What Does a Bubble Look Like? / by Adam Howard

Last Update looked at the Australian property market and how it's value had changed over a long period, and whether there was a longer term trend that might point to where the property market is headed.

I actually had an old mate, one whom I have spoken about in other Updates, The Developer, ask me what I thought could be expected from the Perth property market over the coming years.

My response?

Sideways movement.  No drastic upwards or downwards movements for the foreseeable future.  And when a gentle upward movement in CPI (inflation) is factored in I guess this equates to property prices gradually dropping.

Think about this way.  When my old man was at the top of the tree in WA for CommBank in the early 1990's his package was about $75k pa and our house in Nedlands was worth about $300k.

Let's say that was 1994, or 21 years ago.

Now, a State General Manager for one of the Big Four is on about $250k - $300k pa, and a quarter acre block in Nedlands is worth about $1.7m.

So, using that job as a proxy for the whole economy (big leap, I know, but just follow me here), wages have increased by around a factor of 4 times in 21 years, and property values have increased by around a factor of 5 or 6.

Summary?  Wages need to catch up, or asset values need to slow down for a bit.  My money is on property slowing down a bit.

Last Update we also looked at how a bubble manifests itself and why it might burst, and whether one exists in Australia’s property market at the moment.

The summary was, yes, some parts of the property market are overvalued, but calling the entire market a bubble, or discussing any potential correction as a looming bloodbath is somewhat extreme.

This is a really topical issue now as, following over 6 months of talk, the RBA and APRA (the Australian Prudential Regulation Authority, the banking regulator), have been able to persuade the banks to introduce some “macro prudential” measures to try to keep a lid on the amount of investor loans being provided.

As I noted last Update, Glenn Stevens our RBA Guvna, even called what was happening in the Sydney property market “crazy”, which was very strong wording for a conservative banker.

And that leads me onto my first point: the national market, particularly in Australia, is the aggregation of a number of geographically distant markets; and that each State market is, once again, the aggregation of a further number of geographically distant markets.

Each of these sub-markets are largely independent, with prices moving in response to preferences and decisions made mostly by the local residents.

So, when talking about the property market it is important to define which market is being discussed.

We will talk more about the factors that impact these decisions later and how various sub-markets are performing later.

First, back to the macro prudential tools being used. 

Over the past month all the banks have introduced firm rules around the following:

1.       Higher interest rates for investment loans, compared to owner occupied home loans (a difference now of between 0.30% and 0.60%);

2.       Maximum Loan to Value Ratios (LVRs) of 70% for high risk areas (such as mining towns);

3.       Refusal to provide or approve Lenders Mortgage Insurance (LMI) for investment loans; and

4.       Point 3 means investment loans essentially have to be at 80% LVR or lower.

This means that if you are going to take out an investment loan at the moment you need to have more cash, or equity in an existing property, than previously; you need to be investing in areas with strong fundamentals, and you need to be prepared and able to pay more for your debt.

Firstly, how much more will you be asked to pay?

Well, the lowest rate you could obtain for a home loan of $500k at the moment might be as low as 4.18% variable.  Maybe even lower if you wanted to go with a bank that only exists in the internet (seriously, they exist).

But if you wanted to borrow the same amount to buy an investment property, the lowest rate might be 4.60% or even higher.

In the field of behavioural economics, the above measures are what is called a “nudge”.  These new rules won’t stop many people from taking out investment loans for the following reasons:

-          The impact of a rate increase of 0.60% on a monthly basis for a new investment loan of $500k is actually only $250.   It doesn’t break the bank;

-          Investment in high risk areas has been declining for a while;

-          The majority of investors don’t use LMI as they have sufficient equity to keep their overall LVR at or below 80%.

The nudge is meant more to psychologically discourage people from investing…and it’ll work.

From a lender’s perspective it makes things a bit harder, which is painful, but from an economist’s perspective it is encouraging as it is a good step in diffusing the risk of a bubble forming and bursting.

To explain what I mean I want to briefly talk about what happened in the US in the lead up to the 2007 property crash, which caused the GFC.

The property boom that occurred in the US had its genesis in the early 1990s when the US central bank, the Fed, began lowering their equivalent of the cash rate.  This was a trend that was continued post 2000 and exacerbated by the need to drop rates further following the dotcom bust of 2001.

It was made potentially more severe by the fact US tax laws allow the interest on owner occupied home loans to be used as a tax deduction.  Not only investment loans….but your own home loan.  That provided an incentive to max out your home loan.

The George Dubya Bush administration then proceeded to butcher the economy for years to come by cutting taxes (reducing government revenue) while running an increasing government fiscal deficit due to vastly expanded military spending (increasing government spending).  The Administration’s primary tool used to try to boost domestic consumption was to encourage looser lending policies by mortgage brokers (such as Countrywide), in a bid to stimulate economic growth.

