Property prices have always been a popular topic of conversation in Sydney, but the subject has become more contentious since the onslaught of the Global Financial Crisis. Views on prospects for Australian property prices range from the bleakly pessimistic to the wildly optimistic. Iconoclastic economist Dr Steve Keen is one of the more prominent pessimists and expects a fall in property prices of as much as 40%. At the other extreme, research firm BIS Shrapnel recently released forecasts that prices in capital cities will rise by almost 20% over the next three years. Of course, both sides have their critics. Macquarie Bank economist Rory Robertson is so convinced that Keen is wrong that he has offered a wager in which the loser will have to walk to the top of Mount Kosciusko wearing a t-shirt saying “I was hopelessly wrong on home prices! Ask me how”. Meanwhile, many dismiss the optimists as mere shills intent on talking up the market in the interests of their clients.

Faced with a debate like this, the only recourse for the Stubborn Mule is to look at the data. Fortunately, I have been able to get my hands on a rich set of data (and ideas) from University of New South Wales economist Dr Nigel Stapledon*. Stapledon has painstakingly assembled data on Australian property prices back to the 1880s and rental data back to the 1960s. This data underpins a detailed comparison of the Australian and US property markets in Stapledon’s forthcoming paper  “Housing and the Global Financial Crisis: US versus Australia” in The Economic and Labour Relations Review, Sydney. By comparison, the House Price Indexes published by Australian Bureau of Statistics (ABS) commence in 1989.

A first glance at Stapledon’s index of Sydney property prices does indeed appear to show a meteoric trajectory that would inflame the passions of the pessimists.

Sydney House Price Index

Of course, asset prices tend to exhibit exponential growth, so it is far better to look at historical prices on a logarithmic scale. This reveals a striking trend. The growth of Sydney property prices has been remarkably consistent at around 9% per annum over the last 50 years.

Sydney Property Prices (log scale)

Prices for Australia overall show a similar trend, with average prices over the six major capital cities growing at an average of 8.6% per annum since 1955.

Australian Property Prices

What these charts do not take into account is the effect of inflation. Indeed, inflation varied significantly over the last 50 years, so adjusting for the effect of inflation shows that the trend in Sydney house prices has not been so stable. Booms such as those from 1987-1989 and 1997-2003 are made very clear in the chart below. But it is also evident that  prices have failed to keep up with inflation over the last few years. Nevertheless, over the last 50 years, Sydney house prices have appreciated an average of 3.1% over inflation and that is before taking rental income into account.

Sydney Prices (inflation adjusted)

One difficulty with long-run property price data is that fact that observations are typically based on median house prices, which does not take into account changes in the quality of houses. The median house in 2009 may be “better” than the median house in 1955 and changes in price may reflect this change in quality as well as price appreciation. Stapledon has attempted to take this into account by constructing an index for Australian house prices (six capital cities) that is adjusted for both inflation and standardised to “constant quality”. The trend in real prices, adjusted for quality over the period 1955-2009 has been an increase of 2.1% per annum over inflation. This compares to an increase of 2.7% per annum over inflation without adjusting for quality. So, at a national level, quality changes overstate the trend growth rate by 0.7%. While Stapledon has not constructed a quality-adjusted index for Sydney, assuming that the national trend applied would lead to the conclusion that Sydney house prices have a trend growth rate of 2.4% over inflation.

Australian Prices (quality and inflation adjusted)

Interesting though this historical exploration may be, the question we would like answered is where prices may head in the future.

One approach to the problem is to assume that growth in property values in real terms may change in the short term, but over the long term will revert to a long term trend. Enthusiasts of trend following may see some significance in the fact that Australian prices still appear to be above the longer run trend, while Sydney prices have already fallen below trend. Of course, depending on the time period used to determine the trend, very different conclusions may be reached. If I were to base the trend on the full history from the 1880s, the last 50 years would appear to be well above trend.

