Markets Unplugged

The global housing markets are in chaos, but what about New Zealand? Is New Zealand Real Estate going to be immune from a massive drop in values? The US has seen a 30% fall from the peak, and the UK a 20% fall, and in both cases prices just keep falling. Both these nations have had similar booms to NZ, so will NZ experience a similar fate?

The state of the NZ housing market has a debate that has raged every since the global housing bubble burst. Is the NZ market really different from the UK and USA markets or is it simply going the same way, but with some sort of weird time lag? Amongst all the opinions around is there anyone who can give an honest and impartial analysis of the market and what its going to do next? Or is everyone so biased in their views that nobody can be expected to be impartial? Well the job of an analyst is to be impartial so with that in mind – let’s take a look at the state of play with the NZ property market.

Can house prices even be predicted?

There are many analysts around who claim to have a property market model that will predict house prices. However – when you look into these models most of these are based on only a few different factors, available supply, current demand, fundamental measures of valuation, and there you have the answer. But the truth is that none of these measures were useful at predicting how high prices would go on the way up, so why would they be useful on the way down? The market is not solely a function of supply and demand, nor is it solely a function of sentiment.

The best property market model that I have found ‘out there’ is the one described in Grow Rich with the Property Cycle by Kieran Trass. Trass’s model uses 17 different factors, which conisist of emotional drivers, demographic drivers, and financial drivers, the combination of which divide the market into 3 phases of ‘Boom’, ‘Slump’ and ‘Recovery’. Guess which phase we’re currently in? Yep… the Slump.. we are in a Slump but how low will prices go before the Recovery happens?

How low could it actually go?

In order to get some idea of how low prices we can actually go – we have to look at history as a guide. While ‘past performance is not indicative of future results’, they sure are handy when it comes to giving us a ballpark idea of what could potentially happen. At least a worst case scenario is what we are after. In the book Bubbles and How to Survive Them the author made a study of various historical house price crashes around the world. He found that the average housing crash lasted 4 and half years and resulted in an average fall in prices of 35% in real money. New Zealand had a housing ‘crash’ in the late 70′s with prices falling 37% in real terms over 7 years, however, due to the extremely high inflation at the time, nominal prices did not fall by much. So therefore nobody really counts this as a ‘crash’.

The below graph is very telling and shows the increase in the NZ house price to (annual) income ratio since 1989:

As can be seen from the above graph – NZ house prices have massively increased vs incomes since about 2001. Back in the early 90′s the ratio was only around 5, which then increased to 6.5 by the year 2000 and then it simply took off – peaking at over 10.5 at the peak of the housing mania in late 2007. What this says is that over the past 20 years, house price growth has outstripped wage growth by a factor of 2:1. To go back to where we were 20 years ago would take a 50% drop in prices from the peak in 2007. To take us back to the year 2000 prices would mean a 39% drop in the average house price.

However house price to income ratios just give us a historical context of what prices have done in the past. In the world of property investing, houses are priced off their rental yields achievable assuming 100% financing. In essence, rental yields are like P/E ratio of a stock. Simply take the annual rental achievable for a property and divide it by the house price, and you have a measure of how ‘expensive’ a property actually is. So then, what about historical rental yields on property in NZ?

NZ rental yields are poor

According to Census data, in 2006 the median NZ weekly rent was $201 per week, in 2001 the median was around $193 per week and in 1996 the median rent in NZ was $172 per week. This gives us a fairly constant rental yield of about 5% on average from 1996-2001 but then from 2001-2006 according to our data the average rental yield dropped down to only 2.9%. In other words rents increased about 1.7% per year on average from 1996-2006 yet at the same time house prices increased on average by 10.4%. This staggering difference shows the extent of the house price surge in the new millenium far above and beyond rental values and inflation. It is interesting to note that rental yields seem to more or less track inflation over time.

Conclusion – Something has got to give

If this house price “correction” is to play out like the historical average of a 35% drop in real values (for the average housing “crash”), then  something has got to give. NZ house prices in nominal terms are only 10% down from their peak, so there is a long way to go to get a 35% drop in real values given that inflation is very low. The most likely scenario is that we are going to see a combination of falling prices coupled with inflationary pressures (rents and incomes will increase) for some years. The Reserve Bank is forecasting a 20% drop in values, so perhaps the additional 15% drop in real terms is going to come from wage and rental inflation spread over time. It will be interesting to see how this one plays out.

Good luck with your property investing!