The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Thursday, August 4, 2011

Surprising Similarities: US & Aussie House Prices

A friend, Dominic Stevens, who is CEO of the annuity provider Challenger, shot me a chart of Australian house prices compared with US house prices over the long-term. This particular chart seemed to suggest that there was an enormous difference in the growth rates. Dom asked me whether it was right.

So we took up the challenge of answering his question. In Australia, all home sales data is collected by State Government land titles or valuer generals’ offices. However, none of these agencies make comprehensive sales data available prior to around 1975. We therefore view any indices purporting to rely on data before the 1970s as quite suspect, and certainly a very poor representation of the national market. It also turns out that reliable US house price data starts in about the mid 1970s too.

The two most respected indices in the US, produced by S&P Case-Shiller and the FHFA, begin their benchmarks in 1987 and 1975, respectively. Robert Shiller has tried to construct a longer-term house price series, but relies on a “five-city” median price proxy between 1934 and 1952, and presumably poorer data prior to that. It is hard to fathom how one could legitimately argue that a sample taken from five US cities is somehow a decent representation of 50-100 cities spread across the US.

For Australia, we used RP Data’s information to construct a comparable “all regions” median price index (ie, as broad as possible) based on the criterion that we needed at least 12,000 dwelling sales per quarter. This begins in 1975 and by the end of that year we are including nearly 20,000 sales per quarter.*

The results of our analysis over this 36 year period are shown in the chart below. The first interesting insight is that Australian house prices grew no faster than US house prices right up until the late 1980s. And even during the next one and a half to two decades, the growth rates were similar. It is only the recent financial markets’ crisis and ensuing recession that has caused a noticeable disconnect. (Click to enlarge chart.)

Over the 32 year period stretching between 1975 and 2007 (ie, just before the GFC), the inflation-adjusted compound annual capital growth rate (“CAGR”) for Australian dwelling prices was 2.6 per cent. In contrast, the inflation-adjusted compound annual capital growth rate for US dwellings was 1.7 per cent.**

That is, there was only a 0.9 per cent per annum differential in the real house price growth rates realised in Australia and the US in the three-plus decades before the US sub-prime crisis materialised (of course, cumulatively this gives rise to a material divide in house price levels).

Since 2007, or the advent of the GFC, the differences between the two countries have widened considerably given the strongly divergent economic circumstances.

The US had its worst recession since the 1930s depression with the unemployment rate surging to 9.2 per cent. Australia, in contrast, suffered only one quarter of negative GDP growth and today has an unemployment rate of 4.9 per cent. Within the housing market, US mortgage default rates are more than 11 times higher than Australian equivalents (8 per cent compared with 0.7 per cent) notwithstanding our far steeper interest rates.

The effects of the crisis, and the 15 per cent to 30 per cent peak-to-trough fall in US dwelling values, led the US market’s real CAGR to fall from 1.7 per cent to just 0.5 per cent. Since default rates and the unemployment rate only ticked up mildly, Australia’s real CAGR has remained relatively stable at 2.5 per cent.

One question is whether the long-run differences between the two markets have been driven by per capita incomes. We find that real per capita national incomes have been nearly identical over the last 36 years.

There has, however, been a substantial disparity in inflation rates, with consumer prices in Australia growing at about a 1.2 per cent per annum higher pace than the US. This may be related to the fact that the RBA has a substantially higher inflation target than the Federal Reserve.

In addition to the underlying economics, a range of institutional, regulatory and tax factors have likely conspired to cause divergent outcomes.

For example, US home owners get the benefit of tax deductible mortgage interest payments, whereas Australians do not. This has led US borrowers to use more leverage, and hold it against their homes for longer (resulting in higher and more volatile default rates).

Australians, in comparison, typically pay down their mortgage debt quickly (because it is expensive) over a 15 year period, well in advance of the normal loan’s 25 year term.

In the US, households also pay capital gains tax above a certain threshold, whereas Australians (and those living in Canada, the UK, New Zealand, France and Germany) do not.

Finally, Australia has a much denser urban structure, with 61 per cent of our population residing in urban areas with more than 750,000 people, whereas the US is far more decentralised, with a comparable rate of just 47 per cent.

As always, the devil is in the detail!

* For the technical boffins, we use a simple median price index because it includes the maximum amount of data. An hedonic index would not be possible because we don’t have sufficient property attribute information in the 1970s and a repeat-sales index excludes too many observations for our liking.

**Again, for the boffins, our analysis of all alterations and additions data collected by the ABS implies that you should probably knock about 0.5 per cent to 0.6 per cent per annum off the CAGR to account for capital improvements to homes when using median prices.