Another popular approach is to consider housing affordability. This approach either looks at ratios of house prices to income or ratios of housing servicing costs (whether interest or rent) to income. The assumption is that these ratios should be stable over time and if increases in house prices result in reduced affordability this indicates the prices can be expected to fall in the future. Stapledon is critical of this approach, arguing that:

while income is expected to be a major influence on prices, there is no theoretical reason for any fixed relationship between prices and income or between rents and income

Over time, people may change their priorities and place a greater or lesser importance on housing and, as a result, be prepared to spend a larger or smaller proportion of their income on housing. Stapledon argues that a better approach is to examine rental yield, which is the ratio of rents to prices. Since the property prices can be expected to keep pace with inflation (and, in fact, outpace inflation), rental yields should be comparable to real yields (i.e. yields over and above inflation) on other asset classes. The easiest real yields to observe are those of inflation-linked Government bonds.  The Reserve Bank of Australia publishes historical data for inflation-linked real yields back to the late 1980s. The chart below compares these Government bond real yields to Stapledon’s history of rental yields. While the correlation is not perfect, both rental yields and real yields show a downward trend from the late 1980s/early 1990s which has only recently begun to reverse. Since rents have not fallen over this period, this provides an explanation for the strong growth in property prices over that period.

Australian Rents and Inflation-Linked Bonds

So what could this approach tell us about property prices? Rental yields have already risen further than bond real yields, but certainly could go higher. What this means for prices does also depend on where rents themselves may be headed. The chart below shows the contribution of rents to consumer price inflation as published by the ABS. While the rate of growth in rents has slowed, history would suggest that rents are unlikely to go backwards. A cautious, but not overly pessimistic forecast could see rental increases falling to an annualised rate of 1% while rental yields could climb back to 4%. The combined effect would be a fall of 12%. Since prices have already fallen by 7% over the year to the end of March 2009, this would amount to a fall of almost 20%.

Rent Inflation (Quarterly)

This is certainly a significant drop, but still half the fall that Keen expects to see.  For prices to fall by 40%, even assuming rents remain unchanged rather than growing by 1%, it would be necessary for real yields to rise to 5.8%, which exceeds the record level since 1960 of 5.4%. On this basis, I find it hard to be as pessimistic as Keen. Indeed, the latest data from RP Data-Rismark International suggests that prices are once again on the rise. The next ABS release is a little over a month away, so it will be interesting to see whether they see the same recovery.

The relationship between rental yields and real yields is an interesting one, but ultimately does not provide definitive predictions, but rather an indication of a range of outcomes that would be precedented historically. Of course, as Nassim Taleb has emphasised, unprecedented “black swans” can occur so history does not allow us to rule out more extreme events. Furthermore, nothing here addresses the question why prices in the US have fallen so dramatically and yet Australian prices could suffer far milder falls. That is the primary focus of Stapledon’s paper and is a topic I may return to in a future post, but this one is long enough already!

UPDATE: In this post I noted that the historical data shows a marked shift in behaviour from the mid-1950s without providing any explanation as to the cause of this shift. Needless to say this is a subject Stapledon has given some serious consideration, and I will quote from his doctorate, “Long term housing prices in Australia and some economic perspectives”:

From a longer term view, a key observation is the clear shift in direction in house prices and rents from circa the mid 1950s. House prices, in particular, jumped significantly, best illustrated by the rise in the price to income ratio from about one: one to about 4:1 in the 2000s. Looking at demand and supply variables…indicates that this shift in direction cannot be adequately explained in terms of the demand variables of income and household growth. Supply side factors appear to be more crucial and there is a substantial literature emerging in the US emphasising the importance of supply side variables and specifically the propensity to regulate to constrain supply. The evidence presented in this thesis of the lift in the cost of fringe land in the major urban areas provides prima facie evidence that supply factors have been a significant factor explaining the upward trajectory in house prices in Australia since the mid 1950s.

* I would like to thank Dr Stapledon for generously making his data available to me.

UPDATE: finally, I have published the post on why I don’t think Australia’s property market will experience the same fate as the US market.