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Rationalizing Real Estate Bubbles In Australia & China at Trader’s Narrative

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As Jeremy Grantham quipped: All bubbles share one thing in common, they are all considered to be unique.

The co-founder of Grantham, Mayo, Otterloo & Co., has gone on the record that there are still two bubbles in play: Australian and UK real estate. He has also mentioned in other more recent interviews that the bursting of the Chinese real estate bubble could potentially be prevented or managed by the restrictive policies that dampened speculation.

He was recently in Australia meeting with GMO clients and his dire predictions about the real estate market there drew numerous controversial responses in the press. Grantham believes that Australian real estate prices are 42% overvalued because the price to income ratio has risen to almost 7.5. But according to the RP Data, the correct ratio is a much more benign 4.3.

rpdata Australia housing bubble not here Jun 2010

The difference in the two ratios comes about because GMO focuses on the largest cities (which have much more expensive housing prices) while RP Data uses housing data from all of Australia. In a recent blog post, RP Data’s Research Director, Tim Lawless, wrote in a post titled “Housing Bubble? Not here”:

When you compare this to other countries you can see there are fundamental differences not just in the size of Australia‚Äôs population but the fact that it is so heavily centralised…

This smacks of rationalization. And it is rather silly to argue, as Lawless does, that unlike other countries, the vast majority of real estate wealth and population is concentrated in a very small geographic area and then to turn around and say that we should dilute the data with cheaper real estate from extremely sparsely populated areas outside of the 5 major cities (Sydney, Melbourne, Brisbane and Perth) to get a more accurate picture of what is going on.

Wouldn’t make more sense to use GMO’s methodology if you’re going to argue that the Australian market is unique because “60 per cent of all home sales take place across 0.5 per cent of the land mass”?

Lawless’ explanation is that people want to live in large cities and they are bidding up this limited resource. This, however, is nothing but a sophisticated variation on the tried and true, “They’re not making any more land.” excuse.

If we jump into a time machine, we can make the same rationalization for the Japanese real estate bubble in 1989 when one square foot in Tokyo’s coveted Ginza district was selling for $93,000 US. It also reminds me of Greenspan’s pathetic excuse (when he was Chairman of the Fed) that real estate can’t be in a bubble because it is not a homogeneous market.

This sort of argumentation reminds me of the real estate bubble in Spain. I vividly remember the (in)famous Economist magazine cover story that laid out in meticulous detail why Europe and most of the world was undergoing a real estate bubble because I happened to be in Europe at the time. The cover story was full of empirical data. For example, the high price to rent ratio, the low affordability (price to income) as well as the fact that in one year, more units had been built in Spain than Italy, Portugal, France, and Germany combined.

When I finished reading it I was convinced. But remarkably when I spoke with the locals, they brushed such concerns aside with their own rationalizations. Here are some of the reasons they gave me why there was no bubble and why real estate prices would keep going higher:

  • Spain has a growing economy
  • it has much further to go to catch up to other well developed nations like Germany
  • it is a major tourist destination so demand not just from domestic sources
  • Spain is starting from a low level of home ownership
  • people cheat and don’t report their ‘true’ income
  • families help couples to buy property
  • the transition to the Euro created a lot of ‘dinero negro’ or undeclared cash

All of the above may have been true, but when the bubble finally popped, none of them made one tiny difference. The same sort of rationalization occurred during the last real estate bubble in England (in 1989). People said it was because of land shortage and the demand for housing in London (the concentration argument) and that prices had hit a new plateau because of government intervention (not allowing rezoning).

Another analyst calling for a 40% correction in Australian real estate prices is Prof. Steve Keen (Australia’s answer to Prof. Shiller). He recently wrote an article with some alarming charts like this one:

inflation adjusted real estate Australia Japan US Jun 2010

So on the one hand we have RP Data and an unconcerned Reserve Bank of Australia and on the other we have Jeremy Grantham and a bookish economist who points to empirical evidence. This is beginning to sound familiar.

