The New Zealand Property Market - The Bubble that Never Bursts

The New Zealand Property Market - The Bubble that Never Bursts

Originating from the UK, I knew that the Brits had an unhealthy fascination with home ownership and property investment. However, their enthusiasm is positively muted by comparison to the zeal with which New Zealanders embrace property ownership, it really is the only game in town. 
So rather than just relying upon the often heard refrain of 'you can't go wrong with property', lets try and delve a little deeper, starting with some of the factors that have influenced this rush to own property, including:

•     The desire to own something tangible

Many people feel much more comfortable owning something they can touch, rather than a stock or bond etc, giving them an added sense of security.

•      The ease of obtaining cheap credit

It is much easier for ‘Joe Blow’ to obtain finance for a house purchase, commercial property or ‘Buy to Let’ than any other investment. Also, with the credit explosion and the relaxation in lending criteria we witnessed throughout most of the last decade, almost anyone with a pulse could obtain a mortgage.

•       The almost complete lack of pension plans in NZ

This lack of pension offering means that most people see property investment as their one and only retirement plan.

•         A tax policy that encourages property investment

For many years the NZ tax regime has favoured property investment with a number of tax breaks, not the least of which being a complete lack of any capital gains tax, making property investment more attractive than other asset classes.

•     A relatively unsophisticated and under-regulated financial services industry

There is still a feel of the ‘wild west’ when it comes to regulation of financial service providers and the services they offer. The Reserve Bank of NZ (RBNZ) has consistently chosen a light approach and this, allied to incompetence and some good old fashioned corruption has undermined investors’ confidence in the sector, leading to a lack of viable and trustworthy alternatives to the old chestnut of property investment.

Of course, many of these factors exist in other parts of the world and it is for precisely this reason that we witnessed a property price boom not only in NZ but globally, in the years running up to the 2008 global financial crisis (GFC).

In the aftermath of the GFC, many of these countries suffered a property price collapse, bringing them down to more ‘normal’ levels. However, Australia and New Zealand suffered less than most, with rather modest falls and quicker recoveries, indeed by some measures NZ prices are almost back to their 2007 highs, especially around the Auckland area.

So what does the future hold? Are prices still overvalued or can we expect to see another price boom? If they are going to fall, how far should we expect them to go? What can history teach us about property boom and busts?

Firstly, lets take a look at the market currently and try to see how it looks in terms of value.

There are three main measurements that are used both locally and internationally as a means of assessing whether a countrys’ housing stock is over or undervalued.

•         The house price to income ratio

When this ratio is at 3 or below, it signifies a market that is affordable. The current figure for national house prices is 4.74 (seriously unaffordable) and for Auckland it is a vertigo inducing 6.18 (severely unaffordable). 

The chart below gives us some historical perspective.

 We can see that although the ratio is below the 2007 peak, it is still nowhere near the long term average.

•        The house price to rent ratio     

      The historical International long term average is 15, and currently this multiple is  at 21.11 having only fallen 6% from its peak, so we still have some way to go. 

•       The trend in ‘real’ (inflation adjusted) house prices.

As I have mentioned in previous posts, all asset prices are 'mean reverting' meaning that they oscillate around a long term average, swinging from under to overvalued and back again. These cycles can happen over many different timeframes, sometimes taking decades to complete a full cycle. However, no matter how long it takes, once the asset has reached its point of maximum overvaluation, the long term average will start to act  like gravity, pulling it back to earth.

The chart below shows real or 'inflation adjusted' house prices in the U.K from 1975 to the present day.

It is easy to see this oscillation around the mean, but one very important point to note is that prices do not just correct back to the mean or 'fair value', they only reach bottom when they are once again undervalued, with the extent of the undervaluation often proportional to the size of the preceeding overvaluation.
Whilst this is a chart of U.K house prices, the same principles hold true the world over.

Here is a chart of the current N.Z situation

Lastly I want to show you what happened when the greatest property price bubble the world has ever seen finally burst. During the 1980's asset bubble, real estate prices in Japan rose by as much as 6 to 7 times. At its peak in 1991 all the land in Japan (a country the size of California) was worth approximately US$ 18 trillion, about 4 times the value of all the property in the US at the time.

Here is the chart of Tokyo land prices.

Look familiar?

Now I am not trying to suggest that N.Z property prices are anywhere near as overvalued as Japans were at its peak. But it should now be reasonably clear that prices are still seriously overvalued and that the correction still has a long way to go.

 But prices are going up again I hear you cry, and indeed they are. So lets look at some of the reasons why, and whether they are sustainable.

• Shortage of new housing stock

Since the GFC there has been a considerable contraction in the number of new homes being built due to excessive costs of both the raw materials and the local government permitting process

• Low interest rates

The RBNZ has kept interest rates at historic lows to try and revive the economy. This has been a boon for both new home buyers making homes more affordable, and existing house owners allowing them to remortgage at cheaper rates.

• Banks once again offering high LVR mortgages

For the banks, the fear from the effects of the GFC has dissipated, to be replaced with their more usual emotion, greed. Having lowered their Loan to Value ratios on their mortgages to much more conservative levels in the aftermath of the economic turmoil, they are now once again chasing business and offering LVR's up around where they were before the crisis. They truly are nothing if not predictable!

