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The outlook for residential property

by James Weir | Mar 28, 2017 | Financial Planning, Investments, Property Loans

Our asset allocation consultant, Tim Farrelly, has done a deep dive on what he sees as the drivers behind Australian residential property. Applying his usual analytical bent his conclusion is that falling interest rates over the past 30 years have been the primary driver of rising property values, but now those rates have probably bottomed. We think you’ll find it reasonably easy to follow and given how topical the subject is we thought it well worth publishing.

“If returns came out of history books, then librarians would be the richest folks around”

-Warren Buffett

Residential property has been a wonderful investment for millions of Australians over the past 30 years and longer.

So much so, that investors know that, despite minor short-term slow-downs, residential property will always show excellent capital gains in the long term. They know this because it always has been this way in the past. Their parents bought their first house for four thousand pounds and it’s now worth over a million dollars. Every house they have ever bought has made money. And, better still, everyone they know has made money on residential property. Not most people – everybody. Investing in residential property makes you rich. It’s an historical fact!

Well, almost. Unless they have been very unlucky, past investors in residential property have done well and that is an historical fact. As is shown in Figure 1, capital growth has been exceptional for a long period of time.

However, as Warren Buffett also noted, past returns and future returns are quite different things.

This Editorial looks to understand past returns from residential property and then to use that understanding as a basis for forecasting future returns. To understand where the price rises came from, it helps to be able to break apart the role of fundamental factors, such as growth in rents, from market factors, such as how much the market is prepared to pay for a dollar of rent.

In essence, this approach says that the price of a property is determined by net rents multiplied by the amount the market is prepared to pay for each dollar of rent. We call this the Rent Multiple. If we have a property that produces $10,000 per year in net rent and the market is prepared to pay $40 for each dollar of rent, that property is worth $400,000. For the property to increase in value, either net rents must increase or the Rent Multiple must increase – or some combination of the two.

Let’s look at an example using the property described above. If, over the course of a year, rents rose 3% and the Rent Multiple rose by 5%, the house price would rise by 8%. This is the increase in rents (3%) plus the increase in the Rent Multiple (5%) as shown in Figure 2.

Where this approach becomes very useful is in understanding the contribution of each factor to past growth in property prices. As can be seen in Figure 3, increases in rents have been very much the junior partner in this exercise. Prices have risen much, much faster than rents. That is to say that the increases in prices have not been backed up by increases in the fundamental earning power of property. What has driven the major part of the price increases is a huge increase in the Rent Multiple.

As outlined earlier, the Rent Multiple is the amount buyers are prepared to pay for each dollar of rent. The Rent Multiple is the inverse of the yield on a property. The yield is calculated by dividing net rents by the property value, whereas the Rent Multiple is the value divided by the net rent. As can be seen in Figure 4 (overpage), a soaring Rent Multiple means tumbling yields.

Clearly, the major driver of increasing housing prices in Sydney and Melbourne has been the huge expansion of the Rent Multiple. In the case of Sydney houses, the Rent Multiple has risen from around 15 times rents in the 1980s to a massive 65 times rents today – even after a period of softer prices. Other capitals have experienced similar increases.

From an institutional investor’s perspective, Sydney residential property is outrageously expensive. By way of comparison, commercial property trades at around 13 to 20 times rents and shares trade at about 16 times after-tax profits. As a result, institutional investors rarely invest in residential property.

Why is residential property so expensive?

farrelly’s believes it is because prices are set by those looking for somewhere to live rather than conventional investment metrics. Owners of residential property are, of course, largely owner occupiers, with a fair number of private investors. Both behave very differently to institutional investors who look at the earnings power of an investment and the potential for growth in earnings. In trying to make sense of residential property prices, it helps to think about how residential buyers and sellers go about deciding what to pay or accept for a property. From there, we will propose a theory of how prices might behave and then, finally, look at the data and see if our theory translates into the real world.

How home buyers decide what to pay for a property

How much do home buyers pay when looking for a house? The answer? Whatever they can afford.

Home buyers, after their first day of house hunting, invariably return deflated. “Is our dream home really that far out of our range? I can’t believe how little we get for our money.” After that first day, the buyers’ strategy becomes clear – work out the maximum they can possibly borrow and then go looking for the least worst place they can buy for that amount of money. Concepts like yields or the Rent Multiple just don’t come into it. They just want their own home to live in and in which to raise a family. So what do they spend? Whatever the bank will lend them.

