Australia's double housing trouble

The Australian housing market has most people scratching their heads. On the one hand there are those such as veteran US funds manager, Jeremy Grantham, who are convinced that our market is an unmistakable housing bubble.

On the other hand, many analysts claim that high house prices are a direct result of a crippling shortage of supply, caused by restrictions on the rezoning of land on the edges of major cities, and policies that force property developers to foot the bill for the cost of delivering water, sewage, road and electricity to new housing estates.

The issue has aroused even greater attention in recent weeks, as a number of hedge funds have amassed short positions on the Australian banks, expecting that an eventual steep drop in house prices will leave banks nursing heavy losses.

Goldman Sachs' chief economist Tim Toohey has made an extremely valuable contribution to the debate, in a comprehensive 70-page report, A Study On Australian Housing: Uniquely Positioned Or A Bubble?, that takes a close look at the different forces driving the Australian housing market.

Toohey's conclusions offer something for those on both sides of the debate. He argues Australia does indeed face a looming and acute housing shortage. At the same time, he estimates that Australian housing prices are currently between 25-35 per cent overvalued. As a result, he says, we run the risk that Australia's house prices could drop sharply if a sharp decline in Chinese growth prompted a steep drop in our export earnings.

The report points out that Australia's population is currently growing at its fastest clip since 1969, rising by 2.1 per cent year on year. As he notes, this rate "is more reflective of a developing nation than of comparable wealthy developed nations”.

This faster population growth partly reflects a spike in the birth rate. But rising net migration is even more important, accounting for two-thirds of population growth.

The trouble is that over the past six years, Australia has not been building homes at a fast enough rate to meet the needs of its surging population.

As the report points out, in the 20 years between 1985 and 2005, Australia built an average of 150,000 homes each year for every 240,000 increase in population. That translates to 60 per cent of a new home constructed for each new person.

But in the past six years, this trend has changed. By mid-2009, the population had to rise by 480,000 in order to achieve the 150,000 new homes constructed in a year. For each new person, only 30 per cent of a home was constructed. It's even worse in NSW, where only 20 per cent is constructed for each new person.

At the same time, there's a huge change in the demand for housing, as the children of the Baby Boomers are now hitting the key household formation age.

Over the past five years, there's been a surge in the growth rate of the 25-29 age group – which has been rising by an average 3.7 per cent each year. This will result in an average 2.7 per cent annual growth rate in the 30-34 year age group in the five years to 2016. This is a dramatic increase, considering these two age groups averaged growth rates of less than 0.3 per cent per annum for the 15 years up to 2006.

The combination of these two factors – the increasing population, and the growing number of people in the key household formation age – is setting the state for a chronic housing shortage.

According to the Goldman Sachs report, "We see an acute housing shortage developing in coming years. At the national level, our base-case forecasts suggest that in 2010 there is currently a demand for housing requirement of 190,000 in 2010, which is set to rise to 196,000 in 2015. This compares to housing completions of 145,000 in 2009.”

It warns that "in the absence of a large and sustained rise in housing completions in the next 5 years, an acute shortage in housing is set to accrue.”

The report estimates there is a national shortage of around 157,000 housing units at present (which compares with the largest historical housing shortage of 28,000 at the end of 1997). The report estimates the housing shortfall will increase to 250,000 units by the end of 2012. It says the housing shortage is most pronounced in Queensland, NSW and Western Australia, while South Australia is the only state with a moderate housing surplus.

So does this housing shortfall justify high Australian housing prices? Not so fast, says Goldman Sachs.

It points out that the way to determine whether housing prices are overvalued is to compare them to household income flows, and the rent they generate. And on these measures, housing prices look elevated. For instance, since 2002, Australian house prices have been hovering around a multiple of ten times average weekly earnings, compared with a ratio of six times in 1997. And based on RP Data-Rismark figures, Australian house prices are now 27 times rents, compared with the average since 2002 of 25 times.  

Goldman Sachs says that it uses two methods to calculate whether housing prices are excessive. The first measures housing affordability (which takes into account house prices, income, lending criteria and mortgage rates), and compares it to its long run average. On this basis, it says, "Australian house prices are 35 per cent overvalued”.

A second measure, which Goldman prefers, includes rises in rents, along with housing affordability. This approach, the report says, "currently suggests that house prices are 24 per cent overvalued.”

But the report says that the Australian housing market is not a speculative finance-fuelled bubble, despite being overvalued. It notes that the refinancing of established homes is at a nine-year low, and that the loan to valuation ratio of established dwellings is well below the levels that we saw at the beginning of the decade.

Still, that doesn't mean that there aren't risks associated with Australian house prices. According to the report, Australian house prices could fall if we were to experience a sharp, and sustained, drop in our export prices. This could happen if China entered a severe recession, or if the global supply of iron ore and coal were expanded sharply, pushing down the prices that we receive for these two key commodity exports. The report warns the second is not a far-fetched prospect. "Our best guess is that iron ore and coal markets could well face this prospect in 2013-14”.

As a result, Goldman Sachs says it is crucial that the Reserve Bank and the government ensure that the current economic prosperity that we're enjoying from our booming terms of trade doesn't spill over into further rises in house prices and debt levels.