Australian Property: Crazy Bullish or Just Crazy?

Yesterday we asked for your thoughts on the Australian property market. You didn’t disappoint. The inbox is heaving with responses. We’ll go through them and publish some, with our responses, in the next day or two.

In the meantime here’s something for property bulls and bears alike. From today’s AFR:

‘Contestants on the Nine Network’s hit reality series The Block were gasping with shock when their homes nabbed more than $200,000 above the reserve prices at auction.

‘All five apartments fetched higher than $1.44 million at the televised auction, beating the inner city’s suburb’s median unit sale price by more than $886,000.’

So just to clarify things, the units sold for more than $1.44 million which was 160% above South Melbourne’s median unit price.

That sounds crazy bullish, with an emphasis on crazy. But then again, we don’t watch The Block. With two little ones to feed, clean and then try to resist tranquilising in the evenings, the TV doesn’t get much of a run in our household.

So maybe the apartments were worth the price paid. Maybe there were some gilt-edged trimmings around the place or the rooms were packed with ‘European appliances’.  In the absence of knowledge of the intricate details of the fittings or the general quality of the apartments, let’s consider the earnings the properties must generate in order to deliver a half-decent return for their new owners.

As we mentioned yesterday, a property’s earnings is the rental income stream it delivers. This can either be explicit (assuming the apartment is rented out to a third party) or implicit (in the case of the owners staying put).

So, at a minimum of $1.44 million, plus 5% stamp duty in Victoria (add another $72,000), your cost base for the delightful and fleetingly famous South Melbourne apartment is $1.512 million. Gulp.

What would be the minimum return you would want from your new property? In this low interest rate environment, let’s say 3% gross. On a $1.512 million cost base, that represents rental income of $45,360 per annum, or a weekly rent of $872.

Call us sceptical, but we think it’s a stretch to think anyone would stump up that kind of money for an inner city apartment, especially with the glut of apartments in Melbourne. But the apartments are large and unique, so maybe they would.

So looked at through the lens of a rental (earnings) yield, the net return (after maintenance costs) on capital of these apartments will probably be in the sub-3% region. That’s hardly an efficient use of capital.

The cost of debt capital (which we take to be the cost of a home loan) is over 5% while the cost of equity capital (which we conservatively assume is the return you get from saving your deposit in a bank account) is around 4%.

(Keep in mind, that even if you don’t have to borrow a cent to buy property, there is still an opportunity cost involved. In this case, we have been as conservative as possible and assumed the cost is the interest rate in a high interest bank account.)

On these numbers, the property isn’t even covering its ‘cost of capital’. When companies listed on the stock market generate returns below their cost of capital it results in value destruction (diminished equity value) and a declining share price.

For buyers to willingly purchase property promising such low yields can only mean either the buyer doesn’t care and that they see the purchase as a store of wealth (fair enough) or that they expect to make money not from the rental yield but from the long term capital gain.

From our experience, this seems to be the overriding mentality of property buyers in Australia. That is, income is a side-show, it’s all about capital gains. And because they are tax free, it’s the only game in town.

We remember a conversation with a Melbourne real estate agent earlier this year. After enquiring about a house in St Kilda and the expected rental income, we remarked how poor the income return was. The agent quickly dismissed our schoolboy interpretation of return on assets. You don’t buy property for the income return…you buy it for the long term capital gain it delivers.

There you go…

Getting back to The Block sales, according to the AFR, buyers advocate David Morrell says ‘if it wasn’t for the commercial hype, there’s no way those apartments would have got those prices…anyone who buys an apartment like that, expecting to get a turnover, needs to get their head checked.’

But buyers agent Monique Sasson Wakelin ‘argued that prices paid are “not that crazy, or out of the ballpark” for the area. “South Melbourne is a highly sought-after area, and even though it’s not the prettiest end of Park Road, you’re still within walking distance to the city.”’

The property bulls certainly have the upper hand right now. Actually, they’ve had the upper hand for years, and bears like us have been proven wrong time and time again.

One thing the bears have got wrong is their ability to underestimate the impact of regulation on pushing costs up. There are multiple layers of government red tape and costs that adds to the price of land and the cost of building anything on that land. Add to that an expensive and in many cases unionised construction workforce and all these costs are added on to the final product.

But the bottom line is that unless the earnings from an asset are greater than the cost of capital that procures the asset, it results in a destruction of wealth. That may seem like a weird statement given that rising property prices make many people ‘wealthy’.

But the cost of capital versus the return on capital is a fundamental law of finance. A company with a poor return on capital can keep its head above water by increasing borrowings and raising additional equity from shareholders as long as confidence in the business remains.

But when confidence goes the flow of money stops, finally revealing the ugly economics of the business…which should’ve been there for all to see for years.

Regards,

Greg Canavan+
for Markets and Money

 

 

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From the Archives…

Has the Chinese Economy Hit the Great Wall?
26-07-13 – Bill Bonner

Crisis, Capital Controls, and Accidents of Birth
25-07-13 – Doug Casey

Australia’s Mysterious Natural Gas Shortage
24-07-13 ­– Nick Hubble

Bernanke’s QE Train Wreck That’s Heading Our Way
23-07-13 – Vern Gowdie

The Misallocated Savings of the Chinese Banking System
22-07-13 – Dan Denning


Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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