The banks will assess a loan on the ability of the borrower to pay the interest. They compare the amount of the borrowers’ weekly income that can be spent on interest payments with the interest payments required on the amount borrowed. So, if the borrowers’ earnings rise, or if bank interest rates fall, the banks will lend more to a given borrower. Similarly, when interest rates rise, banks will lend less for each dollar of income. Borrowers want to maximize the amount they have to spend on their property and the banks are only too happy to lend it to them.

When interest rates fall substantially, buyers all over Australia simultaneously find they can borrow, say, 20% more to buy a fixed number of houses. You would expect that, in this environment, prices should rise by around 20%. And, more or less, this is what actually happens, if not immediately.

Note that this only works if the supply of houses is relatively stable. If the supply of houses responded rapidly to changing prices, bank lending would no longer drive prices to the extent suggested here. In Australia, we have some nine million dwellings growing at around a little over 1% per annum – and that is with a building boom underway.

Now, home buyers don’t automatically pay more for a given property just because they have had a pay rise and can borrow more. In practice, they study the market for a while, work out what is the going rate for houses in a particular area, and then go looking for a bargain, or at least something that seems reasonable. Sellers go through a similar exercise. They find out what other houses in the street have sold for and hope to get a price a little bit better than that.

The impact of thousands of such buyers, all making similar assessments, will gradually move prices up when average weekly earnings rise, or if interest rates fall. In the long term, prices should rise in line with the amount the banks are prepared to lend.

How investors decide what to pay

Because home owners aren’t the only buyers in the market we need to investigate the market impact of investors, who, as we have discussed, are rarely institutions who worry about income and how fast that income grows.

Private investors are more concerned with the amount of capital appreciation that may be achieved over a period of time, without being too concerned where that appreciation might come from. For a private investor, a bargain is a property that is cheaper than the house next door, even if both are ridiculously expensive from the viewpoint of an institutional investor.

Private investors believe that residential property will increase in value. Their experience, and the experience of just about everyone they know, is that property prices rise in the long term. So their process for investment turns out to be much the same as home owners. They work how much they can borrow and find a property at a half decent price compared to other properties in the area. And the banks’ attitude to them is much the same – how much interest can you pay and can they pay a deposit?

Affordability: theory and practice

Our proposal is that in the long-run, prices are set by home loan affordability which can be best thought of as how much the bank will lend to the average buyer. In effect, we do something close to the calculation a bank makes before deciding on a loan. The bank will start with the amount a borrower earns, work out what is left over after living expenses and therefore available to be used to pay interest, and then divide by the interest rate payable to arrive at an affordable value, or the amount the bank will lend.

If this works in practice, then we should see long-term prices following a path that is similar to that of the Affordable Value calculation. We should see prices rising as average earnings rise and as home loan interest rates fall. In the short-term, prices may move away from the theoretical Affordable Value – depending on the amount of buyers and sellers active in the market – but prices should come back over time.

Figure 5 compares actual median house prices around Australia with farrelly’s estimate of Affordable Value in different states. The results fit the theory well. As expected, in the short-term, prices seem to take a while to respond to changes in affordability and at times get driven beyond the levels one would expect if they were set by affordability alone. But in the long run, prices seem to follow the path set by changes in affordability.

Looking ahead

If affordability continues to be a key driver of residential property prices, then the major drivers of prices will be wage growth and interest rates, both of which depend to a large part on inflation.

Inflation

Forecasting inflation is a subject in itself. For the purpose of this report, we will assume that the RBA and RBNZ continue to have moderate inflation as one of their primary targets and continue to do an excellent job of keeping it there. Our estimate is for inflation to remain in the 2% to 3% per annum range, averaging 2.25% per annum, in Australia and 2.0% per annum in New Zealand. However, it is possible that inflation could be higher or lower than the targets and so we will also look at the impact of higher or lower inflation as well as our base forecast.

How fast can wages grow?

The data for average weekly earnings growth compared to inflation is shown below in Figure 6. What we see is that wages move broadly in line with inflation, generally with some scope for real growth, usually reflecting productivity increases.

