Property bubble? 24% overvalued prices? – This is the best study on Australian property market!

There is no property bubble, but property prices are more than 24% overvalued.

According to an article from SmartCompnay, Goldman Sachs’ chief economist Tim Toohey has made an extremely valuable contribution to the Australia property bubble debate. In his recently released comprehensive report, A Study On Australian Housing: Uniquely Positioned Or A Bubble?, he took a close look at the different forces driving the Australian property market.

Toohey’s conclusions argue Australia does indeed face an acute housing shortage. However, he also estimates that Australian property prices are currently between 25-35% overvalued. As a result, there is a risk that Australia’s property prices could drop sharply if a sharp decline in Chinese growth prompted a steep drop in our export earnings.

The report points out that Australia’s population is currently growing at its fastest clip since 1969, rising by 2.1% year on year. As he notes, this rate “is more reflective of a developing nation than of comparable wealthy developed nations”.

This faster population growth partly reflects a spike in the birth rate. But rising net migration is even more important, accounting for two-thirds of population growth.

The trouble is that over the past six years, Australia has not been building homes at a fast enough rate to meet the needs of its surging population.

As the report points out, in the 20 years between 1985 and 2005, Australia built an average of 150,000 homes each year for every 240,000 increase in population. That translates to 60% of a new home constructed for each new person.

But in the past six years, this trend has changed. By mid-2009, the population had to rise by 480,000 in order to achieve the 150,000 new homes constructed in a year. For each new person, only 30 per cent of a home was constructed. It’s even worse in NSW, where only 20 per cent is constructed for each new person.

At the same time, there’s a huge change in the demand for housing, as the children of the Baby Boomers are now hitting the key household formation age.

Over the past five years, there’s been a surge in the growth rate of the 25-29 age group – which has been rising by an average 3.7% each year. This will result in an average 2.7% annual growth rate in the 30-34 year age group in the five years to 2016. This is a dramatic increase, considering these two age groups averaged growth rates of less than 0.3% per annum for the 15 years up to 2006.

The combination of these two factors – the increasing population, and the growing number of people in the key household formation age – is setting the state for a chronic housing shortage.

According to the Goldman Sachs report, “We see an acute housing shortage developing in coming years. At the national level, our base-case forecasts suggest that in 2010 there is currently a demand for housing requirement of 190,000 in 2010, which is set to rise to 196,000 in 2015. This compares to housing completions of 145,000 in 2009.”

It warns that “in the absence of a large and sustained rise in housing completions in the next 5 years, an acute shortage in housing is set to accrue.”

The report estimates there is a national shortage of around 157,000 housing units at present (which compares with the largest historical housing shortage of 28,000 at the end of 1997). The report estimates the housing shortfall will increase to 250,000 units by the end of 2012. It says the housing shortage is most pronounced in Queensland, NSW and Western Australia, while South Australia is the only state with a moderate housing surplus.

So does this housing shortfall justify high Australian housing prices? Not so fast, says Goldman Sachs.

It points out that the way to determine whether housing prices are overvalued is to compare them to household income flows, and the rent they generate. And on these measures, housing prices look elevated. For instance, since 2002, Australian house prices have been hovering around a multiple of ten times average weekly earnings, compared with a ratio of six times in 1997. And based on RP Data-Rismark figures, Australian house prices are now 27 times rents, compared with the average since 2002 of 25 times.

Goldman Sachs says that it uses two methods to calculate whether property prices are excessive. The first measures housing affordability (which takes into account house prices, income, lending criteria and mortgage rates), and compares it to its long run average. On this basis, it says, “Australian house prices are 35% overvalued”.

A second measure, which Goldman prefers, includes rises in rents, along with housing affordability. This approach, the report says, “currently suggests that house prices are 24% overvalued.”

But the report says that the Australian property market is not a speculative finance-fuelled bubble, despite being overvalued. It notes that the refinancing of established homes is at a nine-year low, and that the loan to valuation ratio of established dwellings is well below the levels that we saw at the beginning of the decade.

Still, that doesn’t mean that there aren’t risks associated with Australian house prices. According to the report, Australian house prices could fall if we were to experience a sharp, and sustained, drop in our export prices. This could happen if China entered a severe recession, or if the global supply of iron ore and coal were expanded sharply, pushing down the prices that we receive for these two key commodity exports. The report warns the second is not a far-fetched prospect. “Our best guess is that iron ore and coal markets could well face this prospect in 2013-14”.

So what do the conclusions mean for property investors? I believe it basically says that you should control your debit servicing ratio but you should still invest.