Thursday, July 07, 2005

Hole in the Housing Bubble

New York Times July 5, 2005

SYDNEY, Australia - For several years, dinner party chatter here did not linger on favorite Australian subjects like rugby, cricket, sailing and surfing or politics. No, all the talk was of real estate: how much a house was worth, how much more this year than last, and how much more valuable it would be next year.
It was not just the rich who were getting super-rich, their multimillion-dollar homes with water views rising rapidly in value. Every homeowner was making money, at least on paper, and Australia is a country with one of the highest levels of home ownership in the world. A midlevel office worker, for example, who bought a house in a middle-class Sydney suburb for 188,000 Australian dollars in 1996 was offered 720,000 Australian dollars ($504,000) in 2003. Sound familiar? As in many regions of the United States these days, house prices here seemed to defy gravity. They just kept going up and up and up - in Sydney, by 11 percent in 1997, according to the Real Estate Institute of Australia, followed by a leap of another 21 percent the next year. After more modest increases, prices rose by 16 percent in 2002, and another 23 percent in 2003. It was similar in other major cities.
"It overshot all models, all predictions," said Rod Cornish, head of property research at Macquaire Bank.
In the last two years, though, the Australian housing boom has come to a halt, in a move that many experts see as the first signs of the end to a housing bubble, not just in Australia, but also in the United States as well as several other rich countries around the world.
It is impossible to say for sure how the situation will work out here - or in the United States, for that matter. But so far, despite predictions that housing prices in Australia would plummet by as much as 20 to 30 percent, there are no signs of a crash. Prices have leveled off noticeably or dropped slightly, at least in Sydney, Melbourne and Canberra. They continue to rise at a modest rate in Perth, Darwin and Brisbane, the major cities in resource-rich states, where the local economies are being buoyed by China's insatiable demands for raw materials.
Nationwide, for the year ending March 31, the rise in house prices was 0.4 percent, the lowest since 1996, according to the Australia Bureau of Statistics.
"It's been an orderly correction," said Mark Steglick, managing director of Gowings Properties, a Sydney property development company, who said that there had been few foreclosures or forced sales since the boom ended. "There's not blood on the streets."
Looking ahead, local housing experts expect prices to flatten out, perhaps remaining stagnant for a number of years to allow gradually rising incomes to catch up with the sharply higher level of home values.
But there are significant differences within the market that may provide some clues as to how housing booms elsewhere could run out of steam.
Prices for investor-owned apartments have fallen considerably more than for owner-occupied houses. Nationwide, prices are down about 10 percent from the peak.
The most expensive homes, particularly those along the coast, have held up better than the rest of the market. "My jaw drops at some sales," Mr. Steglick said, describing a house in Vaucluse, a posh Sydney suburb, that recently sold for $17 million Australian dollars ($12.7 million). The home does not even have direct access to the beach, though it does have spectacular views of the soaring Opera House and of the Sydney Harbor Bridge. It last sold in 2001 for 12.1 million Australian dollars.
Australia is no stranger to booms and busts in housing prices. The latest boom began in the mid-1990's, following a bust brought about by the recession of 1990, one of the worst in Australia's history, and far more severe than the downturn in the United States at the time. Unemployment soared to more than 10 percent as interest rates reached as high as 17 percent.
Those high rates knocked many potential buyers out of the market, but even more importantly they also saddled many existing homeowners with a greater debt than they had assumed when they took out their loan.
House financing here differs significantly from the United States, where the 30-year fixed rate mortgage has been the norm and most adjustable rate mortgages delay rate increases for several years and then limit them to set annual amounts. In Australia, fixed rate mortgages are very rare. The standard mortgage is a variable, with the rate rising automatically whenever the central bank raises interest rates.
So someone who borrowed at 12 percent in 1985 found that his monthly mortgage payments had gone up by nearly 50 percent five years later, when the rate was just over 17 percent.
There was "blood on the streets" then, with thousands of foreclosures and forced sales.
The market remained stagnant until around 1996 or 1997, when prices began to rise, first in Melbourne, then in Sydney.
As in the United States in the early 2000's, the primary driving force behind the housing boom in Australia was the decline in interest rates, which dropped to about 7 percent here by the end of 1997. Simultaneously, unemployment fell, continuing to shrink to as low as 5.5 percent today.
Another factor driving house prices, especially in Sydney, is the quality of life. In surveys of the most desirable cities in the world, Sydney is regularly in the top 10. Moreover, not many major cities offer such a wide variety of beachfront properties, many of them attracting wealthy people from around the world.