Currently, real wages growth in Australia is very slow, reflecting the sluggish Australian economy. As the economy gradually improves, we see that picking up, but not too much. We expect average income growth at around inflation plus 0.75% per annum in the next decade in Australia.

Interest rates

In the long run, interest rates tend to be driven by many factors, but the key one is inflation, or expected inflation. It is our expectation that interest rates will increase modestly over the next decade to, say, 3.0% or 3.5%. Rates may even go higher. What they will not do is go much lower. Nonetheless, we can test the impact of a range of different interest rate environments on Affordable Values.

Affordability through to 2027 under different scenarios

We can test the impact on affordability of our base case and for a number of different scenarios. Nonetheless, given we need either high wages growth or falling interest rates to drive affordability, even without looking at the numbers, we can quickly see that growth in affordability is likely to be much slower than in the past. The various scenarios in Figure 7 make assumptions about what real wages growth and interest rates would be under different inflation scenarios. And, while the 1.5% to 4.5% range of inflation scenarios may seem narrow, moving outside those scenarios doesn’t change the remarkable conclusion from this review that almost regardless of what scenario we look at, the rate of growth of housing affordability is likely to be extremely low going forward.

This suggests that capital growth is likely to be around 2.5% per annum or less for the next decade, which, when added to the extremely modest rental yields on offer, suggests very modest pickings for residential property investors over the next decade, as is summarised in Figure 8.

While the analysis here is focused on the Australian market, anecdotally the same logic largely applies for the New Zealand market although farrelly’s lacks the data to back-test the affordability model in NZ. As can be seen here, the outlook for the Auckland residential property market looks much the same as that of Melbourne and Sydney, and for all the same reasons.

What could go wrong with this forecast?

Forecasts are based on assumptions, many of which could prove to be wide of the mark. In this case, there are many factors that could lower residential property returns below even these modest forecasts.

What could make returns even lower than forecast?

Foreign investors become net sellers – this is possible, particularly if the markets show signs of weakness. In property markets like Hong Kong, investors are notoriously fickle. However, anecdotally, much of the foreign buying in Australia and New Zealand has been for lifestyle rather than investment purposes.
Local investors become fearful, take flight and dump property – again, this is possible, but unlikely. There is a very strong underlying belief in property as a sound investment. It would take a long time to break that belief.
Changes to the capital gains tax treatment or deductibility of interest expenses— again, this is possible, but unlikely to have too much impact. It may slow new investors entering the market but any changes would in all likelihood be grandfathered and so would not effect existing investors.
Massive overbuilding – there have been signs of this in some suburbs of Sydney, Melbourne and Brisbane and, if building activity keeps going at current rates, that certainly would lower returns. However, building approvals are slowing and so the long-term impact should be modest.
Even tighter regulatory controls on bank lending practices – this has already been happening to some extent and has been incorporated into this analysis. Further tightening of lending standards will further lower capital growth.
Recession – this could hurt returns in the short term and medium term, as recessions tend to move the actual value below Affordable Value for a while. On the other hand, recessions tend not to impact affordability in the long term.
Much higher interest rates – these would have little impact on nominal returns but could be devestating for highly geared investors. This is quite unlikely as central banks will be very cautious about lifting rates too far too fast.
Legislation aimed at improving housing affordability by reducing housing prices – this is a real possibility but the impact will be targeted to slow capital growth rather than reduce prices substantially. This is a political tightrope – don’t expect too much from our politicians!
Transaction costs – the cost of buying and selling a house normally comes close to 8% to 10%, enough to reduce returns by 1% per annum on a 10-year investment. This will apply to all new investors considering a residential property investment

What could go right?

Because these forecasts are somewhat pessimistic, instead of worrying about how the returns might be much lower than forecast, it is possibly more useful to worry about whether and how returns might be much more attractive than expected.

farrelly’s sees two main catalysts:

The foreign investment floodgates open – this is possible, but unlikely. The New Zealand government has been on the housing affordability case for some time, with limited success it would seem. Now, even Australian politicians have woken up to the idea that this is a major issue for a large part of the population. Restricting the impact of foreign investors on affordability is too easy a win. If increased foreign capital flows was a factor that was really driving property prices, expect it to be shut down quickly.
The politicians attack the affordability issue by making it easier to buy property – this is low hanging fruit. First time home buyer grants, allowing banks to ease lending criteria, allowing superannuation savings to be used to buy a first home – all just make the affordability issue worse. Again, this seems unlikely as most politicians seemed to have worked this out. But it is ripe for the populists.

