Property, Bubbles, and Reform

I've recently given some thought to buying property. It's not that I enjoy giving up my Saturday’s to attend open home after open home, or that I like the fleeting sales pitch of the man or woman in a pin-striped suit. It’s more to do with the fact that at present if you’re not part of the race to buy, then you're part of the battle to rent - another less than impressive game. 

Over the last several years many have pushed the view that property in Australia (specifically the major capitals) is overvalued. Some have described it as an 'asset bubble,' which if true, and it were to pop would have serious ramifications for investors and society in general. The answer to whether property is in a bubble state is a complex one but I think I can form somewhat of a rational argument in agreeance of this position.

Bubbles can be defined in a number of ways. To me a bubble is a reflection of prices that have departed from fair value - and by quite some way. How we define fair value is somewhat complex because property is both an investment vehicle and an asset that we derive some kind of personal and less quantifiable benefit. If we deal with the former first, as an investment vehicle, property at current market yields is not at present a strong performer in the average investment portfolio. In large, this is due to rising property prices and negligent movements in rents. Some would suggest my argument is flawed because I am not considering where rents will be in five years from now, or future capital appreciation but these are not guaranteed even though those in property would like to think so. Some will also say that I have not considered the tax benefits. Fair enough, but these are not as large as some make it out to be. Any reasonable investment analysis should also consider risk. There is a generation of property investors that think property has negligible risk. How have they arrived at this conclusion? Well property has always gone up. So the only risk is on the upside – or put more simply, the chance that you miss out on owning a property which will be worth more, later. This is delusional economics. Property like any investment entails risk. That property prices have trended upwards for the last 25 years is amazing feat but hides an ugly truth that may blindside those that don't know their limits.   

The personal decision to own property also yields some kind of value. Whether it is the value derived from a plot of land, having a backyard, or being situated near your favourite cafe, all these factors and many more add to the value proposition. But to me, like many others the ownership proposition has overstepped its bounds such that the happiness or welfare we may derive from the decision is overshadowed by the burden of future payments. It may not be at breaking point but it would be silly to ignore this rapidly moving marker. Let me put this another way. You pay to watch your favourite football club turn up every week and you accept a rise in ticket prices because you rationalise that the enjoyment that you derive is worth the cost. If ticket prices rise beyond what you consider a fair price, then you are left with two choices: pay over the odds for this enjoyment or seek alternative means of viewing this game. In property, it would be hard to argue that the balance between eudemonia and the financial burden is not skewed in one direction. Whether you point to the high levels of mortgage stress, or the record low first-time home buyers in the market, it is not that we are valuing the personal joys of property ownership less, rather those joys are being dwarfed by a market that knows no rules.

But we've only addressed part of the question as to whether or not this is a bubble state. It’s not just that values have departed from fair value, because if it’s just temporary, then one could argue that its noise or just a minor aberration. In this country, we've done our very best to inflate property prices and there are three culprits. The first is negative gearing, the second foreign direct investment, and the third SMSF's. Forget the undersupply of property units or the insatiable demand that is being shouted from the roof top. These are mere fodder designed to divert attention away from the problems with the system that we have.

Negative gearing was introduced in the mid-1980s when Australia opened up its borders to the world and greater domestic investment was required. It represented good policy at the time, but in the 30 years since, it has become an economic distortion of epic proportions. With low interest rates and excessive leverage, investment in somewhat of an unproductive asset has been rewarded way beyond the basic principles of risk and return. While I am not suggesting that negative gearing should be removed, a failure by governments to even give some consideration to the structure of such a policy that has encouraged people to borrow way over their head is not good governing.

Number two on my list is foreign direct investment. Again, hear me out before coming to your own conclusion. I don't believe that foreign direct investment is bad. It is part of the world that we live in and can have many great outcomes. However, like all good things, there is a point in the schedule where the benefits pale in comparison to the costs. Some of the overseas investments into the Australian market fit this description. When property is being bought by international investors, and where there is no intention to occupy the property, it must be asked how can this be good for anyone? Again, I'm not suggesting that radical action is required but sitting idly on our hands is not an option either.

The final culprits are the self-managed super funds which have really taken to property in recent times. Whether it is because of the rude shock of the stock market in 2008 which exposed people to the risks of investing in shares, or the allure of the capital gains in property in recent times, or just the preferential tax rate on these capital gains, SMSF property purchases are seen as a good addition to the portfolio. Whether they are or not is a difficult question because it depends on the size of future capital gains, future tax levels, and a list of assumptions as long as my arm. For those that argue it provides them with diversification - well if you think property will diversify portfolio then look to the U.S. and most places around the world over the last few years. Once again, SMSF's should not be ruled out from buying property but the approach needs to be measured and that is the message here. Unless we put all our cards on the table, at some point in the future (and not in the distant one either) we may be exposed to a monumental correction. What will ignite this correction is an argument for another day but what is certain is that even with these artificial props (my three culprits) that we have created to spur the market, we are not safe.

As I lose out on another auction, to a buyer that has gone approximately 20% above the reserve, I am warmed by the recent words of the effervescent Charlie Munger - "If you stay rational yourself...the stupidity of the world helps you".