Real Estate Bubble

Is Australia Next?

There is considerable concern in Australia over whether current housing prices represent a real estate bubble or an extended bull market in property. It is very difficult to distinguish between the two until the very late stages of a market collapse. The uneasy feeling among some Australians that the market might be digging itself into a rather deep hole is matched by a suspicion that the best way to get out of a hole is to first stop digging.

The major problem with this solution is that too many of the players in real estate have a vested interest in shovelling harder and faster. Banks, home builders, furniture stores, lumber yards, real estate brokers, and even the last group of buyers who arrive late into a mature market have very good reasons for keeping the party going regardless of the long-term perils for the economy as a whole. If a rapidly rising housing market suddenly turns into a bubble, there are a lot of people who will say goodbye to their well-paying careers. They have everything to gain by risking a deeper hole that may or may not crash the system, and everything to lose by calling a halt to the expansion before things get any worse.

What are the Causes of a Real Estate Bubble?

In a country with a rising population or accelerating affluence, real estate tends to go up in value fairly consistently as people enter the market or trade up to better properties. Bubbles tend to be created when extraordinary measures are taken to speed up the annual amount of property transactions.

Suppose there is an average demand for five new houses a year based on demographic factors. If the industry only builds three, there will be a rise in price during a tight market. The shortage of new homes will lead to fat profits for investors and will encourage others to get into the business.

In the next year, ten new houses are built instead of three. Now there are more houses available than demand for them and the industry is stuck with two unpalatable options: either to sell at a reduced price—which hurts the bottom line—or to sit on the houses in inventory and wait for demand to catch up when additional houses will be wanted next year.

There is a third option, however, that allows the industry to have its cake and eat it too—at least for a while. If next year’s demand for housing can be brought forward to this year, additional houses can be sold at the high-margin price they are accustomed to. Buyers therefore need to be incentivized into entering the market earlier.

Since the whole idea is to keep prices high so everyone can be handsomely rewarded, the usual economics textbook method of lowering the price of a house is not in the business plan. Instead, financial institutions start fiddling with the ordinary terms of a mortgage in order to increase the potential pool of home buyers. Someone who may not qualify for a fixed rate mortgage until they save up enough of a down payment to lower their monthly expense to a bearable level is instead able to qualify right away for a creative work-around such as a variable-rate mortgage.

This makes their payments affordable now, but promises to make them unaffordable later unless their income rises. In a rising market, many people are tempted by this particular concept, since rising home prices mean that they will be able to bail out and even make a profit if their bet on higher future earnings doesn’t materialize.

Expansion of the Real Estate Bubble

Now that a number of home buyers have been robbed from the future, there will be an inevitable slowdown in housing sales until supply and demand once again balances after several slow sales years allow the average annual demand to eat up the surplus. This leaves the industry right back where it started and the solution remains the same as before: Bring additional future demand into the current market at the current inflated prices.

Since the pool of future home buyers have already been raided for those who will soon qualify for a traditional mortgage but qualify right now for a variable-rate mortgage, new and even wilder enticements will be used. No money down and non-qualifying mortgages are the next step, which will bring forward people who do not even meet the already loosened standards for variable-rate mortgages. This represents a further siphoning of future demand into the current market.

A steady supply of home buyers continues to be created by these imaginative methods. Best of all, they are not especially interested in the cost of the house since their only concern is finding someone to say yes to their mortgage application.

Real Estate Bubble Collapse

The typical Real Estate Bubble ultimately collapses when the supply of home buyers from the future has been fully run dry. An ominous harbinger that this stage approaches is when interest-only mortgages become common. These are the last desperate attempts at future-demand-robbery. The final crop of buyers consists of people who have no chance of ever paying on a traditional mortgage and real estate speculators who bank on controlling as much real estate as possible at the lowest monthly drain while waiting for market appreciation to make them wealthy.

With a large stock of houses and no buyers at any price, demand quickly collapses back to semi-dormancy. Many people struggling with escalating mortgage payments are no longer able to escape their obligations and fall into foreclosure, further damaging the price of existing homes as desperate banks struggle to move these non-performing assets off their balance sheets at any price.

Speculators who have been hoarding large supplies of housing and making an occasional sale to finance the mortgage payments on the many properties they hold now find themselves “underwater” in all of their mortgages due to the collapse in retail price. Unable to sell without writing someone a check, and unable to carry all of their properties without continued cash flow from sales of their existing inventory, these commercial-sized players now fall into the same whirlpool as individual homeowners and are destroyed either quickly or slowly but ruined nonetheless.

Peculiarities of a Potential Australian Real Estate Bubble

The one apparent difference between Australia’s current situation and most of the real estate bubbles that have ravaged property values worldwide in recent years is that Australia is not particularly beholden to the new construction industry but is rather more in the grip of large-scale investors who have kept the country’s already rising real estate market fuelled by withholding large stocks of housing. This pure speculative play is encouraged by quirks in Australian property and capital gains tax laws which grant favourable treatment to empty properties as opposed to rental units.