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Investment News and Views, Direct from Our Team.

The Great Property Bubble Part 2: Rationality disapears

It seems that the entirety of Australia has forgotten their year 8 maths. House prices cannot compound at rates greater than inflation and wages over the very long term. Whilst they have grown at rates greater than inflation and wages over the last 25 years, they have moved inversely to the falls in interest rates from high teens to low single digits. If the world inverted from here and those who borrowed money were paid interest on their borrowings from the banks, then maybe house prices could continue their run. Believing this will happen is a bit like believing gravity will change direction.

The article in todays paper highlights a perfect example of the extremes of irrationality. Suggesting house prices will compound at 8.52% for the next 50 years with wages growing at around 2-3% is possibly the most irrational statement I have heard since the Dot-com bubble mania. If house prices grow at 5% above wages and inflation, then the average house would be 11.46 times more expensive in half a century. A house which is currently $700,000 will be over $8 million in todays dollars.

So lets think about this. The average household wage will be earning $100,000 (gross) and will remain that way after inflation, however the average house will be over $8 million. How does someone earning $100,000 buy a house for $8 million? They can’t.

The definition of a Ponzi Scheme:

“A Ponzi scheme is a fraudulent investment operation where the operator, an individual or organization, pays returns to its investors from new capital paid to the operators by new investors, rather than from profit earned by the operator. Operators of Ponzi schemes usually entice new investors by offering higher returns than other investments, in the form of short-term returns that are either abnormally high or unusually consistent.” (From our good friends at Wikipedia)

So we have the key elements required for a Ponzi Scheme:

1. Paying returns from new capital rather than profits (profit only from capital growth from someone paying a higher price not rental return)
2. The need to entice new investors by offering high returns. (How many articles are there about how much people are making from property. There is a section of the SMH showing “hot” suburbs with returns of 40% per annum (abnormally high returns). I can’t find their section on “cold” suburbs.)

A market which requires new entrants to continually pay a higher price than those before them with no income based price reference is a Ponzi Market. The very grey reported numbers which come from perhaps not the most trustworthy of sources – used house salesmen – on house prices only serves to pump up the market.

There are more sheep who believe house prices always go up at rates above wages and inflation than rational thinkers. This will not always be the case, however whilst this paradigm exists, more suckers will get sucked into the craze. It is those that get sucked into the last stages of the Ponzi Scheme that are the worst effected. Add leverage to this and you have a recipe for a great deal of pain. Glen Stevens the head of the RBA knows this and is constantly warning on house prices. His calls are falling on deaf ears.