The media, politicians, real estate agents and banks will
all have you believe that there is a shortage of housing (for sale and rent) in
Auckland. They sight the shortage as the reason for prices posting continuous
double digit increases. However if this were actually the case we would be
seeing motels, hotels and hostels being booked out, with people in need of
somewhere to sleep being forced to pay by the night. Campgrounds would be
turning people away and we would have tent cities pop up in any available ‘green’
spaces. If you could not afford or find vacancy in any of the above options, you
would have to turn to sleeping on the streets. We are seeing none of these
symptoms.
There are reports that apartments are difficult to sell, which tells me that there
is no shortage of places people could call home. Instead, prices for houses
with large sections are leading the march higher in price. This is due to the
perceived further increase in the price of land – otherwise apartments would
also be rising. Would-be speculators are hoping to flick the land later down
the track at a profit, hopefully with no additional improvement required.
Price is a signal. In the property market, high prices are a
signal that we need more homes. We are seeing an increase in supply with new
buildings under construction, but yet house prices continue to climb.
So if it’s not a lack of supply, what is the cause?
House prices are a function of two factors: interest rates
and banks willingness to lend. Without both or either of these two factors
being favorable to buyers – no one would be able to pay the current prices by solely
drawing down their savings. There are very few buyers who have the required
cash to buy outright, let alone pay the messily 10% deposit now required under
the LVR rules.
Housing has been a very good investment for not only the owners
but also the banks. If a borrower was to default on their interest payments,
the bank can repossess the house and sell without incurring a loss on their
lending misjudgment. This creates a feedback loop and encourages more bank
lending into the housing sector, with banks generally falling over themselves
to lend against property. From the banks point of view what can go wrong?
Borrowers are willing to pay the required interest rate, saddling themselves
with what would traditionally be considered a mountain of debt. All because
renting is seen as throwing ones money away? And interest payments are not when
renting can actually be cheaper? This is due to the misguided conception that
house prices can never go down. Where have I heard that before?
Combine this with the interest rate spread banks are
currently making due to the OCR only recently increasing from historic lows and
the housing market considered low risk, the banks are generating huge profits.
They are acting in their best interests. But in doing so, creating one final
bubble that will leave a very sour taste in all property investors’ mouths for
a generation.
Ultra low interest rates places banks at risk when rates
eventually rise (as they now are). This is because banks typically borrow short
to lend long. There is a mismatch between their funding and lending duration. This
is not a problem when rates are stable or falling, but as they rise banks
profits will shrink, along with banks margins. Combine this with the increase
costs of interest payments now required of the borrower; the housing market is
all of a sudden in a very fragile state. The only positive (if prolonging the
bubble is the ideal situation) is that interest rates are still positive, that
is the cost of money is higher than the CPI price inflation. This give the
Reserve Bank of New Zealand (RBNZ) room to move, with interest rate cuts, if
the wheels look as though they are going to fall off the property market. This
will merely delay the inevitable. The
underlying problem is not fixed.
One cause of high house prices is commonly blamed on
foreigners investing into the property market. If the RBNZ was not obsessed
with the “high” exchange rate, this would not be a problem. All foreign central
banks that are engaging in reckless monetary policy would see their currency
drop in value against the Kiwi Dollar. This would increase property prices for
foreign buyers, damping demand automatically.
So how did we get into the position that banks look at
property as a favorable assets to lend against and investors / home owners are
willing to commit to purchasing an item that will tie them down for years to
come? What has been building in the property market over the last ten years is
a feedback loop that has signaled to both banks and buyers that property is a
safe investment. As prices rise, banks feel comfortable lending against
property, allocating more scarce capital to the property market. As prices
continue to rise investors / potential home owners worry they will miss the
boat and jump in, borrowing too much money, but hoping further down the track
their home would have increased in price to make the sacrifice now worth it.
We need to step back further to see why prices first
increased, what ignited the initial spark? Interest rates can only be below
their natural market level with an artificial supply of the currency. This is
initially done by the RBNZ (through the OCR) and compounded when banks engage
in fractional reserve banking. As this money flows through the economy, it will
not do so evenly and will be looking for a safe home. Ever hear the term ‘Safe
as Houses’? That is where it ends up – in New Zealand’s case. There is simply
too much money, chasing too few goods. In this case everyone is chasing
property. Simply building more homes will not fix the over valued market. The
2000’s tech bubble was a prime example of this. Increasing supply results in a
larger misallocation of capital and will make the bursting of the bubble that
much more painful as mistakes are finally realised. Price inflation in consumer
goods always follows asset inflation, causing the RBNZ to further raise
interest rates, compounding the problem I touched on above.
How do we tell the air may finally be escaping from the
bubble? Watch the stock market. This is the best gage of inflation and readily
available bank credit we have at our fingertips. While the NZX is rising, we
can be reasonably confident property prices will remain elevated. As I like to
say ‘Enjoy the party, but dance close to the door’.
The solution is easy, but not politically acceptable (what real
solution ever is?). We need to stop the expansion of the money supply, stop
fractional reserve banking (both assist to keep interest rates low), and reduce
the amount banks are able to lend against property. The last point will most
likely automatically be rectified with the change in policy of credit expansion
to be not actively allowed by banks. Make no mistake about it, this will be a
very painful process, but it will put our economy on a more fundamentally sound
footing. Unfortunately I do not see the necessarily changes any time soon –
either by the RBNZ or either major party who could form a Government.
The bubble will burst, history shows this happening. What
policy actions will the Reserve Bank and Government use to respond to an
economy entering recession due to a fall of (or failing to rise) house prices? I
think 2007 / 2008 gives us the answer. It will not be pretty. As Patrick Barron
says: “Fear the boom, not the bust.”
This was written in April 2014, so far prices show no sign of falling.
