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According to The Economist, Australian house prices are more overvalued than the US housing market at its peak.

According to the economic journal, there are two ways to track valuations: price-to-rent ratio and price-to-earnings ratio.  Just as a share price reflects a company’s future profits, house prices should reflect expected return.  If both measures are well above their long-term averages, then the property market is overvalued.

Australian house prices, The Economist says, are 53% overvalued relative to rental return and 38% overvalued relative to income. Australia, today, has more household debt than America at its housing-market peak, which leaves it – again according to The Economist – more vulnerable to a credit crunch, higher mortgage rates or a recession which drives up unemployment.  Either of which, The Economist says, could send house prices tumbling.

What balderdash!

I am not referring to the premise that a credit crunch, higher interest rates or rising unemployment would have a negative impact on the housing market, but rather the two measures used by The Economist to measure housing value.

According to our most recent Matusik Snapshot (Matusik Snapshot 499 – House price update) – how could you not subscribe ? (Snapshot Subscription form 24 issues $100) – Australian housing is becoming quite affordable again.  Falling end prices, coupled with falling interest rates and rising household incomes, have now made housing across Australia – and especially in Queensland, Western Australia, South Australia and Tasmania – much more affordable. For example, it now only takes 30% of household income to buy the median priced dwelling in Brisbane, even less in Perth, Adelaide and Hobart.

Prices are starting to get to the point where people will start buying again.  That doesn’t mean that prices will necessarily rise quickly, but they are unlikely to crash as strongly suggested by The Economist.

The Economist’s other housing value measure – the ratio of average house prices to average rents model – is seriously flawed.

There are several logical reasons why our house price to rent ratio is high; the sum of which dismisses The Economist’s claim.

Now, as recently outlined, the value of investment property (that is, stock held by investors) should be determined by its return (i.e. rent) but not owner-resident or even secondary homes.  Why?

Close to 70% of Australia’s dwellings are held by owner-residents, of which half are owned outright.  A third of Australia’s dwellings are held by investors and are rented out.  We can sell our principal place of residence tax-free.  Investment property is subject to capital gains tax.

In addition, two-thirds of the Australian housing dollar is spent on renovations, a trend which has accelerated since the introduction of GST on new dwellings about a decade ago. We estimate that close to 80% of this renovation money is spent on owner-occupied homes.

In contrast, very little is spent on improving investment dwellings.  Improvements to Australian investment property are done to increase the rental return, not necessarily the sales price.

Given the current tax laws, it makes good economic sense for owner-residents to improve their homes.  Hence, there is a large difference between the price of owner-occupied homes and investment property across Australia.  Many rental properties sell for prices in the mid-to-high $400,000s.  Most owner-occupied properties sell for much more, with close to 70% selling for prices over $500,000 and near to 40% selling for amounts in excess of $600,000.

Owner-residents generally prefer detached houses over attached stock.  The reverse is true for investors.  Attached stock is, more often than not, cheaper than detached housing.  More renters live in attached stock than detached product.  This further exacerbates the reason why end prices – when pooled together – far exceed rents in this country.

So there is little wonder that the average price of Australian houses is much more than the average rent.  Our rental stock is inferior – for the most part – to the dwelling stock held by owner-residents.  A simple drive around any of our cities will illustrate such.

A house of horrors it is not!