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Here’s how the housing bubble bursts

It’s a pretty widely accepted fact that Australian housing is among the most expensive in the world today. Compared to other countries, and to the rental yield earned on investment property, we’re right up there.

Of course, just because something is expensive doesn’t make it a bubble. So what does?

You might remember a little high school economics, specifically the old ‘supply and demand’ interaction. Basically, when supply exceeds demand, prices fall as suppliers fight each other to make a sale. But when demand exceeds supply, prices rise, as buyers fight for the limited amount of widgets available.

That’s all pretty straight forward. It’s no secret that the new supply of housing, especially in close proximity to the major urban areas around Australia, is tight. There’s simply not much of it coming onto the market, relative to the growth in our population…

A fundamental basis for current prices

It’s this dynamic that has taken prices to where they are today, and without growth in supply, there’s a very fundamental basis for current house prices – namely, that supply/demand interaction I just outlined.

Changes to that equilibrium happen when we push on either side of the supply/demand seesaw.

A sudden release of a significant tranche of well-located land, for example, would see the same demand spread across a greater supply, and lower prices (or at least a pause in the upward trajectory of house prices) would result.

No-one has a crystal ball. As the old joke goes, economists have predicted nine of the past two recessions. I’m not predicting either a bubble, or a house price crash. But it doesn’t take much effort to imagine how one might play out.

If it happens, here’s how…

In recent times, government policy has acted – likely inadvertently – to add significant pressure to the demand side of the equation.

Not only are self-managed superannuation funds now allowed to invest in residential property, they’re being allowed to leverage up to 60% or even 70% of the property value.

Australians are used to property being something of a Magic Pudding. No matter how high prices go, they continue to rush higher. The RBA itself has warned that future house price growth is likely to be “slower in future than in the previous 30 years”, but as a whole, we refuse to listen.

So, while direct property investment now makes up only 3% or so of SMSF balances, that number is likely to go higher – perhaps significantly so.

All of that extra demand will have to go somewhere – in the end, it’s likely to either force governments at all levels to facilitate considerable extra land releases or prices will be pushed higher.

And with precious little land available in close proximity to major metropolitan areas, there’s a fair chance it’ll be the latter.

When — not if — interest rates rise

Higher prices will mean increased indebtedness for homeowners – owner/occupiers and investors alike. In a period of low interest rates, such incremental debt will seem affordable, if only just.

But when (and decades of economic history says it’ll be when, not if) interest rates start to rise, it won’t take long for stretched households to come under significant mortgage stress. The U.S. sub-prime crisis is sufficiently recent that I don’t have to outline the price spiral than can eventuate when mortgage stress becomes widespread!

If you own your own home, and have a job, a fall in house prices is unwelcome, but needn’t be problematic. If you’re an indebted property investor, however, a fall in prices can do significant damage to your investment returns.

To wit, if you’ve borrowed 90% of a property’s value, and that property’s price falls 10%, your equity is completely wiped out!

The conventional wisdom suggests that property is ‘safer’ than shares, and that property prices ‘never go down’. Such conventional wisdom, should it prove unfounded, could provide a rude shock for investors.

For SMSF trustees and beneficiaries, that runs the risk of putting a significant dent in account balances and retirement nest eggs.

“The only way a smart guy can go broke”

Correctly forecasting a bubble, and its bursting, can be a ticket to endless speaking engagements and a career as a celebrity forecaster.

But while Australian housing is undoubtedly expensive, I’m not convinced that we are indeed faced with a potential housing bubble sometime soon, and even less that we are currently in one.

However, as Warren Buffett once remarked, “Leverage is the only way a smart guy can go broke”.

It is incredibly hard to justify allowing self-managed superannuation funds to borrow money to invest, thereby magnifying investment risk, given that the role of superannuation is to ensure retirees have sufficient funds at the end of their working lives.

That’s especially the case when such borrowing may be the very catalyst that creates the problem in the first place!

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