Fears about the recent boom in Australian housing, especially apartment, construction and the surge in Sydney and Melbourne property prices appear to be on the money.
That’s the clear takeaway from a speech delivered this morning by Luci Ellis, the head of the RBA’s Financial Stability Department.
Ellis wasn’t talking directly about the Australian housing bubble, or even the specific circumstances the market finds itself in at the moment. But in her speech, Booms, Busts, Cycles and Risk Appetite, Ellis addressed the drivers of booms and busts and their consequences.
Ellis proffered two plausible sources of booms and busts. The first scenario she said was “over-exuberance in the face of a genuine structural shift”.
She added (our emphasis):
This is the mechanism that Kindleberger identified: first, the ‘displacement’, the real change, then the ‘mania’ or overreaction to that change (Kindleberger and Aliber 2000). This is why the busts almost never fully reverse the original boom. There was almost always something real at the beginning that doesn’t go away. Sometimes when the mania turns to panic, you see an overreaction to the down side. But even if you do, it’s unlikely to be as big as the fundamental shift that started it all.
That’s important, Ellis said, in the context of the structural shift to a low-inflation, low-interest rate world from the late 1990s and early 2000s that drove the initial surge in Australian house prices at the time. It is also likely to be an important factor in recent years as global and Australian growth potential appeared to even the most casual observer to take a material step lower after the sugar hit of the initial central bank interest rate and QE programs in the aftermath of the GFC.
We need go no further than the current housing booms in the countries with negative rates to see the impact this structural shift lower in interest rates and inflation has had on housing.
In an Australian context it is also important because the combination of low rates, relatively low inflation – by Australian standards -, the generous tax treatment of investment properties, and the need to build more dwellings after a chronic decade of undersupply, combined to drive the recent surge in construction and prices.
But as Ellis, channelling Kindleberger, says, there was an underlying structural shift which drove the initial surge. The question is what impact the mania phase, and subsequent potential overbuilding of apartments will have on the overall market.
Ellis’ second hypothesis on booms and busts looks directly at this potential overbuilding. It’s wonkish, but it’s very good (our emphasis):
The second source of financial boom–bust dynamics will be well known to anyone who has studied complex dynamical systems in other fields: simply put, it is lags. In particular, it is the lags inherent in stock–flow dynamics. As I have emphasised on other occasions, many of the relationships important to financial stability depend on the balance of demand for and supply of a stock quantity that evolves only slowly, like the stocks of different kinds of property. The flow is the thing we can influence, but often it is just a small fraction of the stock. Because of this, the flow variable will typically ‘boom’ when some shift in the fundamentals means the stock variable needs to be higher. And when the stock transition is over because it has reached that equilibrium, the flow will ‘bust’.
That’s a real risk to apartment prices in particular as a large amount of stock is completed in the next 18 months and needs to be funded by an increasingly APRA-constrained banking sector – at least for new investment loans.
“Remember Kindleberger’s displacement idea: history is full of shifts to new (stock) levels, but the transition doesn’t last forever. At some point the (flow) boom ends,” Ellis said.
Again, Ellis wasn’t specifically talking about housing, or apartments at the moment. But her speech contained a clear warning to those who think that the boom won’t end.
She said specifically:
Stock–flow dynamics are central to property market developments, as we have long known. The actors in that market know that, too. But just as there’s a Greater Fool Theory of investment that helps perpetuate booms in prices of financial assets, it sometimes seems that there is a Slower Builder Theory of property development, where everyone knows that not all the projects underway will make money, but yours will if you can just complete it before the other guys complete theirs. This coordination failure can end in painful busts in building activity, because the boom went beyond underlying demand.
Which is the risk for buyers of apartments given the current flow coming to market.
In a recent report, the Australian Population Research Institute (APRI) said, “there is an enormous pipeline of apartments about to hit the Sydney and Melbourne marketplacce. There were 13,00 to 14,000 apartment completions in Sydney and Melbourne in 2014 and 2015. This number will increase to around 22,000 in both cities in 2016 and in 2017.”
That, the APRI says, leaves off-the-plan investors “among the most financially vulnerable of recent dwelling investors”.
The reason they say this is that the APRI believes off-the-plan investors “are likely to find the value of their apartment at settlement is worth considerably less than at the point of purchase”.
That’s problematic because “the banks will only provide finance equivalent to their assessment of the value of the property,” which means some investors will forego their deposits while offshore investors may have difficulty raising the additional cash required to complete the purchase, the APRI said.
Ominously they warn, “in both cases this will add to the stock of apartments on the market, putting further downward pressure on the price”.
Ellis didn’t set out to give a specific warning on Australia’s apartment boom. But in explaining the dynamics of the boom-bust cycle she shined a light on the risks in this sector of the property market in the years ahead.