Now is not a great time to be investing in residential property

Low returns, high transaction costs, and the threat of rising borrowing costs all make Residential Property a dubious proposition at this time, despite magnificent past performance.

Are apartments as safe as houses?

by James Weir | Aug 8, 2016 | Investments, Property Loans

Lower interest rates are almost certain to fire up a housing market and property developers will make out like bandits as they rush to bring on new projects to meet the fueled up demand. This certainly appears to have happened here in Australia where a record number of unit approvals have now rolled into commencements. One look at this chart from UBS Asset Management shows why this may be spelling trouble: whenever you see a chart go all but vertical you have to stop and wonder, particularly when you’re talking about the supply of dwellings, since there are only so many people to buy them and live in them.

One analyst estimates there is about 12 month’s oversupply of new dwellings, which is hardly surprising given, as the chart shows, there are more than four times the number of apartments being built now than in 2000. Of those being built, 88% are in Queensland, New South Wales and Victoria, leading to assertions of an apartment glut. For example, there were 2,700 apartments a year added to the Melbourne CBD over the past 14 years. Right now, however, there are 19,640 apartments under construction in the City of Melbourne, with an additional 18,800 approved for development.

If the property market does cool down it’s quite possible apartments will be the catalyst. By the end of June there had been 96,000 completed apartments settled in the previous 12 months and there were 92,000 pre-purchased apartments due to be settled. One problem though is the banking regulator, APRA, firstly instructed the banks to reduce their investment lending activity overall, so they have been lowering the amount they will lend against apartments and some lenders have listed specific postcodes they are avoiding altogether and, secondly, pressured the banks to reduce their lending to non-residents. The decline in funding availability means some buyers are having to resort to non-bank lenders, which comes at a cost.

Also, while it’s unclear how many apartments have been purchased by Chinese buyers, Meriton in Sydney is reporting that following the Chinese government’s crackdown on capital leaving the country they are seeing off the plan buyers walking away from their 10% deposits, which hasn’t happened before.

If an apartment is bought as an investment and is to be rented out, the estimated yield in Melbourne is now 3%. Once you deduct costs the net yield is about half that, so 1.5%, which is lower than a government guaranteed term deposit. That means the only possible justification to purchase a Melbourne rental property is expected capital gain. If supply is about to rise markedly, that expectation will look increasingly like speculation.

Borrowing to purchase property in a SMSF

by James Weir | Jun 2, 2014 | Financial Planning, Property Loans

Taking out a loan through your Self Managed Super Fund to buy property has become a much talked about strategy, with some commentators even attributing a good chunk of the recent rise in Australian residential property prices to it. Given that the particular kind of loans required to buy property in a SMSF, non-recourse loans, only account for $10bn out of the major banks’ $1.3tn mortgage books, that sounds unlikely.

Buy an investment property – including your office

This strategy is flexible enough to allow you to buy all kinds of different investment properties in your SMSF, from residential through to commercial. While buying a residential property can be a perfectly fine strategy, it is particularly attractive for someone running their own business because it offers the chance to purchase your own work premises and effectively pay yourself rent to pay off the loan. For example a barrister buying their chambers or a business owner buying a warehouse.

Lots of rules – care required

SMSF’s are regulated by the Australian Tax Office and are subject to a heap of rules and regulations designed to prevent tax avoidance, the improper use of super funds and to protect people from themselves, and borrowing in a SMSF attracts a whole set of extra rules. As usual, the ATO is diligent and stringent in enforcement. That makes for a complex environment overall, so you don’t want to go into this kind of transaction without giving it due thought and careful attention to detail.

Also the banks are obliged to be very careful in lending to SMSF’s, often requiring sign off by a financial planner, and many transactions fall over in the documentation phase.

Before you buy

The SMSF must be allowed to invest in property under its trust deed and have it form part of the fund’s investment strategy. If your SMSF was set up pre-2007 you’ll want to check that carefully.

What can you buy?

A fundamental rule for SMSF’s is that they have to be for the sole purpose of providing for a member’s retirement, which restricts what a SMSF can do.

