We have pleasure in sharing with you, farrellyâs SPOTLIGHT.
A service that provides in depth coverage of subjects that are of interest to long-term investors but perhaps not well covered by mainstream research providers.
For many years Greg has been a champion of Tim Farrellyâs Investment Strategy which brings a long-term focus to the outlook for markets – a focus which delivers far more reliable and useful observations than the majority of analysis that has an essentially short-term perspective.
Over the course of the year there will be eight SPOTLIGHT reports that will review subjects such as the outlook for residential property, interest rates, hedge funds, private equity, private debt, gold, and where active managers do and donât make sense. It will attempt to debunk some of the many myths that enjoy such currency in the investment world.
SPOTLIGHT aims to be evidence based, long-term in orientation, written in plain English and, above all, useful for investment decision makers.
We hope you find the content of interest.
From the team at Davis Private Wealth.
After four decades of supercharged growth in residential property prices, we are finally seeing some of the froth come out of this market. Is this an opportunity for investors or first home buyers to get set? Or an opportunity to take profits? This SPOTLIGHT outlines why we are entering a very different environment for residential property prices.
The golden law of residential property investment has changed – for decades
For generations, Australians have known that residential property prices just go up and up. There are pauses from time to time but, over time, prices recover and go to new heights. The golden law of residential property investing is to get set as soon as you can, gear as much as you can and wait for the returns to roll in. Millions of Australians have made fortunes using this strategy. Unfortunately, it is a strategy that is about to stop working. The old recipe for success is about to become a recipe for disaster.
Because the fundamentals driving residential property prices have changed
Rental growth has little impact on prices. Inflation has little impact on prices. In practice, the key driver of capital gains seems to be bank lending policies and Affordability – how much the banks will extend as a loan to any individual. Bank lending policies depend on wage growth, interest rates and the bank regulator.
For the past four decades wages have risen, and interest rates have fallen leading to an inexorable increase in the amounts that banks will lend and therefore the price of residential property. Once interest rates hit zero, that driver of higher prices reached its limit. In fact, that driver has now gone into reverse – interest rates are rising.
The short-term outlook for residential property is poor
Our estimate is that the amount that banks will lend to property buyers will fall by between 30% and 40% over the next two years. That implies a fall in property prices of at least 20% over the next two years or so.
The long-term outlook isnât much better
Eventually, rising incomes will repair some of the damage to prices. But this will take time. Decades rather than years. Our estimate of the ungeared capital gains for property investors over the next 5 to 10 years are in the order of 1 to 3% per annum. Gearing will make that negative.
Home buyers hold your fire. Investors aim elsewhere altogether
There will be a better time to buy residential property in the coming two years. Homeowners who are looking for somewhere to live should prepare their finances and wait for a solid fall before buying. Investors will find better opportunities in other markets.
SPOTLIGHT on residential property
âIf returns came out of history books, then librarians would be the richest folks aroundâ
Warren Buffett
Residential property has been a wonderful investment for millions of Australians over the past 40 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 grandparents bought their first house for four thousand pounds and itâs 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. Itâs a 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 consistently strong for decades. While 7% per annum does not sound particularly high, when applied to an investment where 80% of the capital is borrowed, that 7% is transformed into something closer to 30% per annum after factoring in rents less interest payments. Now that is eyewatering!
Figure 1: Capital gains on median three bedroom house prices (%pa) to Jun 2022
However, as Warren Buffett also noted, past returns and future returns are quite different things. Just because an asset has performed well in the past does not guarantee future performance. Prudent investors try to understand what factors have driven past performance and then consider how those drivers will behave in the future.
This SPOTLIGHT outlines the evidence that the key driver of residential property prices is how much that banks are prepared to lend to homebuyers. It is not rental growth and it is not inflation or wages for that matter. The latter does make some contribution to price growth but only so far as it impacts banksâ willingness to lend.
Figure 2 clearly shows that it is not inflation, wages growth or rents that primarily drive prices. In this table we show the total increases rather than annualized increases because it more clearly demonstrates the disconnect between these variables. Obviously, something else is driving residential property prices.
Figure 2 : Capital gains on median Sydney Three Bedroom house prices
Why rents donât impact residential property prices?
Outside of residential property, most investments are bought with some consideration as to the income that the investment will produce and how fast that income will grow. When institutional investors look at shares, they carefully consider the profits a company earns and how quickly those profits might grow. When institutional investors consider commercial property investments, they look at the level of rents and how fast those rents may grow. Investing in commercial property today produces a yield of somewhere between 4% per annum and 6% per annum and an expectation that rents will grow at around the rate of inflation. We compare this to yields on residential property around Australia in Figure 3. We include a conservative 1.5% per annum estimate of costs such as agentsâ fees, rates, vacancies and ongoing maintenance.
This leaves average yields on Australian residential property at 2% per annum or lower. This would be fine if residential rents grew more rapidly than commercial rents. However, as we saw in Figure 2, residential rents grow at around the rate of inflation which is about the same rate that commercial property rents grow – but commercial property pays much higher income along the way. This is why institutional investors, who care about yields and income growth, are rarely seen in the residential property market.
