Our non-existent housing bubble | John Wilson, PIMCO | Commentary | Business Spectator 7/10/10 2:53 PM

Commentary 3 Comments

Our non-existent housing bubble

John Wilson, PIMCO
Published 6:34 AM, 7 Oct 2010 Last update 10:18 AM, 7 Oct 2010

Much has been made of the recent strong growth in house prices in Australia. A number of
commentators describe the market as being a price bubble and predict price falls of 40-60 per
cent to return them to fair value.
Australia, either in whole or part, has had several property booms and busts: the 1830-40s,
1880-90s and 1920-30s, and more recently the commercial property boom of the late 1980s
and early 1990s. The question is, are we in the midst of another? Is the recent sharp rise in
prices for established dwellings a sign of unrealistic speculation and if so, what will be the likely
fallout?
This is against a backdrop of the deflation of a housing bubble in the US and elsewhere, which
may serve as a touchstone for assessing Australia’s position.
Our conclusion is that pricing in the Australian housing market is in line with longer-term
affordability ratios and, given the apparent supply constraints, will not come under undue
downward price pressure providing the economic outlook doesn’t falter. I will explain why.
One of the enduring features of the Australian social landscape is the high level of home
ownership. Over the last fifty years, house ownership has been steady at 70 per cent, give or
take a per cent or two. What has varied is the proportion of owners who have a mortgage; 35
per cent currently compared to 30 per cent ten years ago.
The other notable feature has been the rapid rise in household debt. In the early 1990s,
households on average had debt equal to half a year’s disposable income; by 2006, debt had
risen to around one and half years’ income. It has since stabilised.
Most of the rise is due to housing (both owner-occupied and investment properties) with not
much change in other household debt, such as credit card debt and car loans.

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Our non-existent housing bubble | John Wilson, PIMCO | Commentary | Business Spectator 7/10/10 2:53 PM

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The rise in household debt is in line with that of many developed economies over the same
period. This reflects greater access to funds resulting from financial deregulation and also to a
structural decline in interest rates following the high inflation of the 1980s. The level of interest
rates in most developed economies in the past decade has been about half that in the decade
to 1995, increasing the level of debt that households can service.
With much of the additional debt channelled into housing, it’s unsurprising that real house prices
have also risen substantially.
In Australia there are roughly 8 million households. A third of these households own their
dwelling outright, a bit more than a third own their property with a mortgage, and about 30 per
cent rent. Nearly 80 per cent of us live in separate houses and, surprisingly, this has not
changed much in the last 15 years. While the number of people per dwelling has declined
somewhat (from 2.69 in 1994-95 to 2.56 in 2007-08) the size has increased. Lone person,
couple-only and couples with dependent children households each account for roughly a quarter
of all households. The majority of households (62 per cent) depend on wages and salaries, with
23 per cent of households relying mainly on government pensions and allowances.
Life cycles
As people progress through different life cycle stages and their family structures and financial
situations change, their housing needs and preferences also change. In particular, tenure is
strongly related to life cycle stages, generally following a pattern of renting in early adulthood,
moving to home purchase and mortgages as partnerships are formed and children are born,
and owning a home outright in older age. Few people under the age of 35 years own their home
outright, compared to 69 per cent of lone persons and 86 per cent of couples who are aged 65
years and over. Similarly, couples are more likely to own a home and the proportion increases
with the age of their children.
Two strong demographic influences have been working in opposite directions on the home
ownership rate. Australia’s ageing population pushes toward a higher home ownership as home
ownership increases with age, while there has been a gradual decline in the relative importance
of couple family households as rates of family dissolution and the proportion of the population
who have never married have increased. In practice, these have offset each other.
First home buyers (FHBs) represent new entrants into the home ownership market. They
generally account for a third of the turnover in any one year, although this can be increased by

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Our non-existent housing bubble | John Wilson, PIMCO | Commentary | Business Spectator 7/10/10 2:53 PM