The increase in home values, and the expanding economy, also sent Sidney residents in search of second homes. In the late 1990's, the housing boom hit Byron Bay, which juts into the ocean, about 500 miles north of Sydney.
"It just flew in here," Barbara Sexton, a real estate agent, said about the swift rise in interest in a beach community where the rich now mingle with writers, artists, backpackers and hippies, and dolphins frolic with surfers. "I do believe this is the greatest boom we've had."
People would come to Byron Bay for two-week vacations, Ms. Sexton said, and spend the second week looking at property.
The market has now softened, but limits on development in a town where the council is dominated by Greens, who are determined not to let the area go the way of the uncontrolled Gold Coast, an hour north, are likely to keep prices from falling significantly.
A 700-square-meter piece of land on the beach recently sold for 1.8 million Australian dollars ($1.3 million), Ms. Sexton said. A modest three bedroom cottage on the water - "beach shack" in the Australian vernacular - recently sold for 4.1 million Australian dollars ($3 million), double what it sold for five years ago.
With interest rates falling and as the value of homes soared, homeowners began borrowing against their equity, whether to renovate or buy the latest flat screen television. It was a lending practice introduced here by Citigroup, and now followed by nearly every bank.
The economy has continued to expand - it is now in its 14th consecutive year of growth - and with money and confidence, people not only bought their own homes, but properties for investment as well. In this, they have been actively encouraged by Australia's tax laws.
In contrast with the United States, interest payments on an Australian home mortgage are not tax deductible. But for those who invest in property and rent it out, the payment is deductible as an expense against rental income.
If total expenses exceed income, the loss can be offset against ordinary income. In a country where the top marginal tax rate is 48.5 percent, that provides a strong incentive to search for ways to reduce taxable income.
For example, an investor who has $30,000 a year in rental income, and $40,000 in expenses, including the mortgage, can take a deduction of $10,000. But when the property is sold, the gain, quite substantial in recent years, is taxed as a capital gain at a rate of no more than 24 percent.
"The market was awash with people turning over properties," said David Edwards, owner of the LJ Hooker real estate franchise in Palm Beach, an hour north of Sydney, where the rich and super-rich have holiday homes. A house, with a view over Whale Beach, sold for $1.7 million in March 2002, Mr. Edwards said. The owner put on a coat of paint, planted a few trees, and sold it four months later for $2.1 million. Nine months later, it sold for $2.5 million.
In 2003, the governors of the Reserve Bank of Australia began trying to talk the market down, with speeches about households having too much debt and about the housing bubble.
The Reserve Bank, the equivalent of the Federal Reserve in the United States, also went to commercial banks to examine their loan portfolios, and did something called "stress testing." Assume unemployment went to X percent, or the interest rates went to Y, regulators asked, could the bank handle it?
The central bank found that banks were in pretty good shape, but the exercise made the banks more cautious about lending to property investors, said Mr. Cornish of Macquaire Bank.
In late 2004, the central bank started raising interest rates, by a quarter point in November followed by another quarter point in December. There was another quarter point increase in March.
"They hit the brakes, lightly," said Shane Oliver, head of investments strategy and chief economist at AMP Capital Investors, who estimated that the value of his house on the water in Avalon, a small suburb north of Sydney, has gone to $3 million, from $700,000 in 1995.
But no one was sure of what was coming, and the fear was that rates would continue to go up. The psychological impact was just what the central bank wanted and was needed.
The median price for a three bedroom house in Sydney has gone up only 0.2 percent so far this year. It has dropped 5.2 percent in Melbourne, according to the Real Estate Institute.
The leveling out of housing prices is beginning to have a ripple effect on the rest of the economy. "Housing equity withdrawal has now ceased," the governor of the Reserve Bank, Ian Macfarlane, said in a speech in mid-June. That has contributed to a sharp slowdown in consumer spending. Some of the major retail stores, like David Jones and Coles Myer, seem to have been offering almost perpetual sales since November.
Now the question on people's minds: is the decline over, or is the worst yet to come?
Mr. Oliver thinks Australian house prices are still at least 25 percent overvalued, as measured by their historical values, and as a ratio to wages. It now takes 500 weeks of average wages to buy the typical home in Australia, Mr. Oliver wrote recently in his newsletter, much more than the 350 weeks, on average, required in the United States.
Still, he is not predicting a crash.
"It's easier to trigger a panic in the share market than in the housing market," Mr. Oliver said. "People get attached to their homes."
While analysts express comfort with their predictions that the market will remain soft but not collapse, they are not cocky about it. A sharp increase in unemployment or interest rates could trigger an even sharper fall in real estate prices, they warn.
"We're still vulnerable to shocks," Mr. Cornish said.


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