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 11, 2011

Which is cheaper: UK or Aussie housing?

You often hear that Australian housing is more expensive than, say, UK or US housing, if not the dearest in the world.

Wild fluctuations in currencies make international comparisons hard, to say nothing of profound differences in house price data, household formation and population growth rates, the availability of new housing supply, the urban structure of nations, interest rates, and the legal, tax and institutional features of housing markets around the world.

By way of example, the rate of home ownership in Germany is around 40% compared to circa 70% in Australia, the UK, Canada, and New Zealand.

In the US there is capital gains tax levied on the owner-occupied home while mortgage repayments are tax deductible. In contrast, the owner-occupied home is CGT exempt in Australia, the UK, Canada, and New Zealand, but this comes with a cost: mortgage repayments are not tax deductible, as they are in the US.

One country Australia does share strong commonalities with is, naturally, the UK. The UK also has the benefit of very good housing data that is not plagued by “sample selection biases” (ie, when you only get a fraction of the total population of home sales, as you do with US house price indices).

So today I wanted to address two simple questions.

First, have Australian housing costs risen more rapidly than their UK equivalents over the last couple of decades?

And, second, how far did UK house prices fall during the GFC given the near complete disintegration of its banking system, with the whole or partial nationalisation of many of their largest lenders. (UK taxpayers ended up owning 100% of Northern Rock, 83% of RBS, and 41% of Lloyds.)

I ask this question because the correspondence between the Aussie and UK banking systems, which are both dominated by a small number of big institutions, and their housing markets (both have near-identical approaches to tax and similar demand and supply fundamentals), makes a study of the UK downturn a credible guide in the event that something—god forbid—catastrophic were to happen here.

That is, it gives us a reasonable indication as to how far Australian house prices might decline if our banking system imploded, the economy careened into an acute recession with soaring unemployment and default rates.

For the purposes of this analysis we have taken the broadest possible UK house price measure, which is produced by a group called Academetrics. We then compare this to our standard RP Data-Rismark Hedonic Combined Capital Cities Index.

The results, which are illustrated in the two charts below (click to enlarge), are fascinating.

First, in the 15 or so years prior to the GFC, UK housing costs actually increased at a substantially greater rate than their Antipodean counterparts.

Of course, the cataclysmic economic and financial collapse subsequently experienced in the UK in 2007-08 resulted in a very significant contraction in UK dwelling prices.

Specifically, on a peak-to-trough basis, UK home values fell by 13.6%. This compares with a smaller 3.9% peak-to-trough decline in Australian dwelling values, which did not have to contend with big increases in unemployment (or arrears).

Monetary policy also works differently in Australia, with almost all borrowers on “adjustable rate” loans. In the UK, the split between variable and fixed rate loans has historically been around 50:50. This makes it harder for the UK central bank to deliver cash-flow relief to borrowers in the event of a crisis.

The circa 14% drop in UK house prices is noteworthy but perhaps not as big as some might have expected. For example, the Aussie sharemarket (as measured by the ASX/S&P200) has fallen further in the last month or so.

And based on a far less-accurate benchmark for US housing costs, the S&P Case Shiller Index, which unfortunately excludes about 40% of all US homes, the correction on the other side of the Atlantic was twice as steep. This might be partially explained by the fact that US default rates were nearly three times higher than comparable UK arrears (and about 10 times higher than Australian defaults).

A more interesting finding speaks to relative value. Because of the much stronger run-up in UK house prices prior to the GFC, the overall change in housing costs over the last 18 years has been virtually identical to Australia’s notwithstanding the sharp recent correction.

This can be seen in two ways. First, the levels in the charts are similar after accounting for a couple of decades worth of value changes. Second, the compound annual growth rates between 1993 and 2011 are statistically indistinguishable (7.3% in the case of Australia, and 7.0% for the UK).

If we plot the two house price benchmarks on a so-called “logarithmic scale” we can also evaluate their changes on a truly like-for-like basis. A log scale transforms the first chart such that movements in the two lines represent the same percentage change. As you can see in the second chart, the two lines look like one.

As a final test, we can compare house price-to-income ratios. Thankfully the economists at ANZ, which happens to have a British CEO, have done this for us (see the third chart below). It turns out that the UK house price-to-income ratio is actually higher than Australia’s, which suggests that Aussie housing may actually be better priced.

Based on the analysis above, residential property in Australia looks to be just as good value as UK housing today. Indeed, with demonstrably superior economic and household income prospects, and faster household formation rates, one might reasonably project superior returns going forward.