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D-day for Australia’s Real Estate Bubble?

by Pater Tenebrarum, Acting Man:

Unknowable Degrees of Bubble Insanity

Back in February, we brought you an update on the truly insane real estate bubble in Australia (see: “Australia’s Housing Bubble – In the Grip of Insanity” for details) in the wake of Jonathan Tepper of Variant Perception reporting on an eye-opening fact-finding tour in Sydney.

This rotting shack in Sydney and its tiny plot of land sold for nearly $1 million in May of 2014 – more than two years ago. Since then, house prices in Australia have increased even further. Yes, it is an insane bubble, no doubt about it.

As every seasoned market observer knows though, the fact that a bubble has obviously attained crazy proportions does not mean it cannot become even crazier. We only need to think back to the Nikkei index in the late 1980s, the Nasdaq in the late 1990s, or the grand-daddy of modern-day bubble insanity, the Souk Al-Manakh bubble in Kuwait in the early 1980s.

The latter example is generally less well known than the others, but it is unsurpassed in terms of sheer mass dementia. What made this bubble so special – at its peak Kuwait’s stock market had a total capitalization of more than $100 billion, which made it the third-largest equity market in the world behind the US and Japan at the time, a fact that should have told market participants they were skating on very thin ice – was the use of post-dated checks to pay for stock purchases.

The bubble needed a trigger to pop, and that trigger was delivered when one day, a single one of these post-dated checks actually bounced. One of the biggest market crashes in history ensued – a truly dramatic wipe-out, that in the end destroyed the country’s entire OTC stock market.

As we have pointed out previously, while residential real estate is actually a consumer good, analytically it should be treated as akin to a capital good maintained over several consecutive stages of production, as it renders its services over a very long period of time (the same principle holds for other durable goods – see J.H. de Soto, Money, Bank Credit and Economic Cycles).

One implication of this is that interest rates are very important to the valuation of real estate. At present, the administered central bank interest rate in Australia is at a new low, and since it remains actually high compared to similar rates in other developed countries, it may well decline even further.

Gross market rates all over the world have so far continued to follow the downtrend in central bank rates, so the market has yet to reassert itself (we plan to post an in-depth discussion of the current trend in gross market rates soon). As long as rates remain low, real estate bubbles tend to remain well supported.

Let us not forget, the bursting of a number of housing bubbles in 2006-2009 (in the US, Spain and several other countries) was preceded by a slow but steady increase in interest rates and a sharp slowdown in money supply growth in the major currency areas. Neither one nor the other are in evidence in Australia at present – at least not yet.

An Important New Development

One of the reasons why interest rates are so important in keeping residential real estate bubbles from imploding is that they make otherwise unaffordable properties seemingly affordable.

Most home buyers use mortgages to finance house purchases, and the size of the monthly payment is therefore a main criterion in terms of affordability. Given that these are usually very long term loans with terms ranging from 15 to 30 years, the level of interest rates makes an enormous difference.

Below is a slightly dated chart via Variant Perception (ending in Q2 2015) that compares Australian home prices, household incomes, rents and construction costs. It should be obvious how irrational house prices have become in light of the huge gap that has opened up between these time series.

The chart also demonstrates that low interest rates are indeed of overwhelming importance in sustaining these sky-high prices. There is certainly little else that will.

Read More @ Acting-Man.com

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