A SMSF can buy residential or commercial property. However, it can’t buy a residential property from an ‘associate’, which is defined very broadly to include many different kinds of related parties, including the members of the fund.

It also can’t buy a property with a view to developing it because that can be interpreted as the super fund assuming the role of a property developer, which breaches the sole purpose of providing for the members’ retirement. In fact, there are even rules surrounding what you can spend money on by way of maintenance once you’ve bought a property, because you’re allowed to maintain the property but you can’t improve it.

You can’t buy a holiday home that you intend to use yourself, not even for just one night a year, nor can you buy a home that you intend to move into and rent from the super fund.

The exception to the ‘in-house’ asset rule

A SMSF can not only purchase a property that’s for business purposes from an associate or related party, but you’re also allowed to rent commercial premises from your super fund, as long as it’s at a commercial, or arm’s length, rate. This makes it ideal for small-business owners: rather than paying rent to a landlord and have the money disappear, you more or less pay rent to yourself in order to buy a long-term asset.

How much can you borrow?

Banks will generally lend up to an LVR (loan to valuation ratio) of 80%, with the loan serviceability assessed against not just the expected rent but also super guarantee payments, the super fund’s earnings and any contributions you make.

There are a few differences to normal home loans, like they don’t usually allow for redrawing cash. You are allowed to refinance a SMSF loan.

The benefits of buying property in a SMSF

As well as the opportunity to pay rent to yourself instead of a landlord, the biggest benefit of buying property in your SMSF is, as usual, the tax savings. Rent received by the SMSF is taxed at the concessional rate of 15%, and if you’re in pension mode, it’s tax free! If you sell the property, capital gains tax rates are likewise lower: 15% if for some reason you sell it in the first year, 10% if you sell it after that point and zero if you’re in pension mode.

What’s more, by maximising your concessional super contributions (for the 2015 financial year that is $30,000 p.a. for someone aged 50 and under and $35,000 for over 50) you can put those funds toward reducing the loan. That’s a great way to pay down the loan tax efficiently, since you’d only pay 15% tax on the concessional contributions (unless you’re earning more than $300,000 p.a., in which case you’d be paying 30% contributions tax). And remember, the rent your business pays is a deductible expense too.

If the loan on the property is negatively geared you can claim the same deductions as if it was in your own name. You just want to remember that with the low super fund tax rates of 15% at the most, negative gearing is a more limited benefit than outside of a super fund.

How it works

According to one of the banks there are no less than 17 separate steps in borrowing to purchase property in your SMSF.

The loan the SMSF takes out is a non-recourse loan, meaning that the bank can’t come after other assets of the super fund should it default on the payments. That in turn makes the banks a little more cautious in lending to a SMSF, which is generally reflected in the charges and the loan approval process.

Because the SMSF can’t borrow directly, you have to set up a bare trust, which holds the legal title to the property until the loan is paid off, with the SMSF holding beneficial title. The trustee of the bare trust has to be independent of the SMSF trustee. Like the SMSF trustee, it can be an individual or a company, and again like the SMSF there are advantages to having a corporate trustee. But that means setting up a company, which adds to the cost.

The risks

Each one of those 17 steps mentioned above represents a point where errors could crop up to derail the process and the consequences of making a major blunder are severe: the ATO can sting you for half the value of the asset. So you need to get it right, which generally requires getting professional advice.

The other risks are the ones typically associated with investing in property:

It is an illiquid asset, so especially for members approaching retirement who have to draw a pension, you need to remember that you can’t just hack off a corner of the property and sell it in a hurry to raise cash
All those various steps tend to add to the transaction costs, like legal fees, loan establishment fees, stamp duty, conveyancing costs, etc.
You would have to think very carefully before buying a property in a small SMSF because you need to be mindful of retaining sufficient diversification of your investments
If you’re not the tenant in the property you need to be mindful that they can present problems of their own
If you don’t already have a SMSF you need to be clear on whether it is a suitable structure for you.

Overall, borrowing to buy a property in your SMSF can be a great strategy, especially for small-business owners who can rent the premises to themselves. But there are lots of risks associated that you have to be comfortable with and you need to be very careful in the administration of the whole transaction so you don’t fall foul of the ATO. It is no coincidence that geared property investments account for a very small overall proportion of SMSF investments.

