How can investors cope with a property bubble? Q&A with Philip Soos
There are few topics that cause as much debate among property pundits and housing economists as Australia’s potential property bubble.
It’s a divisive topic. Those who say that we are experiencing a housing bubble are often labelled scaremongers, while those who consistently deny the presence of a bubble are accused of spruiking.
Philip Soos is an economist and post graduate candidate at Deakin University. He has recently co-authored Bubble Economics: Australian Land Speculation 1830-2013 with Paul D Egan.
Property Observer asked Soos to explain past bubbles in Australia’s economy and how Australian investors can cope with a potential bubble.
What is your new book about?
The book provides a conclusive answer to the debate that has been raging in Australia for the last decade – is there a bubble in the housing market? Paul D. Egan and I used a fairly conventional approach to investigate this possibility.
We examined the work of the small number of economists who identified the US housing bubble and predicted the GFC, analysed past real estate bubbles in Australia’s history going back to the 1830s, and used a paper published by the RBA in 1999 (Two Depressions, One Banking Collapse) as a template for the book.
What we found is that Australia’s history is littered with real estate bubbles (really, land market bubbles) that later collapsed, pummelling the banking and financial system and repeatedly sending the economy into recession or depression. The stock market has often bubbled over as well, but the effects weren’t nearly as bad.
What is the difference between a bubble and a normal business cycle peak?
Every capitalist economy experiences fluctuations or business cycles, especially given its dynamic and chaotic nature. Business cycles are driven by a number of factors, particularly rapid industrialisation and urbanisation, mining and manufacturing booms, and the rise and fall of speculative asset bubbles. The former are typically based on fundamental movements in the domestic and world economy, but the latter is caused by irrational exuberance.
Due to the reasons mentioned below, mainstream economists pay little attention to the cycles in stock and land markets. If they did, they would notice that many business cycles throughout history have been strongly influenced by real estate booms, financed by private debts the banking and financial system extends to speculators. Controlling the regular pattern of asset bubbles would considerably tame the business cycle.
What are some big bubbles Australia's property market has seen?
The first land market bubble occurred during the 1830s. Speculators purchased enormous amounts of government-owned land, holding them in the hopes that prices would always rise. But fall they did, resulting in Australia’s first depression in the early 1840s, which the economy promptly recovered from.
The second bubble was insane, developing during the 1880s. Bank and non-bank lenders provided credit to everyone who wanted it, underpinning a period of mass speculative fervour, primarily in commercial CBD real estate. There were reports of Melbournian city blocks doubling in price within the space of several months in 1887. The bubble collapsed in the early 1890s, resulting in the worst depression on record, relatively worse than the ‘Great Depression’ of the 1930s.
The next bubble formed during the 1920s, though this was muted compared to the two previous bubbles. Banks were more cautious and adopted prudent lending standards which ended up saving them during the depression. The movement in real estate prices were smaller relative to the previous land market cycle. The banks favoured lending to the business sector rather than households during these three bubbles.
The mid-1970s saw a commercial bubble, feeding into a smaller residential bubble which peaked in 1974. Both were financed by a sharp rise in lending by the banking and financial sector and eventually burst, bringing about a recession. The high rate of inflation and wage growth did, however, help to mitigate the large private sector debt burden.
During the late 1980s, another commercial bubble developed, centred in Melbourne, Sydney and Perth. After peaking in 1989, commercial real estate prices collapsed by 60% through to 1993, a thorough blood-letting. This produced the early 1990s recession and, to date, Australia has escaped a further recession.
The latest, and easily the largest, land market bubble in post-WW2 history began in 2001. This time around, the commercial property market is playing a backseat role, with the housing market severely overpriced by a range of fundamental indictors, indicating severe trouble will occur when it collapses. The illiquid, over-leveraged, under-capitalised, highly concentrated, foreign-funds addicted, and heavily over-compensated banking and financial sector is eerily reminiscent to that of the 1880s.
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Are any markets in Australia currently in a housing bubble?
All capital city housing markets have experienced a surge in prices since the mid-1990s, with Melbourne posting the largest gain between the low in 1996 and apparent peak in 2010. Perth has also boomed, with prices doubling in a couple of years after 2004, peaking in the March quarter of 2007.
According to our preferred measures of a housing bubble - rising real (inflation-adjusted) prices, accelerating mortgage debt and aggregate net rental income losses - all capital city markets are in the bubble zone, though some are larger than others. Darwin has the highest yields, so it appears to have the smallest bubble.
What is the relationship between purchasing for capital gains and housing bubbles?
The crazy race for capital gains (paper gains or phantom wealth) is the cause of the bubble. Property investors accumulate huge debts to speculate on the future movements of housing prices, expecting continual rises. Fundamental metrics like household incomes, rents and yields are dismissed, as rapidly rising prices become the new norm.
To protect themselves from a crash, should investors be seeking rental returns rather than purely capital growth?
Yes! The fundamental value of a property is based on the income it produces, not what prices could be next year or the year after. Gross yields were around 7% during the mid-1990s, falling to 4% today. Those who have focused on positive cash flows rather than capital gain will come out ahead.
Housing prices can only rise so far given the staggering burden of household debts, currently around 110% of GDP as of 2013. This is a historical high and aligns with other nations having experienced a bubble: Ireland, Denmark and the Netherlands. Unfortunately, 67% of investors are negatively-geared as of 2012, up from 51% in 1994, indicating they are focused on capital gains, not rental income.
Why do you believe economists "get it wrong" when it comes to bubbles?
There are two primary reasons why the economics profession as a whole always fail to identify real estate bubbles and predict the subsequent economic downturns.
The first is the theory taught and practised is a pseudo-science (neoclassical economics). It imagines a world where people can see into the infinite future, know all information and always make rational decisions. Furthermore, banks, debt and time do not play any role in these models. Economists assume housing and land markets operate efficiently by definition; therefore bubbles can’t exist by this logic. It’s a religious-like belief, but with very dangerous consequences, especially for middle and low-income earners.
The second reason is due to vested and conflicts of interest. It is almost impossible to gain the honest opinion of an economist, researcher or analyst into matters of real estate and banking. Economists, particularly those in senior and executive roles within government and industry, are unwilling to jeopardise their incomes and privileged status by pointing out the obvious. If they did, they would be kicked to the curb by their employers by the end of the day.
It’s also the reason why our book has been suppressed by the mainstream media, echoing the experience of other published authors who have come to the same conclusion, such as Australian businessman Lindsay David (Australia: Boom to Bust). Our two books have a combined 1,000 plus pages of the most in-depth research on real estate, banking and mining available, but no mainstream journalist or reporter will review or cover them. This is to be expected, however, given the irrationality of the times we live in.