At the Guardian, Gareth Hutchens criticises some market economists for their forecasts of a correction in house prices in 2016, while house prices in Sydney and Melbourne actually grew at double-digit rates. Market economists Saul Eslake and Stephen Koukoulas have attempted to explain the divergence between their forecasts and outcomes by referring to unexpected RBA cash rate cuts and higher than expected population growth, among other factors. I would suggest they should have simply said the market has stayed irrational longer than they expected.
What we are seeing in Sydney and Melbourne is a property price bubble, in which a mania has gripped property buyers. This type of mania afflicts markets from time-to-time, and we should not think we are immune to it in Australia. Famous historical examples of market manias are the Dutch tulip craze, the South Sea bubble, the US stockmarket before the 1929 Great Crash, Tokyo real estate in the 1980s, and the US housing market before 2007-08. In Sydney and Melbourne, we now have property markets dominated by a mixture of speculators and people gripped by a fear of missing out, people who want to buy a property before it becomes even more ridiculously over-priced.
The mania could continue so long as people can access cheap debt and can meet mortgage repayments, but eventually constraints will be reached (or possibly rationality will prevail) and price growth will stop. And we will see a re-evaluation by the market of property prices, particularly given price growth has been massively ahead of the growth in rents. The most recent CoreLogic Hedonic Home Value Index report (available for download from CoreLogic) notes:
“Over the growth cycle to date, Sydney dwelling values are up 69% while rents have increased by approximately 10%; this has caused the gross dwelling yield to fall from 4.5% in June 2012 to the current record low of 3.0%. Similarly, in Melbourne, dwelling values are 51% higher over the cycle to date, while rents have risen by a much lower 9.6%. The divergence between dwelling value growth and rental growth has compressed Melbourne’s gross yield profile to a new record low of 2.9% from 3.8% in June 2012.”
Gross rental yields as low as this in Sydney and Melbourne are unsustainable (see figure below). Generally, they would only be tolerated by an investor who expects a large capital gain in the future. But the likelihood of that diminishes every time current property prices reach even more unsustainable levels.
In a rational market, there should be a close link between property prices and rents, as rent signals the market value of the services provided by a property. Of course, low interest rates are relevant, and perhaps investors are coming to accept lower returns generally, but why should Sydney and Melbourne property investors accept much lower yields than those in other markets?
The massive divergence between the growth of property prices and rents is a big clue that the Sydney and Melbourne property markets are very likely suffering from irrational exuberance.