices, and broader economy exposed to a sudden liquidity shock as the banks are unable to roll-over their foreign borrowings (let alone increase them).

Few people realise that the Australian Government’s October 2008 guarantee of bank funding and deposits was issued after the larger banks made it clear to the Government that they were facing extreme difficulty in rolling over their wholesale funding, meaning that they would have to immediately withdraw credit from the Australian economy and might eventually face insolvency. So while it might be true that Australia’s banks satisfactorily managed credit risk, avoiding the excesses of the sub-prime lending prior to the onset of the global recession, their heavy offshore borrowing created a liquidity risk that also rendered them too-big-to-fail, eventually leading to the Government’s funding guarantee. Hence, whilst many American and European banks became insolvent on the asset side of their balance sheet, due to holding dodgy loans and derivatives, Australia's banks also faced insolvency, except that it was on the liability side of their balance sheet. Again, a greater exploration of these issues is found in The Great Crash of 2008.

Supply-side squeeze?

A common view held by the mainstream Australian press and property "experts" is that Australia's strong house price growth is due largely to a chronic undersupply of homes. Take, for example, this recent statement from Industry Research and Forecasting firm, BIS Shrapnel:

An undersupply in the Australian property market will force residential property prices up by 30%, according to a BIS Shrapnel chief economist. Frank Gelber gave members at a Real Estate Institute of Victoria lunch a very optimistic forecast for house prices, as reported in the Sydney Morning Herald. "At the end of the day, we haven't got a bubble in our residential market. We're undersupplied, not oversupplied … [House] prices will go up another 30 per cent over the next three years... We’re not over-geared, we’re not overvalued and we’re not oversupplied," he said. ''I can't remember in the last 30 years a time when I have been more comfortable and optimistic about investment in the market.'' Australia’s recovery would not be affected by global economic uncertainty, he added.

Observers from countries that have experienced housing booms and busts would be familiar with this kind of economic delusion.  Remember this testimony from Federal Reserve Chairman, Ben Bernanke, in 2005:
 
House prices have risen by nearly 25 percent over the past two years. Although speculative activity has increased in some areas, at a national level these price increases largely reflect strong economic fundamentals, including robust growth in jobs and incomes, low mortgage rates, steady rates of household formation, and factors that limit the expansion of housing supply in some areas.
 
How about the classic land (housing) shortage argument previously used to justify sky-high house prices in Japan, the UK, USA, and Ireland:
 
Leading up to Japan’s bursting real estate bubble in 1990, we were told that this time was different: house prices simply reflected the growing economic power of Japan Inc. and there was a land shortage in overcrowded Tokyo. Today, Japanese real estate prices are still less than 50% of that peak value reached more than two decades ago. During the U.K. bubble, Brits blamed zoning requirements for creating land shortages until prices crashed to the lowest multiple of income on record in 1997. Similarly, builders in Northern Ireland predicted severe housing shortages if planners did not release more land in 2003. And before America’s bubble burst, there were land shortages across the country, from Florida’s undeveloped west coast to the deserts of Nevada (from Forbes) .
 
So is Australia different to these other nations? Is Australia's housing shortage genuine, justifying the high price tag? Or is it a case of same story, different bubble? To investigate this issue I have first plotted the average number of people per dwelling and the average dwelling size, as measured by the average number of rooms per dwelling:
 

According to the ABS, the average number of people per dwelling has fallen significantly, whilst the average number of rooms per dwelling has been increasing.
 
In fact, the number of people per dwelling in Australia has fallen steadily for the past 50 years, from 3.6 in 1960, 2.75 in 1990, 2.62 in 2000, and 2.56 in 2008. So the growth in the number of dwellings has actually outstripped the increase in the population and, therefore, the average number of occupants per dwelling has fallen considerably. Only in the past year or so has the rate of new building fallen behind population growth, as evidenced by a small increase in people per dwelling in 2008. Based on these measures, therefore, there is little evidence of a chronic housing shortage in Australia.
 
Second, I have plotted long-term house price growth (left panel), population growth (middle panel), and dwelling construction relative to population growth (right panel), in each of Australia's capital cities/states to determine whether there is any obvious link between population growth/dwelling construction and house prices (see here for the full study). For if Australia's house price growth had been driven by fundamental supply/demand imbalances, you would expect price growth to have been far stronger in high population growth/low dwelling construction regions than in low population growth/high dwelling construction regions.
 

As you can see, the macroeconomic data is inconclusive. Whilst tight housing supply goes some of the way to explaining the price out-performance of Brisbane (QLD) and Perth (WA), Sydney (NSW) experienced the lowest house price growth over this period despite having the third lowest level of housing construction relative to population growth. By contrast, both Adelaide (SA) and Hobart (Tas) have experienced robust house price growth despite both low population growth and high levels of housing construction.
 