The Reserve Bank of Australia’s deputy governor Ric Battellino recently went on record to take the same position as that outlined by Lawless:

People feel that house prices in Australia are quite high and that’s quite often because the ratio of house prices to income that are published for Australia tend to focus mainly on prices in the cities, and they are quite elevated…

The RBA has increased the interest rate 6 times since October 2009 (when it was increased from 3% to 3.25%) - the cash rate in Australia stands currently at 4.5%. But they have not targeted the real estate market the way that Canada has by introducing new policies to reduce speculative or highly leveraged transactions.

Bubble Brides
If you think Australia’s 7.5 price to income ratio is high, then China’s (Shanghai to be more specific) price to rent ratio of 60 is downright terrifying. But there is an amusing explanation offered for that countries runaway real estate prices.

It all goes back to the unintended consequences of the One Child Policy. Since male children were preferred, this lead to a skew in the Chinese population. For every 120 male children, 100 female children were born. Today this means that if you are a bachelor in China, you face stiff competition for a bride. Since women are in low supply, they are setting the rules. Unfortunately for many young men in China, having a home is now a prerequisites for being marriage material in the eyes of their girlfriends. Competition between males, as a cultural and demographic reality, is one of the reasons for the unrelenting increase in real estate prices.

Here’s an interesting story from a recent article, “China’s housing boom spells trouble for boyfriends:

Wang Haijun, a real estate agent on Beijing’s east side, said he can always tell when a desperate bachelor walks into his office.

“They’re always the least rational buyers,” Wang said. “They don’t care how little money they have. They just want an apartment as soon as possible. They take on a mortgage with the longest terms and highest interest rates. But they have no choice. They have to get married. I feel sorry for them.”

However we rationalize bubbles, it is important to remember that they still remain bubbles.

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6 Responses to “Rationalizing Real Estate Bubbles In Australia & China”  

  1. 1 Rod

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    Great stuff, thank you!!

    One more reason to be careful with your trading/investment: Event risk is unusually high.

  2. 2 Rohan Clarke

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    You seem to be spreading your wings a little wider over recent weeks - without compromising the quality of your thinking. Great work.

    For some further context (although the same conclusion) you might like to have a look at this

    My read of the latest numbers on housing finance, building approvals etc is that the top is in for the Australian housing market.


  3. 3 Sumeet

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    Hi Babak,
    Very good post.
    Could you help me with any such data on India? I have not found any good article / link so far.
    As I live in Mumbai (Bombay), it seems to me that real estate prices are ridiculously high. But, empiricial evidences would be very helpful.

    The difference is though a much better central bank policy in India - which actually tries to reduce speculation.
    The -ve difference here is lot of black money (money unaccounted for) which has only 1 place to invest - real estate.


  4. 4 Gedeon

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    In 2000 -2001 the Howard government introduced a new law that effectively made investing in real estate the perfect option for people to park there money. The change was that you only have to pay 15% tax on an investment property if you hold it fir mire than 12 months. This is extremely low and has spurred a wave if real estate investment that has artificially pushed up the price if real estate. Almost anyone you meet over 40 has a portfolio of multiple properties…

  5. 5 foj

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    Thanks for sharing, very interesting and useful post.

  6. 6 Ben

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    When the Australian government is forced to raise capital gains taxes to secure tax revenues from what will be the real estate bubble, this will cause a slow and steady exodus out of the market. Investors who were leveraged by collateral from their existing portfolio will more or less receive “margin calls” from their banks as their investment property values decrease over time to a point where it is no longer comfortable for banks to accept those properties as collateral.

    This will have a devastating impact on real estate markets in Australia. The key distinction with Australia is that there is negative gearing, and then what the government is forced to do, if given the time, is to reduce the effect on them by raising capital gains taxation on whatever is left of the market value profits.

    Now is a good time to SELL if you have a portfolio of properties in Australia. Wait too long, and you could be thrown out of the frypan and into the fire, especially if you are too heavily leveraged with huge debt loads.

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