Is Sydney property market in a bubble? Sydney known for its beaches, food and weather. A quality of life that is on par with New York, London, Hong Kong and parts of Canada have also one of the most expensive residential real estate market in the world.
As with any bubble, the fundamentals which drive the value of the asset as we alluded to is there. But it is only when the market turbo charges the price outside the realm of reality that we would consider the asset class in a bubble territory.
We have gathered some interesting charts to highlight the excess in the market and potentially what a housing bubble looks like. After all we have plenty of historical and ongoing examples of excess real estate markets which act as indicator if there is a Sydney Housing Bubble.
Our conclusion is that the Sydney housing market fit into the pattern seen in previous housing bubbles, cautious on our property market forecast and there will be wider implication across the economy when the price correct investor excesses. Our property forecast is that any depression in Sydney everywhere else will be worse.
What causes a property bubble?
Property bubbles are driven by a number of factors. Commonly it is described when the market become overzealous in anticipating higher future asset value and willing to pay any price to get their hands on the property today. This result in runway asset values today because you can offload the asset at an even higher expected price in the future. The fear of missing out and the greed of continual price increases going forward.
Note it is important to know that future price is an assumption only. A bubble bursts when the materialized reality does not work out to what the speculator thought it would with original buyers holding onto over valued asset.
For the above to happen there need to be a number of enabler factors:
Bank lending – boom ends in a whimper instead of a bang
Real estate is a leveraged asset class. It is a primary driver of middle class wealth in a number of countries not because real estate returns are better than equities or bonds. But because it is one of the few only avenues where every day investors can purchase assets using enormous inherent leverage. For example using a typical Sydney House market median value of $1 million, if you use 90% borrowed funds or $900k mortgage. $100k down payment it is still 10:1 leverage. You are buying an asset that is valued 10 times your equity input.
If you use a “Conservative” deposit rate of 20%, this is still 5:1 leverage. Leverage can be used in equity with margin loan but it is uncommon to be above 50% of 2:1 leverage ratio. Commercial real estate will be hard pressed to use anything above 50% loan to asset ratio as well.
Traditionally, the offset factors are these are liquid assets and fall prices is only real once the house is sold. This is only true for owner occupiers. For investors any fall in asset values couple with the use of leverage means additional equity input. If prices fall more than your equity and with no additional capital input, the banks will pull the plug.
Australian residential property lending is driven by banks. With little or no securitization market since the GFC. The banks are in the drivers seat in the market in lending funds for residential real estate. Australia Prudential Regulation Authority (APRA) has been proactive in limiting the animal spirits of the banking sector in runaway funding for residential real estate.
A critical component of housing bubble in the past was the ease of access to credit by speculators. When credit is loose, lending standard low, number of banks chasing clients to lend money to (i.e subprime crises). It is a crucial ingredient of getting a housing bubble started.
By this standard with strong anecdote evidence of more stringent credit flows, absurd stories still exist still exist for investors that hold multiple properties across the Sydney house market. However they are the exception rather than the norm.
Going forward we anticipate slower credit growth which will put a lid on further price appreciation in the Sydney housing market. However it is already too late for some segments of the market where house prices are already inflated due to prior loose lending standards. We are not day 1 into the excess housing market but near the peak as the last few years, money has been flowing into the market non stop.
Supply and Demand – watch out for the cliff
It is well known historical supply has lagged demand in Sydney. The limited supply we would argue is one of the main drivers of market price appreciation in the Sydney houses.
However we are cautious that current supply will outpace demand in the near future and that it will take the market considerable time to digest upcoming supply. This would put pressure on future housing price increases going forward.
Although history never repeat it self, it does rhyme. One component keen watchers of the housing market should follow is the inflow of foreign capital into Australian property market. The area we are most concerned with the inflow of foreign capital is the funding of new apartment construction.
The weak Aussie dollar has exacerbated the issue, as historically low exchange rate makes purchasing local asset cheaper from foreigner perspective.
As we have noted in the past, the inflow of foreign money can create distortion due to regulatory constraints. Foreign investors can only invest in new housing stock. They are one of the largest providers of funding for residential construction in Australia, particularly gateway cities such as Sydney and Melbourne.
Recent apartment construction, especially in middle ring of Sydney causes some concern. This is an area where gap value will be the widest as number of projects will become marginal in the secondary market once the froth is gone.
Sydney Apartment Approvals
Previously it was standard practice for developers to pre sell a housing project up to 80% before the bank will release the funds for construction. However foreign entrance in the market means construction can commence with almost no pre sale. The goal is to sell the completed projects in foreign markets where Australia residential apartment contain a “safe haven” premium.
The problem arises when construction supply becomes out of step with apartment demand. Then it is up to the market to correct it self. Increase upcoming supply coupled with potential settlement risk and pullback in residential investment lending means that Sydney prices will be increasingly coming under pressure.
House Price to Income Multiple
Similar to price to earning ratio used for stocks, housing can be valued in a similar fashion as multiple of either rental income or household income. In this instance, the house value to median income is a measurement of affordability while rental income is a measurement of value.
Median House Price to Income multiple for Sydney shows that prices is on par with some of the most expensive real estate markets in the world. Hong Kong is by it self completely off the charts.
How did the prices get to where it is today? The chart below shows the trend in house prices in multiple terms over the last 35 years. The increase in Sydney housing prices is really a story of multiple expansion. The issue with multiple expansion is that it is a finite driver of value. When multiple gets to a level where it can be no longer sustained, it will revert to the mean.