At the same time, funds were stripped areas that are recognised as providing long term economic stimuli such as education and health care.

The result was flat GDP growth, a flow of capital out of the US and a widening of the income and wealth gap, but the looser lending policies noted above hid this widening gap, as people could borrow and use equity in their properties as an ATM, topping up their incomes to fund a lifestyle.

Then the buyers for property dried up.  No more investors could be found.  Real wages were dropping so servicing that debt became harder and harder. 

Another feature of a lot of the loans written to those who genuinely could not afford them was a resetting of the interest rate after an initial intro rate, with the rate sometimes jumping upwards by as much as 5%.

Then the defaults started….and kept on coming.

The bust was made potentially worse by home lending being on a “non-recourse” basis.  This means that in the event of a default, a lender can only reclaim the house itself by exercising its mortgage.  There is no ability to pursue the borrower and seize any other personal assets, making the disincentives in defaulting a lot weaker.

Hence the stories about distressed borrowers simply handing the keys to their house into the bank.

This meant banks ended up owning a lot of property, and needing to sell it quickly…and in case you hadn’t noticed, property is not an especially liquid asset.

In summary, the property boom and bust was a result of low interest rates over a long period, tax policies that provided significant incentive to maximise your owner occupied home loan debt, the presence of non-recourse lending and a government supporting a loosening of lending standards.

So, tightening lending policies in Australia to try to keep a lid on the “hot money” flying around is a good thing.

Other reasons why a massive bust in Australia is less likely are:

-          our banks also have the ability to pursue borrowers in the event of a default and a shortfall; meaning there are serious disincentives for borrowers to default;

-          the RBA is more independent than the US Fed, and doesn’t respond to government pressure to lift or lower rates;

-          we have a strong prudential regulator in APRA, with responsible lending practices policed far more strictly now than in the past; and

-          only interest on investment loans is tax deductible.

That said, here are some stats that will shed some light on the concerns APRA and the RBA have about the property market in NSW and Victoria.

70% or thereabouts of Australian households own the home they live in.  By extension, that means 30% of households rent, meaning they have a landlord, who is by definition, an investor.

So, the split in loan types held by all banks is about 70% owner occupied home loans, and 30% investment loans.

At the moment, of all the new loans written in NSW and Victoria over the past 12 months, between 55% and 65% have been for investors.

That’s a fair way above the average proportion of 30%....hence the steps taken to quell investor enthusiasm.

All the major banks and their subsidiaries have employed some or all of the above steps.  AMP has even stopped offering investment loans at all!!

So, enough of regulators and banks.  What about those micro markets and the factors that impact them.

I have been reading a pretty interesting book lately.  Triumph of the City, written by Ed Glaeser, a Harvard Economist, tracks the role of cities as the dominant form of human organisation over the past 3 millennia.

I won’t wax lyrical about it in detail; I’ll just attach a link to Amazon below.

Now, this book isn’t about the property market, and how to make a killing.  On the contrary, Glaeser is interested in steps to keep housing affordable and to make modern living as pleasant and vibrant as possible.

A couple of interesting points in the book though are that demand for housing will remain high in cities that share the following characteristics:

-          hot summers and mild winters, rather than mild summers and cold winters;

-          a benign political environment;

-          good social services (education and health); and

-          the opportunity for the poorer to attain proximity to opportunities to attain greater income and wealth.

I have also been going over Niall Ferguson’s The Ascent of Money again lately and it’s been useful to read the two together as it sheds some light on how bubbles occur.

So, the factors noted above that fed into the US bubble, need to be present to a certain extent.  They are:

-          government policies that encourage property ownership; and

-          tax policies that encourage leveraged speculation.


-          an already wealthy or developed economy; and

-          Unusually improved or at least materially different economic conditions.

If you want to look at genuine bubbles, such as the Las Vegas or Detroit property markets from 1990 to 2007, it helps if the improved economic conditions are happening everywhere else, except where you are (Detroit), or the improvements are short term and unsustainable (Las Vegas).

Detroit’s primary industry, the motor vehicle industry, has been in decline for 30 years, and Detroit’s population has been declining for longer, but property prices still spiked over a 15 year period, due to the factors noted above.

Combine those factors with a population wide belief that property prices always go up, and you have a speculators wet dream.

Until regular folk realised a few things:

-          Economic conditions were poor and local unemployment was high, meaning few buyers and few potential tenants;

-          Real wages were dropping and it was becoming harder to service debt;

-          Detroit is generally an unpleasant place, with brutally cold winters.

Las Vegas’ experience is different in that for a 10 year period the gambling industry was growing as regular folk used their equity to fund lifestyles, which included gambling.  This attracted people to Vegas to work in the casinos and supporting industries.