one-off events which bring forward demand, such as the recent temporary boost to the First
Home Owner Grant. Over 90 per cent of FHBs have a mortgage, the average size of which is
similar to that of changeover buyers; however, they purchase less expensive dwellings. The
majority (58 per cent) of FHBs with a mortgage have at least two income earners, a proportion
that has remained broadly unchanged since 1995-96. As a result, their average incomes are 20
per cent higher than the average for all households. Weekly housing costs absorb 30 per cent of
FHBs' income, on average, which is in line with all homeowners with a mortgage. FHBs have
shown an increasing preference for established dwellings, with the proportion buying new
dwellings declining from 23 per cent to 9 per cent between 1995-96 and 2006-08.
Housing as an investment
Economists argue that housing is a consumption item. Since we all need to consume some
level of housing services, the more we spend on housing, either owned or rented, the less we
have to spend on other things. As a nation, we are not any richer when the price of housing
rises.
At the individual level, however, home ownership is by far the greatest source of wealth
accumulation. Owner-occupied dwellings, net of debt, represent 42 per cent of household
wealth, with superannuation running a distant second at 13 per cent. It has been a good
investment: in the period from 1994-95 to June 2010, the value of owner-occupied dwellings has
increased by 120 per cent in real terms, or 6 per cent per annum compound. The average level
of debt has remained constant at around 40 per cent of dwelling value. Hence, net worth has
increased at the same rate as values.
Housing is seen as both a place to live and as an investment. Across all homeowners who have
mortgages, two-thirds of mortgage payments represent interest (consumption) while a third goes
to repaying principal (investment). Mortgage repayments have remained at a remarkably
constant 30-35 per cent of household disposable income. In effect, 10 per cent of a mortgagee's
household disposable income is saved and invested in their dwelling. The 30 per cent ratio
reflects the lending standards of the major banks, which dominate the home-lending market.
The constancy of this ratio indicates that owner-occupied dwelling prices are determined by two
things: household disposable income and the home borrowing interest rate.
FHBs are the first link in the chain; the amount that they can afford to borrow is determined by
their household income, the level of interest rates and the amount of equity or deposit they
contribute. This establishes the price at the entry level of the market. The changeover buyers,
some of whom sell to the FHBs, benefit from any price increase and use the net proceeds and
their existing mortgage to purchase the next level of housing. With this dynamic and the
constant proportion of income absorbed by mortgage costs, it is unsurprising that in the two
years to June 2010, when average weekly earnings grew by over 11 per cent and home
mortgage interest rates fell by 2 per cent, housing prices responded by rising an average of 17
per cent across the capital cities.
The risks
One of the obvious things about the housing market is that it is local. The level of house prices
depends on local conditions: the availability of work, how much people are paid, ease of
commuting, and the ability to build new dwellings and the price that they can be built for.
The most obvious risk to housing prices is below normal economic growth. Not only would this
put pressure on earnings growth but would make FHBs reluctant to commit to a mortgage
despite lower interest rates that accompany sub par growth. Australia’s growth prospects are
healthy despite concerns about sluggish growth in most of the developed economies. Also, most
of the post-GFC interest rate tightening has occurred with further increases expected to be
modest. Overall, there will be counter-balancing forces for the affordability of housing; either a
strong economy with higher interest rates or a weak economy with lower interest rates.
Another risk is that of a "one-off" shock, such as climate change-induced price hikes, that would
absorb more of household expenditure. However, it is likely that other expenditure items would
be pared back before mortgage repayments are skipped.
Other measures of affordability

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Our non-existent housing bubble | John Wilson, PIMCO | Commentary | Business Spectator 7/10/10 2:53 PM

Despite house ownership depending primarily on the ability to afford mortgage repayments, two
other measures are commonly used to assess whether house prices are cheap or expensive;
housing prices relative to incomes and housing prices relative to rents. Putting aside data
issues, there are conceptual problems with both these measures.
Comparing the current ratio of house prices to incomes with its long-term average ratio ignores
the fact that in many economies households have allocated an increasing proportion of their
incomes to housing as they have become richer. Even a comparison to a trendline ignores the
impact of lower interest rates on affordability. Not surprisingly, this measure will label housing as
“expensive” at best, or more likely as “a bubble” ready to burst.
The second measure assumes that people are indifferent to renting or owning their dwelling.
Australia's persistent high level of home ownership indicates that ownership is a deeply
ingrained life cycle choice. While some may choose to rent and invest into other assets the 10
per cent of household disposable income that is typically dedicated to mortgage repayment, this
is not commonplace. Also, owned properties are generally of a superior quality than rental
properties; hence, it is difficult to directly compare the two.
Comparisons with other countries
In a world where financial markets are closely correlated, it is tempting to assume that the
housing experience of countries will be similar. Hence, the sharp fall in house prices in the US,
UK, Spain and Ireland is seen as a prelude to what may happen in Australia. However, the
evidence points to more differences than similarities. Comparing Australia to the US, the
following differences are apparent:
– The increase in US housing prices was accompanied by a sharp rise in the level of
homeownership; it was steady until 1995, after which it rose from 64 per cent to a peak of 69.2
per cent in 2004 and has since fallen to 67 per cent, with no sign of stabilising. This suggests
lower-quality of owners/borrowers in the US were encouraged into homeownership by the
relaxation of lending standards during the upswing. In contrast, Australia’s home-ownership rate
has been steady at 70 per cent, give or take two per cent, since 1960.
– Supply is responsive in the US. Private dwelling investment (new dwellings and alterations
and additions) increased from 4.5 per cent of GDP in 2001 to 6.5 per cent in 2006 as new
houses were built to meet the demand and encouraged by higher prices. The overhang of new
houses plus defaulted properties continues to put downward pressure on prices. As shown in
Graph 2, Australia’s private dwelling investment has been relatively steady since the 1980s at 5-
6 per cent of GDP. An increasing portion is for alterations and additions, reflecting the lack of
reasonably priced new land releases in many regions. Overall, only about 3 per pent of GDP
goes to new housing stock and, of that, 15 per cent is replacing existing dwellings.
– Mortgage arrears continue to mount in the US; borrowers more than 3 months behind in their
payments are now 9.4 per cent of outstanding mortgages, compared to 3.3 per cent at the end
of 2008. To a large extent this reflects the comparatively difficult economic situation in the US,
but it also represents an unwinding of poor lending decisions. Compare that to Australia, where
less than 1 per cent of mortgages held by the four major banks are in arrears.