Figure 3: Yields on Australian Three Bedroom Houses (%pa)
How home buyers decide what to pay for a property
Buyers of residential property are largely owner occupiers, and private investors. Both behave very differently to institutional investors.
In trying to make sense of residential property prices, it helps to think about how residential buyers and sellers go about deciding what price 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 how closely the theory matches what happens in the real world.
Letâs start with owner occupiers. These buyers, after their first day of house hunting, invariably return deflated. âIs our dream home really that far out of our range? I canât believe how little we get for our money.â After that first day, the buyersâ 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 just donât come into it. Owner occupiers just want a home to live in and in which to raise a family. So, what do they spend? Whatever the bank will lend them.
These buyers generally want to maximize the amount they have to spend on their property and the banks are only too happy to lend it to them – as long as the bank is confident that the borrower will be able to service the loan.
To make this assessment of how much they will lend, the banks estimate the borrowersâ weekly income, how much they spend and therefore how much is available to service their loan. They then test whether the borrower will be able to pay the interest on the loan at the current home loan rate plus a buffer to allow for some increase in future interest rates.
The end result is that when interest rates fall, the banks will lend more to a given borrower and when interest rates rise, banks will lend less to that borrower. When a borrowersâ income rises, the banks will lend more. Crucially, when interest rates fall substantially, buyers all over Australia simultaneously find they can borrow, say, 20% more to buy their dream home. Given that the total number of houses in Australia changes very slowly, you would expect that, in an environment where all buyers have 20% more to spend, prices should rise by around 20%. And, more or less, this is what actually happens, but not immediately.
Note that this idea only works because 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 – including the building boom of the past decade. There is very little extra supply to dampen price increases.
Now, home buyers donât automatically pay more for a given property just because they have had a pay rise or interest rates have fallen and can now 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 – and do – rise in line with the amount the banks are prepared to lend.
How investors decide what to pay
Because home owners arenât 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 were ridiculously expensive from the viewpoint of an institutional investor.
Private investors believe – passionately – that residential property will increase in value over time. 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 banksâ attitude to them is much the same – how much interest can they pay and can they pay the deposit?
Where does negative gearing fit into this? We believe that negative gearing is a further attraction to investors along with the potential for capital gains. Both encourage investors into the markets but ultimately they can still only pay what the banks will lend. It is a part of the mix but has a minimal effect on prices in the long term.
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 is therefore available to be used to pay interest. They then divide that amount by the Serviceability Interest Rate payable to arrive at an Affordable Value.
The Serviceability Interest Rate is the current interest rate plus the buffer aimed to ensure that borrowers can meet their obligations even if rates rise. Six years ago that buffer was typically around 2%, today it has been increased to 3%. So, if the current home loan rate was 4%, the bank would assess the borrowersâ ability to pay their interest in the event that the home loan rate rose to 7% per annum.
Testing the theory
If this idea works in practice, then we should see long-term prices following a path that is similar to that of the Affordable Value calculation. We have already seen that increases in rents, CPI and wages bear little resemblance to price increases. If Affordable Value follows a similar path to actual prices, we can put this as solid evidence that the theory works in practice. Not proof – but certainly evidence.
We see in Figure 4 below, that housing prices in all the capitals do rise in line with affordability over time. Note that the left hand scale is not a traditional scale – on this scale a doubling of prices occupies the same distance on the chart regardless of whether the increase is from $50,000 to $100,000 or from $400,000 to $800,000. This makes it easier to visually assess different rates of increase.
Figure 4 : House prices and Affordable Values
The long-term data does fit the theory – that the amount that banks are prepared to lend does seem to cause property prices to rise in the long term.
Further, 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 do seem to follow the path set by changes in Affordability.
However, these long-term results do not prove the theory – the similarities may be just a coincidence. (And these kinds of coincidences occur all the time in finance!) We need more evidence.
2015 – 2022 : A short-term test of the theory
Fortunately, the past five years have delivered a real time test of our theory.
In early 2017, APRA, the bank regulator, instructed the banks to use a minimum Serviceability Interest Rate of 7.25% when assessing the size of an investorsâ loan. At the time, this rate was about 0.8% higher than the rate most banks were then using.
This policy meant that the Affordable Value fell by about 10%. It also meant that affordability would no longer respond to falls in intertest rates – no matter how low home loan rates fell, the banks would still use 7.25% to in their lending assessment.
Figure 5: Sydney Median 3 Bedroom House prices (2012 – 2022)Â
We see in Figure 5 that the period leading up to the introduction of the 7.25% minimum Serviceability Rate, housing prices showed robust growth on the back of falling interest rates. This increase abruptly came to a halt when the 7.25% policy was introduced. As it turned out, the 10% fall in Affordable Value saw prices in Sydney fall by over 15% over the following two years; Melbourne prices fell by 6% while other capitals were flat.
