Thursday, April 25, 2013

Timing the residential property cycle

One interpretation of recent data is that investors seem happy to jump back into Australian residential property markets. Perhaps due to a search for yield. Perhaps from foreign cash seeking a safe harbour. Or perhaps it’s simply time for the Aussie love affair to be rekindled. Holes are over. It’s houses turn.

With these winds of change in the air maybe it is time to take a step back and look at the long term property cycle itself.

Property industry types talk about the cycle like a mythical being - unless you have witnessed it yourself you won’t know how aggressive the beast can be to your leveraged finances.

Long term regularity of asset price cycles is an intriguing proposition. Is the 18 year cycle really a good rule of thumb? If so, why don’t investors expect the cycle, and remove it through their anticipatory actions?

A simple answer might be that investors would anticipate the cycle if credit markets would allow it. But the banks supplying credit are themselves constrained by previous movements of the market. Thus the interaction of prices and the willingness to supply credit seems to be pretty decent explanation of the peculiar regularity of long term cycles. Thanks Minksy.

One way to think about the nature of the cycle is in terms of returns from yield compared to capital growth. At the bottom of the cycle equities, including property, are seen as risky places to preserve capital. During the boom expectations of capital growth return, and equities become the assets to hold.

If this truly reflects some fundamental emergent dynamic in the economy, a simple rule of thumb is to buy the high yields at the bottom of the cycle, and sell capital gains at the top.

But how do we know when yields are high? We need a relative measure rather than an absolute measure.

In the past I have used the mortgage rate divided by gross yield as a measure of the relative value of residential property. The theoretical picture is the the mortgage rate is a good proxy for the yields, net of capital growth, available in the economic generally. Gains above this rate typically arise from capital gains.

When the gross yield is close to the mortgage rate, theory says that the price is reflecting an expectation of low capital gains. But that would be wrong, given that it is the same theory predicts and equilibrium asset price.

In reality this would be a good time to buy.

The theoretical explanation is that these low growth expectations arise from recent experience of low growth - the same feedback that feeds the cycle upswing when high prices feed into expectation. If markets are myopic, you can forget about finding anything useful about expectations in the prices themselves.

So where’s my evidence for this? The graph below is an update from a previous post. With recent rental growth, price falls, and falling interest rates, this simple measure is showing that now is a good time to buy.

I have also created a second measure - the mortgage payment per dollar of a 30 year loan divided by the yield. The second measure adjusts for the fact that the cost of buying asset, in addition to the cost of interest, is a higher portion of the total cost at lower interest rates.

What is more surprising is the regularity of a head and shoulders-type pattern - similar tops and bottoms, and a similar period to the cycle, in this case 15 years. Not too far from the 18 year rule of thumb. And not too far off the stylised asset price cycle seen so regularly when discussing the latest housing boom

Given this regularity, and the strong buy signal, my internal model of the market suggests two possible future paths.

1. Renewed cycle

A great time to buy in most capital cities was around 1998. This year preceded a boom in Sydney, that cascaded across the country for the next 8 years. My chart shows the cycle at around 15 years, meaning this year is a good time to buy. The 18 year rule of thumb is then 2016 - just three years time.

Given the expected resources shock in the second half of this year and early next, I would not be in a rush. Also it may be wise to get better signals about the direction of international markets, particularly the US before leveraging into Australian housing.

I expect to be on the lookout for well located land in about two years time unless I get strong signals that the second path is playing out.

2. Stagnation

Given the weight of private debt, the already low interest rates across most of the developed economies, and a general reluctance for increased public spending to maintain employment and stimulate private investment, could we be heading to a long credit-constrained stagnation that requires major price adjustments in wages, rents, and currencies.

I have no good reason to believe one way or another. Political outcomes in Europe, China and Japan will be critical, as will our domestic adjustment following the mining investment peak.

My gut says that the fundamentals of continued current account deficits, which reflect inflow of foreign asset demand, and scope for much lower mortgage rates will probably allow for another cycle to ramp up by 2017.

I don’t expect it to be as severe as the last cycle for a few reasons.

  • Inflation will be low unless the AUD falls significantly. Thus real gains could be high without such dramatic nominal gains.
  • Mortgage rates still have scope to fall to around 4% in the next two years.
  • But I expect the memory of the financial crisis and a stricter regulatory environment will mean tighter bank lending
  • The demographic shift of baby boomers seeking to get out of negatively geared residential property will dampen capital gains

If most investors are myopic, those who consider the long term will have an advantage in any market. And what we have seen here is that we seem to be in a relatively attractive period for buying residential property assets. Just remember to consider all the other macro and political factors in your own assessment of the market.


  1. Good advice and wise caveats Cameron.

  2. Great article, found a link to this from Australian Property Forum. Nice to see some balance Cameron. Much better than the typical doom & gloom 'housing bubble' nonsense peddled at the likes of Macrobusiness.