Sydney real estate prices always contained a premium relative to the rest of Australia. However the current premium is high even by historical standards.
If you take a typical residential property yield of 3% – 5% then inverse that. Then you get a real picture on the valuation of real estate in Sydney. Under the scenario of 5% yield, this implies earning multiple of 20 times. Equivalently, for a stock to be priced at 20 times p/e ratio there need to be a great story to justify the future growth.
The current high prices are supported by record low interest rates. The mistake is for investors to overpay assuming the low rates are here to stay. If an asset is purchased at today’s level the low income yield is effectively locked in. Upward movement in rates would wipe out any cashflow growth unless rental income grows substantially from current levels.
Note it is difficult to lock in long term rates under standard mortgage products. Typical lock in is a 5 years at most with 10 year money not very cost effective.
Affordability indicator shows that the current market is stretched and multiple expansion cannot go on forever. Asset owners are banking on income growth to justify the current high prices.
Sydney Rental Income and Vacancy
Chart below shows the capital city vacancy and rental growth rates. Logically, as vacancy increases rental growth slows. Increase level of supply coming to market driven by safe haven money will put pressure on future rental growth rate going forward.
As previous price increases are driven by multiple expansion as result of strong investment flow. If the price to income multiple of property becomes too high then the primary driver of value will be income growth.
Key question in the same investors mind now are:
1) If income is not growing or even falls, would the underlying asset be worth the same? How much to an extent is future income growth priced into the price paid today.
2) What is the future price expectation if rental income (or return on asset) is falling?
3) Given no growth in income, is the current yield on investment worth the risk?
Typical 3 – 5% gross yield on Sydney residential property does not look enticing with no growth in rental. This is coupled with 4% interest on borrowed funds.
Case Study: US Real Estate Bubble in Charts
We use other countries experiences as a guide for the future.
US housing Starts
Chart above shows the severity of housing construction as result of deflation of the housing bubble. The fall of almost 60% from peak means almost halving the peak construction employment levels. While we are not there in the Sydney market. Risk of excess supply should not be discounted as insignificant in any slow down scenario.
Bubble Pricing – what goes up must come down
Chart shows the trend of residential real estate price in the US on a absolute level. The spike from 2002 to 2004 is apparent as is the collapse after. The scale of the chart highlight the extent of the collapse.
The chart below shows the annual year on year changes in prices.
In percentage terms, the collapse in prices post the bubble are just as severe as the run up. The value in 2008 is almost the same as 2002. This coupled with leverage and interest does not mean a break even over 5 years but significant equity losses. Interestingly for Australia, the collapse in the US housing bubble led to the recession not the other way around where the recession cause the fall in asset value.
This is important as others are looking for the trigger in the broader economy like a mining slowdown will result in the end of the Sydney property boom. The fall in commodity prices only affected the mining towns with concentrated mining employment. Eastern Australia states are more diversified with industry, financial and tourism offset any mining slow down.
We see the end as the boom will exhaust by it self. External factor is not required to pull the rug under the market. When prices exceed what most people can pay and lending is restricted. The boom will end in a whimper rather than a bang.
Sydney Property Market Forecast
Given the above factors we consider the future for Sydney residential market to be bleak. The prices are in excess territory while supply is coming online to meet artificial demand. Any slow down will be prolonged as it take time for supply to cease and market to adjust to more natural level. This means that future price growth will not repeat the past performance. A severe downturn in residential market will flow onto broader economy with job losses outside of real estate, the tricky part of forecasting is always finding the exact timing.
However only because there is no hard landing scenario does not mean it will not be painful for residential investors, especially mom and pop investors. Australia has not had a recession for more than 25 years. The leverage built into the system is larger than most expect and any minor shakeout will have far and wide consequences across economic sectors outside the real estate industry.
Just like the collapse of the Japanese housing bubble and recent US experience. US consumer sentiment dropped significantly. We would expect any slow down to be the same in Sydney. Additionally, we are cautious on the discretionary sectors. Standard mortgage products are full recourse rather than limited recourse seen in the US residential lending market.
People cannot just walk away from under water mortgages. Interest payments, albeit lower in a downturn scenario will still have to be paid. Discretionary spending will be the first to be cut. We remember during the GFC where spending at the Pub and eating out literally collapsed overnight. Business spending take time to be cut due to forward planing and contractual obligations. Consumer spending can be stopped overnight.
The silver lining is that Sydney is considered a core market. The best assets will still do better than secondary market.
Investment Implications as result of property weakness
A weak housing market will have wider implications across the Australian economy and the Equity market. Cyclical stocks for specialty retailers and even to an extent the consumer staples will be hit due to immediate decrease in revenue magnified by strong operating leverage in the business models.
Financial institutions will not escape unscathed. To an extent, weak housing market is priced into the current bank share prices. We feel the degree of severity will not be realized until bad debt charges upward spikes from current levels.
We would be keeping an eye of the Commercial Real Estate markets. Asset values have been supported by secondary stock leaving the market. Strong residential market means that the highest and best use of B grade office buildings is tearing it down and convert to residential apartment. This has support prices on otherwise terrible assets in already weak markets.
A slowdown in Sydney property market means that office and industrial sites would be price naturally on a standalone value which could result in pull back in some listed property trusts.