Finally, the below RBA chart shows that house prices have risen equally in Australia's capital cities and regional centres. If housing shortages really could explain Australia's house price growth, we would expect to see city prices climbing much more than in regional areas, since the cities are where the bulk of the population growth has ocurred and where supply-side constraints are more likely to exist.

Although the evidence of supply/demand imbalances in the Australian property market is, at best, inconclusive, it is possible that speculators and 'flippers' might have been drawn into Australian housing because of the perceived shortages, thereby fuelling price growth.

In addition, had Australia's urban planning structure been less restrictive and more market-oriented (like the Texan model), it is possible that house prices would not have risen as far, since supply would have adjusted faster to the increased demand from prolificate lending.

Nevertheless, based on the evidence above, it does not appear that Australia's supply-side situation is all that different from the bubble markets of Japan in the late 1980s, the UK in the 1990s, or Ireland, California, Nevada and Florida more recently.

Bubble trouble?

In my opinion, an Australian house price correction is highly likely in the medium to longer-term. House prices relative to incomes and rents, as well as household debt levels, have simply become too high to be maintained, and all it will take is either a change of sentiment, a deterioration of Australia's economy, another global credit shock, or shifting demographics to bring house prices back into line with incomes and rents. If there is one thing that the global recession has highlighted, it is that asset markets are fluid and can change course abruptly and viciously.

So what are the key risks facing Australia's housing market? Well there are several, some short-term and some longer-term.

First, Australia is heavily leveraged to China, so any slow down in the Chinese economy would likely translate into lower prices for Australia's two largest exports - iron ore and coal - along with other commodites. Should commodity prices fall significantly, it follows that less money will flow into the Australian economy, resulting in lower spending, a contraction in aggregate demand, and higher unemployment. A slowdown of China's economy is highly probable since its two major export destinations - the US and Europe - are facing an extended period of sub-par economic growth from deleveraging as well as ageing populations. To date, China has undertaken massive government stimulus to subsidise production and consumption in order to maintain high growth rates. But as highlighted recently by Jim Chanos, such an approach inevitably produces vast amounts of waste and is unsustainable. Futher, there is evidence that China's housing market is a bubble waiting to burst, and has the potential to dramatically slow China's economy.

The second major risk for house prices is that world credit markets freeze, thereby dramatically increasing Australian banks' cost of wholesale funding and/or reducing their ability to raise funds offshore. Recent analyses by investment banks Credit Suisse and Goldman Sachs estimate that the Australian banks will need to raise between $100 billion and $170 billion of term wholesale debt in the 12 months to March 2011, of which about $78 billion would be the refinancing of existing borrowings that mature.

According to Credit Suisse, the refinancing challenge over the next five years amounts to about $420 billion, with CBA and Westpac accounting for about $240 billion of that. The average term of the majors’ debt is only about 2.8 years.

Goldman estimates that if there were 8 per cent loan growth and no growth in deposit funding relative to the status quo, the banks would need to raise $416 billion in five year’s time. If, as is more likely, deposits in the major’s part of the banking system grew by 6 per cent, they would still need to raise $272 billion in five year’s time. That’s additional to the borrowings that will need to be refinanced.

The Australian banks' wholesale funding task will be both difficult and costly since they will be competing with up to $US5 trillion of existing European bank funding that will mature and have to be refinanced by European banks over the next three years, about $US3 trillion of it by the end of 2012. Australia's banks will also have to compete to raise funds in capital markets against sovereign governments to fund the measures they took in response to the global recession.

Let's also not forget that the Basel Committee on Banking Supervision is looking to add additional layers of counter-cyclical capital buffers to bank capital adequacy requirements in order to mitigate against excessive credit growth and systemic risk.

With all of these factors combined, it will be difficult, if not impossible, for Australia's banks to continue to increase lending for housing. As such, there is little prospect of continued strong house price growth, since continued price appreciation relies on ever-increasing credit growth and household debt levels. Even maintaining current house price levels will be difficult in this new credit-constrained environment.

Even if Australia miraculously manages to dodge the above economic bullets, house prices will still likely come under pressure. This is because for house prices to continue rising, investors and owner-occupiers must continue to believe that capital appreciation will be sufficient to cover the negative income returns from owning residential property. This situation is clearly unsustainable. Once the expectation of continued strong house price growth disappears, households will likely start reducing their borrowings (deleverage) and prices will correct.

Finally, one of the key drivers of Australia's strong house price growth has been the Baby Boomer generation's rampant buying of investment properties to fund their retirement. But with the Baby Boomers soon to enter retirement, it follows that their appetite for investment properties will shrink, thereby removing one of the key demand-drivers of house price growth in Australia. Further, because higher investment yields can currently be earned by placing their funds in bank term deposits and fixed interest than can be earned via rent, it is likely that many Baby Boomers will sell their property investments to fund their retirements. This process of property divestment is likely to accelerate once they realise that there is little prospect of continued high capital appreciation.

The bottom line is that the downside risks to Australian house prices far outweigh the potential upside. Housing is simply the wrong asset, at the wrong price, at the wrong time.