Rational response, or property bubble?

With the official interest rate recently cut to a record low of 2.5%, Sydney's house prices are booming again. Auction clearance rates have been over 80% for the past three months, compared to 57% in August 2011, and the median house price has increased 7.4% to $715,000 in the year to June.

With employment high and variable mortgage rates falling to as low as 4.49%, investors and homeowners are out in force bidding up property prices. I recently attended an open-house for a pretty run down property in Sydney's outer west that attracted over 200 people and eventually sold for $600,000.

RP Data's June report (sponsored by Commonwealth Bank) shows that there are 193 suburbs in New South Wales where it's cheaper to buy than rent. Obviously this assumes that you remain employed and interest rates stay low for the next 30 years, otherwise my friend wouldn't have recently been offered a $1m loan when he's only earning 100k per year.

This is where the danger lies. When we're uncertain or we need to estimate a long way in to the future, we generally extrapolate our current situation. This is why brokers frequently downgrade their company earnings forecasts even over short periods. Humans are not good at predicting change.

Many investors – though fortunately not Share Advisor members – were caught off guard earlier this year when several mining services companies announced large profit falls, for example. Investors expected rapid profit growth to continue indefinitely, and the share prices of some of these companies, such as Ausenco, Emeco Holdings and Ausdrill are now half what they were, and are unlikely to return to their former highs.

I expect this only reflects the beginning of a much longer slow down in the Chinese economy. As mining investment in Australia falls from 8% currently back to its long-term average of 2% (or below), unemployment should increase and those that borrowed based on two generous incomes, or one large income from working in the mines, may be unable to meet their home repayments even if interest rates fall further.

Right now provisions for bad debts for the big banks are at or near record lows, and their share prices are near record highs. That doesn't leave much protection for investors, either.

Do you think higher property prices are a rational response to low interest rates, or are we experiencing an unsustainable property boom? How expensive are Australian properties, and how are you investing based on your view?