Morgan Stanley’s Gerard Minack has diversified from being bearish about US equities into calling Australian housing a dud investment, a bubble, albeit one that just might steadily deflate rather than dramatically pop.  

It’s two months since Reserve Bank deputy governor Ric Battellino delivered a myth-busting speech that included an effective defence of the Australian housing market and the sustainability of the present level of household debt. Minack’s latest newsletter to clients seems to take direct aim at that Battellino speech, but doesn’t go as far as
Sydney academic Steve Keen’s Doomsday forecasting.

Minack produces plenty of evidence that Australian housing is expensive on any number of counts – and there’s no news in that for anyone looking for a home in the capital cities. That process of becoming expensive made housing a rewarding investment over the past decade, but Minack thinks being expensive will make it a poor performer in the years ahead – if we’re fortunate.

The Morgan Stanley economist says there are two potential pins that might pop the bubble. The first is Keen’s dire prediction of large-scale job losses, but Minack doesn’t think that’s likely in the foreseeable future. The second though is that the nation’s landlord class might realise en mass that they’re losing money and bail out.

Minack notes that bubbles more often pop than subside, but sometimes the less dramatic path is followed.

”Sydney, for example, has seen two periods – from late 1980s and from 2004 – where inflation-adjusted house prices were flat or declined,” he writes. And we’ve had a previous look at just that phenomenon of how an Aussie housing bubble deflates.

”This is a best-case outcome. Even so, it would make for a very unusual domestic cycle. Homeowners and investors are banking on steady increase in house prices. Flat or moderately declining nominal prices would presumably affect confidence and spending. Banks have relied on mortgage lending as their bread-and-butter. Growth will be structurally lower.

”Moreover, this underscores an obvious point: while we can debate the macro risks surrounding housing, it is likely to be a very poor investment given current valuations. House prices can – indeed, often do – show no growth in real terms for a very long period. To take an extreme example, real house prices in Melbourne did not surpass their 1891 peak until 2001. Buying a bubble is an extremely bad investment. I expect that the real returns on residential investment will be negative over the next decade.”

RBA’s early move

Minack reckons the RBA appreciates the risk of our housing bubble and that capping house prices was a key aim of RBA policy tightening earlier this year.

”Better to slowly deflate a bubble than to see it pop. If Australia could achieve a cycle where house prices are steady or see moderate nominal declines, while growing incomes at a trend 6 per cent growth rate, it could reduce the over-valuation and financial risks associated with excess debt,” Minack writes.

While appearing to welcome that policy aim, Minack says it was a major error by policy makers to let this bubble inflate in the first place.

”There is no value to society from rising house prices. It is simply a wealth transfer to existing owners from potential buyers. Pumping up house prices creates no more wealth than the RBA printing an extra six zeros on every piece of currency.

”’Worse, by increasing the leverage in the household sector and financial system, it increases the financial risks in the economy, as the last two years have demonstrated elsewhere. In short, there seems a strong case for policy-makers to aim to cap house prices.”

What Minack isn’t sure about is whether the large number of negative-carry property investors could create selling pressure if nominal house prices are flat for an extended period.

Hanging on

I’d argue that the Australian experience is that residential real estate owners, both owner occupiers and the landlord class, tend to hang on grimly as long as they can service the debt (i.e. unemployment remains relatively low) rather than facing up to the on-going financial drain. What Minack does, though, is debunk the real estate spruikers’ claim that “you can’t go wrong with bricks’n'mortar

”Australian Tax Office data confirm that residential investment is a poor investment: total rent has not covered total costs since FY2000 (the date the bubble started to inflate). In short, this is an investment that depends on capital gain for its payback.

”With net income not even covering interest charges, this is a classic Hyman Minsky Ponzi scheme. Ponzi owns the house, and he’s betting that house prices keep rising.

”Not only is the aggregate private rental market a loss-making affair, but a rising share of landlords are making rental losses. The percentage of landlords claiming a rental loss (that is, rent not covering interest and other costs) has increased from 50 per cent to 70 per cent over the past decade. It’s not just that there are more landlords, there are more loss-making landlords.

”This matters a lot. Much of the discussion on the residential market concentrates on owner-occupiers. But arguably property investors represent a significantly larger risk if they became widespread sellers of their loss-making investments.”

Middle-class exposure

A key part of the Battellino defence of household debt sustainability was simply that it tends to be the wealthy who have borrowed the most and therefore they can afford it, but that’s not the case when it comes to residential landlords, claims Minack.

”Certainly property investment is more prevalent at higher income scales. But it is simply wrong to assert that rental properties are largely owned by high-income households: losing on residential property investment is largely a middle-class affair.

”Only 3 per cent of all loss-making properties are owned by taxpayers with a taxable income of over $200,000. Taxpayers who earn $80,000 or less own 80 per cent of all loss-making properties.”

And there are a lot of residential property investors.

”Australia has become a nation of landlords: in 1988-89, 608,000 taxpayers reported rental income, by 2007-08 1,765,00 taxpayers did – 13.5% of the total. This clearly reflects the widespread belief that property is an excellent medium-term investment.

”Over the past decade property has been an excellent investment. But it is, in my view, extremely unwise to expect such gains to continue given current valuations. The investment fundamentals of housing have sharply deteriorated.”