Warning bells are ringing in big-city property markets

Fundamentals suggest we are now looking at a frothy market.

Residential property shows signs of speculative ­activity and is significantly geared, according to Lazard.

Macquarie Bank got more headlines than it might have bargained for in recent days when it suggested Australian home prices will fall 7 per cent next year — is the bank right or wrong?

It might surprise you — even now, after years of warnings — to hear just how highly we value ­residential property.

At a recent dinner I hosted with a strategist from Britain as a keynote speaker, our expert put it to the audience — as many have before him — that residential property in Australia is currently overvalued. He warned that there had been in excess of 10 per cent valuation growth over the past 12 months and it was likely a correction was pending.

Yet at the same time we have seen a continued increase in residential property investment over the past few years. Much has been written of the issues around direct property investment via self-managed superannuation funds. In many cases this is the only asset geared through debt via mandatory limited recourse borrowing structures — often without the recommended strategy of diversification through asset allocation.

In addition, outside superannuation many residential properties are negatively geared with the cost of borrowing and holding the property exceeding the revenue, creating a tax loss. It is estimated that almost a million Australians are involved in negative gearing, which explains the constant interest in property prices across the nation.

The theme of our expert’s discussion led me to examine more closely the fundamentals of residential property compared to other asset classes.

As at the end of September 2015, Melbourne-based Heuristic Investment Systems valued the Australian equity market at 16.1 times earnings versus the 13.3 times long-term average.

In looking at bonds they looked at percentage returns: Australian bonds closed at 2.63 per cent. With a dividend yield from the equity market of close to 5 per cent the premium over bonds is above 2 per cent — not far from the levels reached in the GFC.

At the same time, last Wednesday we saw Westpac raise its mortgage rates on residential property by 0.2 per cent for both owner-occupiers and investors — the first such rise in five years.

Though there has been criticism of this move by the new federal Treasurer Scott Morrison, who believes it was aggressive ­action by the bank, there is a strong expectation that other banks will follow, citing the need to bolster capital under new regulatory requirements.

This surprise move in the homeowner market comes off the back of banks pushing up variable interest rates in July for property investors and initiating tougher lending policies after the Australian Prudential Regulation Authority announced that, in response to new global banking rules known as ‘‘Basel Four’’, the banks must hold more capital against their mortgage books.

More recently, we also saw Macquarie Bank’s high profile report which forecast a 7.5 per cent peak to trough correction from the second quarter in 2016.

It’s worth noting the Macquarie note was accompanied in the same week by a note from ­broker Credit Suisse warning that property in Australia is “riskier than equities”.

Philipp Hofflin from Lazard Asset Management in Sydney ­recently spoke about the fundamentals of the Australian residential property market. Dr Hofflin summarised the key ­aspects of the Australian market as follows:

• He pointed out that this is Australia’s largest asset class and it is significantly geared.

• As such, Dr Hofflin made the point that residential property shows signs of speculative ­activity. He said the median price of $US650,000 ($893,000) in Sydney is 9.8 times income in Sydney and $US526,000 is 8.7 times income in Melbourne. This compares to London (8.5 times), Los Angeles (8.0 times), Toronto (6.5 times), New York (6.1 times), Singapore (5.0 times), Tokyo (4.9 times), Dublin (4.3 times), and Washington DC (4.2 times).

• Looking at valuations, Dr Hofflin estimated residential net yields of 2.3 per cent for housing trading at 62 times earnings, and units with a net yield of 3.1 per cent trading at 46 times earnings, constituting 70 per cent of average Australian household balance sheets.

We rarely see our own market with the clarity of an outsider. Take for example, Dr Hofflin’s observations on the price we are willing to pay for residential ­accommodation: apartments are trading at an effective PER ­multiple of about three times that of equities and housing is trading at about four times that of ­equities.

To look at it another way, on an income affordability basis, housing in Sydney is twice that of cities such as Singapore, Tokyo, Dublin and Washington DC.

How long Australia’s love ­affair with property as an investment class will last, only time will tell.

At some point, the market will experience a correction, though by what margin remains uncertain. Residential investors should never ignore fundamentals, ­especially in a frothy market.

At this stage, while volumes on the sell side have not necessarily picked up, among residential property investors anecdotal ­evidence suggests that the flurry of buyers is fast disappearing.

So did Macquarie go too far? I don’t think so. Whether it’s ­increasing interest rates, more difficult lending policies or valuations, the fundamentals suggest warning bells in the residential property sector.

Will Hamilton is managing partner of Hamilton Wealth Management, a Melbourne-based independent wealth manager. www.hamiltonwealth.com.au