• The effects of the Christchurch Earthquake

The loss of thousands of homes has had a profound effect on the property market, and cannot be remedied in the short term.

• Consumer confidence

The memories of the 2008 GFC are fading, to be replaced with confidence that the worst is behind us and it is only a matter of time before we get back to 'normal'.

All of these factors are supportive of the property market, and particularly regarding  the supply side of the equation, will continue to be for some time. But it is the demand side of things where life should get interesting over the next few years.

If we think back to the immediate aftermath of the 2008 credit crisis, there was a sudden and severe drop in consumer confidence leading to a sharp fall in spending, especially in big ticket items, and the tickets don't get much bigger than a house! Also, the overseas funding that the banks use for much of our mortgage lending shut down, due to the freeze in the European credit markets. This lead to a sharp fall in mortgage lending and tightening of mortgage lending criteria (including the LVRs) as the banks became less concerned with making money and more concerned with survival.
So we have already had a taste of what a financial market collapse can do to property values, and unfortunately the next crisis is just around the corner. However the bad news does not end there, as there are a couple of reasons why this time will be worse.

 When the GFC hit in 2008, governments, corporates and individuals alike had all enjoyed a few good years, so the financial books were in decent shape and there was 'fat' in the system. This allowed govenments the world over to trigger massive stimulus packages in an attempt to stimulate global growth. 
 Fast forwarding to today, we see a very different picture. Government finances around the globe look horrible, and after repeated stimulus packages are getting worse every year. Corporates have downsized and cut costs to the bone in order to maintain profitability, and individuals have dipped into savings, remortgaged their homes and used their credit cards in order to pay the bills. In short, over the last 4 years, all the 'fat' has been used up, meaning that when the next crisis hits we will have nothing left to soften the blow.

Secondly, to try to combat the ongoing effects of the GFC, central banks all over the globe have kept interest rates at historically low levels. This has kept the mortgage burden affordable and resulted in floating mortgage rates being consistently lower than fixed, leading to a huge number of householders in N.Z moving their mortgage from fixed to floating.  
The extent of this swing can be seen in the chart below.

  This is all fine until we have a rise in interest rates , and then because so many householders feel its effects at the same time, its negative impact is magnified, (I outlined why I think interest rates will rise sharply in my post Interest Rates: Where are they Heading?).
Also because of the way that the yield curve moves when interest rates rise, mortgagees are often caught out  when they finally try to fix.
 Let us take a  look at the chart below.

In a 'normalised' yield curve (A), floating rates are cheaper than fixed and the   householder therefore has a floating rate mortgage,the world is a happy place! As the situation starts to change, the first thing to happen is that the 'curve' steepens meaning that the fixed rates go up whilst the floating stays the same (B), the world is still a happy place. Lastly, the entire yield curve moves up as floating rates are finally raised (C), and it is only at this point that the majority of householders decide to fix. Unfortunately now the differential between floating and fixed can be quite large, and the lower that rates are to start with, the more this is accentuated with householders often having to find an extra 10 to 25% just to service their debt.

 We can see that there are some important differences between now and 2008, and although there are some supporting factors for the housing market, I expect them to be overwhelmed by the negatives that will arrive with the next crisis.

So, having established that prices are still overvalued, that they always revert to the mean over time, and that many of the current positives for the housing market will not last, should we expect to see a house price collapse? Well the answer is possibly, but probably not.
There are three ways that overvaluations can correct: the price can fall, inflation can erode it over time, or some combination of the two. In the majority of cases it is the third option that is the most frequent as house prices can often be slow to correct. This is because when people are in financial distress they will only consider selling their property once they have exhausted all other means of servicing their debt. Also, people are incredibly reluctant to sell a property for less than their perceived value, irrespective of the fact that prices have dropped and will continue to do so, they will only except the loss when they have no other option.


 It is because inflation often does most of the damage rather than price that leads to the myth that property never goes down. Many people wrongly believe that if their asset is the same price 10 years after they bought it, they are still breaking even. The reality is that with only a  3% inflation rate they will have lost 25% of its value after 10 years as surely as if the price had dropped  by 25%.
We will likely therefore see a correction lasting many years with prices slow to react at first then falling faster as the economy bites, confidence falls and all other options are exhausted. Meanwhile inflation will just keep chipping away in the background, doing what it always does, costing us money.

To conclude, prices may continue to rise in the short term. But once we roll over into the next stage of the financial crisis I expect the correction to begin in earnest. As we saw in the chart of 'real' house prices above, property is currently 25% overvalued. But as I mentioned earlier, the size of the correction is normally proportional to the size of the preceeding boom, meaning that prices will likely correct even further.

 I expect 'real' house prices to have dropped by 40% from their peak by the time the correction is finished, and if the entire financial crisis pans out as I fear it will the figure will be much higher. If you think that is impossible take another look at that chart of Tokyo land prices and also consider that after the Great Depression of the 1930's a number of areas on the US experienced falls of over 90%!


The point to take from all this is that property is just the same as any other asset,it reacts the same all over the world and it does not have some special immunity making it the perfect asset in all places and at all times, in spite of what many people think.
 There are times when it is right to own and there are times when it isn't. 

 The skill is in knowing the difference.