The bottom line is that it is best that you get professional advice before going down that path and we here at Steward Wealth would be delighted to help. You can contact us on 03 9975 7000 or at info@stewardwealth.com.au

2014 Demographia Housing Affordability Survey

by James Weir | Jan 21, 2014 | Markets and Economy, Property Loans

Source: Leith van Onselen, Macro business “link to full article”

The 10th Annual Demographia International Housing Affordability Survey has just been released and, once again, it ranks Australia as having one of the most expensive housing markets out of the countries surveyed.

This year’s report assesses 360 urban markets in nine countries: Australia, Canada, Hong Kong, Ireland, Japan, New Zealand, Singapore, United Kingdom, and the United States. The survey employs the “Median Multiple” (median house price divided by gross annual median household income) to rate housing affordability. This measure is widely used for evaluating urban markets, and has been recommended by, amongst others, the World Bank and the United Nations, and is used by the Harvard University Joint Center on Housing.

The Survey ranks urban housing markets into four categories based on their Median Multiple, from “Affordable” (3.0 or less) to “Severely Unaffordable” (5.1 & Over) [Table ES-1]. Average multiple data (average house price divided by average household income) is used in Japan, since data for estimating medians is not readily available.

According to the Survey, housing affordability deteriorated somewhat in the major metropolitan markets in 2013.

At the national level, Hong Kong has by far the most unaffordable housing, with a median multiple of 14.9. Australia and New Zealand are tied for second most unaffordable market out of the nations surveyed (both 5.5), followed by Singapore (5.1), United Kingdom (4.9), Japan (4.0), Canada (3.9), United States (3.4), and Ireland (2.8):

As shown above, all of Australia’s 39 markets captured in the survey are ranked as either “Seriously Unaffordable” (14) or “Severely Unaffordable” (25). Australia currently has no housing markets ranked as “Affordable” or “Moderately Unaffordable”. The result represents a slight improvement on last year’s survey, where 30 markets were ranked as “Severely Unaffordable”. A break-down of Australia’s rankings are provided in the below table:

Looking at the major metropolitan areas only – i.e. those with more than 1 million inhabitants – you can see that Australia ranks as third most expensive after Hong Kong and New Zealand (Auckland):

Overall, Australia has moved down the league tables, registering 5 out of the 20 most expensive housing markets identified in the Survey, versus eight in last year’s survey:

The overall decline of housing affordability in Australia over the past few decades (and the modest recent improvements) is clearly evident in the below Demographia chart, which shows the change in Median Multiples in Australia’s major urban markets. The RBA has previously shown similar findings.

Whereas all major Australian markets, except Sydney, had Median Multiples of three in the early 1980s, today all are ranked at around five or above.

One of the key contentions of the Demographia Survey is that higher land prices are the principal contributor to the rapidly increasing home prices in unaffordable markets, as well as increased speculative activity. These land prices include the cost increasing influence of land supply restrictions (such as urban growth boundaries), excessive infrastructure fees and other overly strict land-use regulations:

Operating at cross-purposes, many governments have adopted urban containment land regulations (also referred to as “densification,” “compact development,” “urban consolidation,” “growth management,” “smart growth,” or “livability” policies) that ration land for development… [These policies lead] to materially higher land prices, which makes houses more expensive, just as rationing oil increases the price of petrol…

Regrettably, virtually no government administering urban containment policy effectively monitors housing affordability…

Typically, land use policy authorities fail to compare credible measures of housing affordability with historical standards [above]. Moreover, when faced with the reality that housing costs rise disproportionately relative to incomes, they seek to identify virtually any cause except for the principal cause itself: the destruction of the competitive market for land…

Severely unaffordable markets are also more attractive to buyers seeking extraordinary returns on investment and short term profits. This further raises prices in markets where urban fringe development is largely prohibited by urban containment’s land rationing policies. Substantial international investor activity has been reported in London, Vancouver, the US West Coast markets of Vancouver, Seattle, the San Francisco Bay Area, Los Angeles and San Diego and others. These price increases make such metropolitan areas less livable for average and lower income households.

The key to preserving housing affordability is a “competitive land supply,” which appears to be incompatible with urban containment policy both in economic theory and practice. Further, out-of-control house price escalation destabilizes economies, retarding metropolitan area economic growth and job creation.

