Why I'm a housing bear

Australian residential housing remains extremely expensive, at least according to the latest affordability index from the CBA/HIA (Exhibit 1). The softness in prices, decelerating mortgage flows, falling sentiment indices (and common sense) are sending the same signal.

With a Reserve Bank rate cut looming, however, expect a wave of she'll-be-right commentaries about house prices. Here's why I think we've barely started the residential property bear market:

First, property bulls continue to point to apparently tight supply and population growth as key support for housing. This, in my view, misses the key drivers of house prices. I think that the major reason Australia now has one of the world's most expensive housing stocks is because we've seen a dramatic increase in household debt, which reflects both the willingness of lenders to lend and – because we've gone 17 years without a recession – borrowers to borrow. Because these supports have applied nationwide, the house price boom has likewise been nationwide.

On the other hand, if house prices really were driven by population growth and/or physical shortages, one would expect the housing markets that have become less affordable would be high population growth/tight supply markets. Exhibit 2 shows the change in the CBA/HIA regional indices of housing affordability. The index falls when housing becomes less affordable. What the regional indices show is that the biggest falls in house price affordability (from 2000) have occurred in regional South Australia, regional Tasmania and Hobart. No offence, but these are not high demand/low supply areas. In contrast, Sydney and Melbourne have seen the smallest falls in affordability.

Of course, these two started as Australia's most expensive housing markets. But the point is that if physical supply-demand factors determined house prices, then it would have been expected that these two cities maintained the gap. That they haven't shows both that affordability matters, and that the factors that have led to the broad-based unaffordability of Australian housing are macro, not market-specific micro.

Second, I continue to hear that yield is a support for residential property. The fact is that the rental yield is near all-time lows (Exhibit 3). If houses were stocks, they'd be trading on price/earnings multiples of more than 30 times. Hardly cheap.

Third, there is a big flaw in the typical treatment of housing yields, indeed a big flaw in the assumed returns on property investment. The flaw is simple: gross yields grossly (sorry) over-state returns on property investment.

Although the property boosters don't mention it, a rental property involves more than just collecting rent and watching capital values rise. There is a range of direct costs and depreciation. The Australian Bureau of Statistics estimates gross and net rent across the entire property stock. (These aggregates reflect the rent paid by owner-occupiers to themselves: so-called imputed rent. But the data reflects market rents, and so do the costs of property maintenance and depreciation). Exhibit 4 shows the gross and net rental returns based on that ABS data. On average, the costs of supporting a property have been about 2.3% of the capital value.

The (obvious) fact that the net rental yield is significantly below the gross rental yield has two important implications. First, it means that property on a yield basis is now far more expensive than the most commonly used investment measures suggest. The gross rental yield of about 3% implies a net rental yield of less than 1%. On a price/earnings basis, residential housing is an investment asset with a P/E of more than 100.

Second, the property boosters ignore these costs when they look at historical returns. This produces a huge distortion in long-run property returns. Exhibit 5 shows a long-run comparison of inflation-adjusted total returns from equity and Australian residential property based on the net rental yield. Over the long run, property has come a very poor second to equities.

As most of you know, this does not make me an equity bull. I think both asset classes are over-valued. The point here is simply to nail the misleading arguments made in favour of residential property. These arguments are particularly inopportune given that on almost every measure housing is at all-time high level of expensiveness. For those who don't know, I expect Australian equity prices to keep on falling (medium-term price target for the ASX 200 is 3500). But if I were forced to invest in housing or equities on, say, a five-year view, I'd prefer equities.

So if housing is so expensive, what would make it fall? I keep returning to what got us to these levels of expensiveness: the build-up in household leverage and the absence of significant job-losses for 17 years. Exhibit 6 shows the correlation between household leverage and real house prices. (This also shows how exceptional – for both measures – the past 15 years have been).

So the triggers for house price declines are simple: job losses and a reduced willingness by lenders and/or borrowers to continue to sustain such high leverage rates. This, in my view, will be the story for next year. And the imminent rate cuts won't change that picture.

Why does any of this matter to professional investors? It matters because if we do see the broad-based and significant house price declines I expect, then those declines will likely contribute to a sustained period of below-trend consumer spending, substantial official rate cuts, and difficulties for lenders and property-related companies.

One final point. Having perused a substantial amount of residential property “research” from property agents over the past few weeks, I have been struck by two things. The first is its poor quality. I have seen some truly atrocious statistical jiggery-pokery. One “analyst” showed residential property returns exceeding equity returns by three or four times since the early 1980s. No data I know supports that.

The second point is that most property research comes from interested parties. Regulators require that securities firms, such as Morgan Stanley, disclose all possible conflicts of interest, and impose strict restrictions between research and other parts of the organisation. Residential property is not subject to any such restraints. This is despite the fact that for many individuals a property investment is their largest single discretionary financial commitment. This, in my view, is a major regulatory gap.

Gerard Minack is chief market strategist of Morgan Stanley Australia.