  3. Hello Cameron,

    Is it true you've been censored by MacroBusiness and David Llewellyn-Smith hates your articles because last year he predicted Australian house prices would decline for the next decade? Refer to link below.

    Cameron Murray (Rumplestatskin from MacroBusiness) turns Property Bull

    Thanks for your clarification,

    Oswald Peckinsnout.

  4. Standard variable rates are going to fall to 2.5%? Fixed rates to around 1%?

    Then what?

  5. There are few of the clear examples for what has been discussed yet. Increasing land rates in major cities of India provide a proof in support to this discussion. Let’s have an example of residential properties in Greater Noida and Noida. Few decades ago, most of the land in Greater Noida and Noida was just a land in rural areas that does not have much prices. But, in present context it is one of most costly areas in the country. This can be easily experienced by those home buyers that are looking for a flat in an apartment in Noida or Greater Noida.

  6. Anonymous,

    Yep, mortgage interest rates will come down. Your examples are a bit extreme, but are similar to the rate offered in Switzerland right now. My guess is that over the next two years mortgage interest rates of around 5.0% will be normal, with some better deals at 4 point something.

    Then what?

    Then we have another construction cycle, prices rising faster than wages, lots of new housing investment (relative to population). Probably a much milder cycles all in all given the factors I mention in the post.

    Of course the alternative is a long stagnation, Japan style. Why don't I think this will happen?

    1. Plenty of monetary policy ammunition
    2. Political intentions to start a new boom
    3. Global currency wars being played out. Yet Australia sits on the sideline allowing the currency to appreciate. This is terrible for industrial development, but it allows us to binge on more foreign credit which is seeking out our currency to devalue their own currency.
    4. Lack of fear of debt given how easily Australia escaped the financial crisis.

    What are your predictions?

  7. Hi Cameron, Lef-tee here (I was racing to get out the front door so I just clicked "anonymous") Well I agree that mortgage rates are very likely to keep coming down. What I'm uncertain of is just how much further it's realistically possible for them to fall. I've heard the argument that for Australia, effective ZIRP is somewhere between 2%-2.5% offical cash rate - we'll probably fall into that zone by the end of this year. While I understand that there is currently a bigger spread between the cash rate and average mortgage rates now than there was the last time the cash rate was where it is today, what I really want to know is: just how much cheaper is it realistically possible for mortgage credit to get in Australia?

    It's important to know the answer because making an informed guess as to what housing is likely to do in the future relies on knowing how cheap it's possible for credit to get for one thing. Once we get to the point where it can't be made any cheaper, activity must rely on more government grants, innovative loan products and the equity of those who already own property.

    I used to think that the market could not run for very long without first-time buyers but I have changed my mind - I think it's possible for it to go on for a quite a while fuelled by upgraders upgrading and investors buying from them and from each other. Rising prices create rising equity, which creates the ability for those who already own property to pay more, which feeds back into rising prices in an upward spiral. As long as someone stands willing and able to finance this process, why can't it continue for an extended period?

    My concern is for the next generation coming along. As a roughly average earning household with a house valued at around the national median, mortage payments are easily affordable, given that we purchased 13 years ago. However, if we were to buy the exact same house again from scratch, without the equity we now posess but still with the income we now earn, repayments would nonetheless be a pretty serious financial burden, even at todays low interest rates. While typical first time buyers may not purchase a median-priced house, the whole idea of the very popular practice of property investment is to buy low and sell for as high as possible, so in the longer term their activity tends to turn more affordable property into less affordable property (for the the newbies).

    My predictions for the future will depend for one thing upon how cheap it's possible for mortgage credit to get. At the moment, I tend to think that we will probably see the market driven increasingly by investor activity while first-timers become ever more marginalised by housing costs that are increasingly beyond their financial means. Removal of government incentives has already seen them drop to a little over 3% of the market in those states. I think we will see them turn increasingly to renting and also to purchasing in the unit market. Of course, should there be a large surge of FHBer activity in units, I would expect investors to begin pouring into that arena as well (they already own around 60% apparently) and inflate the cost of those as well.

    I think that we are at significant risk of regressing to a situation whereby many of the coming generations homes will be owned by a rentier class. However, I understand that many people are not troubled by this.

    Perhaps the old practice of people living together as large, extended families under the one roof will become the norm once again?

  8. "Yep, mortgage interest rates will come down. Your examples are a bit extreme, but are similar to the rate offered in Switzerland right now. My guess is that over the next two years mortgage interest rates of around 5.0% will be normal, with some better deals at 4 point something."

    Sorry Cameron - thought you said they had scope to come down BY 4%. I see now that you said they have scope to come down TO 4%.

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