And in the 2011 Survey, Demographia noted the following about Australia:

In Australia, 95 percent of the increase in inflation-adjusted new house (and land) costs were attributable to land, rather than construction from 1993 to 2006. In more restrictively regulated San Diego, house prices were 250 percent higher than in Dallas-Fort Worth in 2007, yet cost only 15 percent more to build…

Demographia’s contention that Australia’s rising home prices have been caused primarily by escalating land costs is supported by evidence. The below chart shows aggregate Australian housing values relative to GDP broken down by the land component and the structure component. As you can see, almost all of the growth in Australian housing values (relative to GDP) has been in rising land values:

Further, this escalation of land costs has occurred across Australia’s housing markets, as evidenced by all capital city markets experiencing strong growth in vacant land values in the decade to 2012, according to RP Data:

A key reason for this land price escalation in Australia (as well as in New Zealand, the United Kingdom, and the expensive markets of the United States and Canada) is that the market’s ability to quickly provide low priced new housing supply is being hampered by restrictive land use regulations, many of which have come into effect since the mid-1990s (Sydney has had long-standing limits on housing development on the urban fringe). Demographia describes the key features and consequences of restrictive housing markets as follows:

Urban containment (More Restrictive Land Use Regulation) relies on intrusive land use regulation, and includes markets where residential development (new construction) is strongly controlled by comprehensive plans or development limits. Generally, it is an urban planning objective to make urban containment the only legal regulatory structure. There is a strong campaign to make the principal alternative, liberal regulation (below), illegal.

Urban containment may also be characterized by terms such as “densification policy,” “compact development”, “urban consolidation”, “growth management” “and ” smart growth.” Generally, urban containment regulation is “plan-driven,” as planning departments and governments determine where new housing is allowed to be built. There is a “negative presumption,” with new development generally prohibited, except in limited areas where it is permitted by government plans.

By severely limiting or even prohibiting development on the urban fringe, urban containment eliminates the “supply vent” of urban fringe development, by not allowing the supply of housing to keep up with demand, except at prices elevated well above historic norms. In addition to higher housing costs relative to incomes, the higher densities in urban containment markets are associated with greater traffic congestion and longer average work trip journey times.

Urban containment policies are normally accompanied by costly development impact fee regimes that disproportionately charge the cost of the necessary infrastructure for growth on new house buyers. There is particular concern about the cost increasing impacts of these fees, especially in Australia, Canada (Canadian Mortgage and Housing Corporation), New Zealand (New Zealand Productivity Commission) and California.

By contrast, affordable housing markets, like Texas and Georgia in the United States, utilise open market-based land use structures whereby plentiful new housing supply is able to be built quickly and cheaply on the urban fringe, thereby preventing rapid house price escalation. Demographia describes these markets as follows:

Liberal Land Use Policy (Less Restrictive Markets) applies in markets not classified as “urban containment.” In these markets, residential development is allowed to occur based upon consumer preferences, subject to reasonable environmental regulation. Generally, liberal land use regulation is “demand-driven”. There is a presumption allowing land to be developed, except in limited areas, such as parks and environmentally sensitive areas. By allowing development on the urban fringe, liberal land use regulation allows the “supply vent” to operate, which keeps house prices affordable. Less restrictive regulation can also be called traditional or liberal regulation. In addition to lower costly housing costs relative to incomes, lower population densities in liberal markets are associated with less intense traffic congestion and shorter average work trip journey times.

So under an open market-based model (provided there are not also substantial physical barriers to housing supply), increased demand, such as from reduced lending standards and easier availability of credit, quickly leads to the building of additional low priced housing on the urban fringe, which helps keep house prices in check and reduces the likelihood of speculative housing bubbles developing. Further, highly leveraged speculators are less likely to be encouraged into open land markets, since there is little prospect of achieving strong capital gains. Investing in open land markets is, instead, more about rental yield.

I will add that restrictive urban planning structures should not be viewed as a one-way bet for house prices, with unresponsive land supply also more likely to result in higher levels of house price volatility and boom/bust price cycles – a fact also acknowledged by Demographia. Why? Because strict land-use policies (planning) steepens the supply curve, which makes house prices more sensitive to changes in demand, increasing the likelihood of the housing market experiencing boom/bust price cycles as demand rises/falls.

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