Then, in late 2019, APRA announced the relaxation of the 7.25% rule. We see in figure 5 that the period in which the 7.25% rule was in place Affordable Value grew slowly but steadily in line with rising average incomes.
Soon after the rule was relaxed COVID struck, and interest rates fell substantially. Falling rates resulted in a 40% lift in Affordable Value. At the time, we forecast that residential property prices would take off which is exactly what they did. Prices rose by 55% in Sydney, 50% in Melbourne, 48% in Brisbane and Adelaide and 42% in Perth.
More recently we have seen interest rates start to rise causing Affordable Value to fall. After the usual lag, prices have begun to fall and are likely to continue to do, exactly as the affordability theory would predict. All in all, the past five years have provided a compelling validation of the theory. Strong evidence that it is indeed bank lending practices that drive residential property prices.
The next few years
 From here we can form a useful view on the outlook for residential property prices both over the next few years and in the longer term.
In the short term, much will depend on the Reserve Bank and how far it will need to lift interest rates to control inflation. We have three scenarios – in the first, inflation and the economy slow in response to higher interest rates without lapsing into a recession. In the second scenario, the current burst of inflation is stickier than most hope and the RBA keeps raising interest rates with cash rates are at a bruising 4.5% by 2024. In the third scenario, the economy lapses into recession, inflation is tamed but the impact of that recession has a substantial impact on property prices.
Figure 6: Changes to Affordability under different scenarios 2022-2024
As can be seen in Figure 6, none of these scenarios provide attractive outlooks for property investors over the next few years. So far, prices have only just begun to fall in the capital cities due to the normal lag between a change in Affordable Value and change in prices. Figure 7 shows farrellyâs estimates of how much further prices may fall in each of the cities under our Base Case scenario from Figure 6.
Figure 7: Potential falls in housing prices 2022 – 2024
Outlook for the next decade
Even the long-term outlook is sobering, particularly for investors who are used to property prices doubling every decade as they have done for the past 40 years. Over the next decade the key driver of prices will, in all likelihood, still be changing Affordability which will depend on average wage growth, a positive, and interest rates, most likely a modest negative.
Our estimates for capital growth are outlined below, again under different scenarios âour Base Case of modest inflation, a high inflation scenario and a low inflation scenario. None suggest that residential property will be a good place to invest.
Figure 9: Forecast changes to Affordability under different scenarios (2022 â 2032)
The combination of low income and modest capital growth suggests that there will be many better places to invest over the next decade. Shares, commercial property and even Term Deposits are likely to produce higher returns, particularly after considering the very substantial transaction costs associated with residential property investment.
The investment outlook for residential property has changed forever
For 40 years we have seen relentlessly rising prices driven by relentlessly falling interest rates and, to a lesser extent, rising wages. Wages will continue to rise but their impact over the next decade is likely to be somewhat offset by the increase in interest rates we are seeing right now.
When prices have fallen to adjust to the new interest rate regime, we will probably then see property prices growing at around 3.0% per annum – in line with long-term wages growth. This is a far cry from the 7% per annum growth we have seen for the past 40 years. If we borrow to invest in property those capital gains are likely to be more than offset by interest expenses of around 4% per annum and transaction costs.
What should investors do?
 Now is not the time to be buying. The short-term outlook is poor and the longer term outlook is only a little better.
We would suggest long-term residential property investors with substantial holdings to carefully review their portfolio with an eye to quickly sell any of their weaker investments – particularly if debt servicing may become an issue. If going down this path, be prepared to accept a reasonable reduction from the price you may have been able to achieve six months ago. There are better places to invest.
Really savvy property investors could prepare to look for the inevitable bargains that will arise if distressed sellers begin to emerge. However, those bargains are probably at least a year away.
Those investors who are not professional residential property experts should begin to focus more on other investment markets such as shares and perhaps even fixed interest.
What should potential home buyers do?
 It is time to get your finances in order. Establish a relationship with a good mortgage broker and get in a position to move quickly if necessary. Sometime in the next year or so you should be able to buy your dream home at prices much lower than those available today.
But donât get too excited though. The home you will be able to buy will not be much different than the one you can afford today. The reason is that if the banks are prepared to lend you $1,000,000 today, that loan is likely to be closer to $800,000 in two yearsâ time. If that proves to be the case, then the house you can afford today with the $1,000,000 loan is probably much the same as the one you will be able to buy with the $800,000 loan.
This is, of course, the whole point of the Affordability thesis. If banks lend less, house prices fall. If they lend more, house prices rise. Borrowers end up buying more or less the same house just at lower or higher prices.
While buyers may end up with the same house, there are obvious advantages to buying that house at a lower price. Paying off the loan will clearly be much easier, and the amount paid on interest will be meaningfully lower.
Perhaps, most importantly, by waiting, homeowners may avoid sinking into negative equity and the terrible sinking feeling that comes with rising interest costs that cut deeply into the household budget. We should not discount the extreme emotional turmoil brought on by the aptly named Mortgage Stress. Non-financial, but very, very real.