Nevada also has very relaxed property development rules, meaning it was cheap, easy and fast to buy big chunks of desert, chop it up and sell it to waitresses, croupiers, bartenders, et cetera.

The good times kept on rolling, until consumers ran out of disposable income….and the first disposable income to get the chop is putting it all on RED 23.

Once again, people realised they couldn’t afford the high rents and/or mortgage payments and decided to leave Vegas.

So, what about Perth, right?  I mean, that’s what we want to know.  What’s happening in Perth and is our market going to tank too?

And what is “tanking?”

Well, back to the idea of micro markets, first.  Western Australia is a big place, and there are different regions; the metro area, the South West, the Goldfields, the North West, the Great Southern.

First, let’s look at short term, unsustainable improvements in economic conditions; the North West.

In 2010 a 4 bed, 2 bath house in Karratha was costing between $800k and $1 mill, and was being rented for between $2,000 and $3,000 per week.  Sound reasonable?  Didn’t think so.  Not when it costs less than $1,000 per week to rent a beautiful family home in Mount Lawley.

A short term spike in demand, with no realistic prospects of increasing supply to balance that, flowing from massive construction projects drew investors and developers like moths to the flame.

This was despite most commentators saying this was a short term phenomenon.

The same spike occurred in Port Hedland, Derby, Onslow and Broome.


Port Hedland is down 25% on 2012 valuations.  So is Karratha.

So, that’s a bust.

The South West?  Just for convenience sake, let’s include Mandurah in the mix with the South West.

The surge in prices in that market occurred earlier, in the lead up to the GFC.  It was a different market that surged there, with high end luxury houses near the waterfront being the flavour of the day.

Eagle Bay is a good example, with buyers picking up luxury properties in 2010 onwards for around 70% of their pre-2009 sale prices.

Mandurah was a similar story, with luxury, canal-side houses being valued at between 66% and 80% of their pre-2009 prices.

What causes these busts?

A sample of purchases at the top of the market (often overshooting the top of the market) by buyers with extraordinarily high (probably better to say artificially high) earnings, limited cash and very high debt.

A buyer you would describe as being highly exposed if any market factors were to shift against them.  And when they did, a lot of luxury properties hit the market and were sold for low prices.

But, those markets are much more speculative than the metro area…so what about there?

The most recent data shows the metro area has dropped in value by about 7% this calendar year.  It is a very flat market.  Not a bust yet, but close.

At this point it is probably a good idea to talk about market fundamentals, as this will make everyone feel a little more comfortable.

Perth is a nice place.  Warm summers and winters.  Easy to get around.  Stable politics.  Good health and education systems.  And until a few years ago, very affordable housing.

Economically, Western Australia is highly focussed on the resource sector, which is a risk, but the resource sector comprises a number of different industries such as oil and gas, iron ore, gold, nickel, copper and more.

It is more diverse than is commonly made out.

Despite this concentration the State also exports tourism, education and health services.  Not subject to the same spikes as the resource sector, but in more consistent demand from the middle class of Asia.

The cyclical nature of the resource sector is best illustrated by looking at employment:  Of the roughly 85,000 FIFO workers employed in 2011/2012, 25,000 have now lost their jobs.

Despite this, if you were looking for a place to live Western Australia would be attractive.  Nice place.  Good opportunities.  Strong fundamentals. 

And that’s where the key driver for the State’s growth and maintenance of property values come from:  net population growth, primarily from overseas.  The people of the Indian rim and South East Asia look at Western Australia and find it attractive; attractive enough to pick up the whole, extended family and move here.

I have spoken about this before, that from 2011 to 2013 the State’s population grew quickly, and the bulk of this growth was immigration from overseas.

So, that’s the State.

What about your house?  There are always reports in the paper about what your suburb has done over the past 12 months, and you can visit the Real Estate Institute of Western Australia’s website, link attached below, and see for yourself what your suburb has done.

But what about your house?

Well, what are the fundamentals?  Let’s use economics and finance terms. There is a flight to quality happening right now, caused by a demand and supply imbalance, resulting in softening prices.

Buyers are unwilling and sellers are desperate and buyers are willing to be patient, find the right asset and walk away if the asset they want is not on offer.

Firstly, on a citywide basis, is it close to the big ticket items people value?  In order, they are the city, the beach and then the river.

On a suburb by suburb basis, does it have access to good quality schools, universities, and high street shopping areas?

On a property-specific basis, is it on a busy or quiet street?  Is it the front or rear house, if the block has been subdivided?  Does it look nice from the road?

The fewer of these boxes that can be ticked, the more speculative the value of your house may be, making it more exposed to market movements.

Food for thought….