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Our non-existent housing bubble | John Wilson, PIMCO | Commentary | Business Spectator 7/10/10 2:53 PM

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The demand for housing is driven primarily by population growth and the number of people per
dwelling, as well as affordability. Recently there has been strong population growth due to both
natural increase and immigration, which of itself would indicate demand of 165,000 new
dwellings a year. This is well above the construction level of recent years which, having peaked
at 168,000 units in 2003-04, has fallen to 128,000 in 2008-09. The average household size
appears to have stabilised at around 2.5 persons per dwelling after falling for many years.
Ideally, supply would be responsive to changes in underlying demand with only minor changes
in price being sufficient to bring on new supply. It is clear that supply has not been responsive
due primarily to problems in land zoning and the development and building approvals process.
While authorities continue to work to reduce impediments to the construction of new housing,
both in our cities and on the fringe, as well as improving public transport, it is clear that the
housing market is not likely to be swamped by an excess of supply in the foreseeable future.
Safe as houses
Australia's housing prices have increased strongly in recent years. Also, the ratio of house
prices to incomes has increased, with some commentators seeing this as pointing to a price
bubble. The evidence is somewhat different. The Australian housing market is remarkably stable
with a steady and high level of 70 per cent of home ownership going back 50 years. While
personal debt has risen in line with house prices, the average equity that mortgagees have in
their homes has remained steady at around 60 per cent. The ability to finance a mortgage is the
main driver of house prices: on average, what households can afford in repayments determines
the price they are willing to pay. This is apparent from the remarkably stable ratio of housing
costs to household disposable income, which has hovered at a little over 30 per cent for the last
decade and a half. A third of mortgage repayments go to repayment of principal; hence, home
ownership is an investment plan as well as a consumption item.
The demand for housing is determined by the number of people who are coming into the
household forming stage of their lives together with housing affordability. Australia’s immediate
economic outlook is supportive of household earnings growth and with interest rates back in
mid-range, any further tightening will be modest. Housing supply will continue to be constrained.
Taking all these factors into account it is difficult to conclude that Australia's housing market is in
a bubble.

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Our non-existent housing bubble | John Wilson, PIMCO | Commentary | Business Spectator 7/10/10 2:53 PM

John Wilson is the Head of PIMCO Australia.

3 Comments

Andy Dufresne wrote:

This assessment of the property market ignores two key factors and reads more as a
Wikipedia entry about the statistical make up of the housing market than anything else (see
Our non-existent housing bubble, October 7).
Granted some strong fundamentals may exist in certain areas, but why ignore the health of
the market at the margins? This is the segment that threatens everyone's housing well-
being. It is imprudent to average out mortgage and income levels. If I hold one hand in
boiling water and the other in ice cold, on the whole I won't be comfortable! Recent entrants
leveraging in excess of 7 times annual income through dodgy brokers and lenders are the
elephant we cannot ignore.
Secondly, if we're so rosy and market driven, why on earth would we have allocated over $2
billion of direct government money to stimulus measures over the last two years? Need I say
more?
7 Oct 2010 8:20 AM

Stephen Green wrote:

John, there's lots wrong with this (See Our non-existent housing bubble, October 7) but
the worst of it was
you said: "the average equity that mortgagees have in their homes has remained steady at
around 60 per cent."
If prices do fall, then this factor becomes irrelevant as their equity will shrink.
You have also aggregated the equity of all Australian mortgagees, surely the people most
vulnerable to a bubble are FHBers (first home buyers) who would have a lot less equity.
7 Oct 2010 11:58 AM

Steven Majewski wrote:

One only has to look at Graph 1 (See Our non-existent housing bubble, October 7) and
the sharp increase in housing debt over the past 30 years to see the picture is very ugly and
it clearly points to housing being overpriced.
Even a moderate fall in prices would cause huge issues let alone a significant fall.
7 Oct 2010 12:15 PM

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