A new model that takes in factors not normally considered in indices shows substantial discrepancies in the growth rates of house prices.
Seasonal effects and a range of variables including interest and unemployment rates, equity prices and housing stock may cause market values to plummet or soar. After a tumultuous couple of years on global stock markets, most Australians have a new appreciation of the risks involved in having a large portion of their retirement savings invested in equities.
The nightly news updates on stock price performances are a sharp reminder of the impact that such volatile assets can have on one’s level of wealth.
Despite holding an even greater proportion of their wealth in direct property than they do in equities, few Australians would be aware that property values are also quite volatile. Without any daily or even monthly valuation figures available for individual properties, there is virtually no way of knowing what prices might be doing, even when the properties share the same postcode.
There is a definite perception among property owners that house prices only go up, but you don’t have to look too far back in time in the United States to see that it is not always the case, says Michael Sherris, a professor of Actuarial Studies at the Australian School of Business. Australia is not immune to events similar to those occurring in the US and many people may be more exposed than they think, warns Sherris.
Several factors have been identified as possible causes of the US house price bubble including: low interest rates and easy access to finance; a move to residential real estate as a safe haven following the dotcom boom and bust; and a rise in new housing developments, which fuelled an increase in subprime mortgages, mortgage-backed securities and investment vehicles.
As with most bubbles there was a bust – and with very serious consequences. The popping of the US house price bubble in 2006 is widely regarded as the trigger for the global financial crisis and continues to cause considerable stress in that country and many others.
A buoyant housing market not only helps consumer confidence but keeps key parts of an economy ticking. Falling house prices reduce wealth, which drags down consumer spending. Construction profits become squeezed, making it less attractive for developers to build, eventually lowering the number of housing starts. Because the collateral is depreciating in value, lenders are forced to tighten lending standards, thereby reducing existing home sales as potential buyers become unable to access finance.
And fewer sales equals less tax for state, territory and federal governments, which forces budget cuts.
Sherris recently modelled the impact of a range of house price risk factors with Katja Hanewald, a senior research associate at the Australian School of Business. In a research paper titled House Price Risk Models for Banking and Insurance Application, the duo looked beyond the factors usually measured in national house price indices.
Overlooking the Big Picture
The new research shows how risky it is to simply take an overview of house prices. It is important to understand how prices vary with postcodes and the overall market to identify the key factors that drive price growth and risks, says Sherris.
Just as an investor in mining company BHP Billiton wouldn’t look to the benchmark stock market index, the All Ordinaries, as the best way to assess the level of risk of investing in that company, home owners need to look beyond property market indices when assessing the risk of owning their home, says Hanewald.
Property owners might also be surprised at the level of volatility in house prices in the same area. According to the research paper, over a period of about 32 years the mean growth rate for house prices sharing the same postcode was 8.26% a year.
However, the spread around this mean value is quite significant. Growth rates could easily vary up or down by another 7.21% at different points in time.
Hanewald says the variations in house price growth, which were larger over short periods of time, significantly reduced over longer time horizons.
While most investors in property hold the asset for long periods, the question is whether they realise how volatile property prices can be. “There is a definite expectation that property prices grow but not much awareness that the growth rate can vary quite a lot,” says Hanewald.
As no individual owns the whole property market, it is somewhat meaningless to look at overall indices to get a clear picture of the value of that property, she says.
The same logic applies to the banks and insurance companies who frequently assess the risk of individual properties for a range of reasons. Factors that should be taken into consideration include different postcodes, seasonal effects, and macroeconomic and financial variables such as interest rates, unemployment rates, equity prices and housing stock.
According to Sherris, banks, insurance companies and individual property owners could benefit from using a variety of models to better understand the impact of the different risk factors. Applications for the models include the risk assessment and pricing of equity release products, mortgage loans and mortgage insurance policies.
It becomes particularly useful to know what could impact a home’s future value for companies marketing products for people planning to finance their retirement income from the equity in their property, such as through a reverse mortgages. With reverse mortgages, home owners can borrow a portion of the equity in the home. Rather than make ongoing loan repayments, the loan is repaid when the home owner vacates the property, such as through death or sale.
According to the Australian Bureau of Statistics, in 2009-10 property assets made up 59.7% of total household assets in Australia, and 43.5% of the homes were owner-occupied. People aged 65 to 74 have 59% of their total household assets invested in property. This number was 61.8% for people aged 75 and above.
Sherris says the issue of assessment of the risk in the value of a home is particularly significant because so many people rely on property to finance their retirement. “The risk for people who rely on the sale of a property to help fund their retirement is that the price will go down at the wrong time,” says Sherris.
It is a point that hasn’t escaped a provider of specialist education and training to self-managed superannuation funds, the SMSF Academy. The academy’s managing director, Aaron Dunn, expects property to play an increasing role in the portfolio of SMSFs as more people take building retirement savings into their own hands.
Counting on the House
The amount of property held in self-managed funds is already increasing. According to the latest Multiport SMSF portfolio analysis, the overall increase in allotments to property rose 0.8% in the December 2011 quarter, taking the average holding to 15%.
Dunn attributes the rise to clarifications made in 2011 by the Australian Taxation Office around the borrowing rules associated with SMSFs and property, as well as younger people with longer time frames wanting to fund their own retirement. While the benefits of property as part of superannuation can be significant, regular analysis is required – including knowing the right time to sell the property – to achieve the maximum capital gain.
Sherris says that while the Australian economy and property owners have been very lucky to date, if China’s financial situation was to sour this would pull the Australian economy down. China’s burgeoning economy has been the driver behind Australia’s resources boom, which has underpinned the recent strength in the nation’s economy.
Vibha Coburn, head of mortgages at Citibank Australia, is more optimistic about the outlook for the property market but says that the location of individual properties remains key to investment success for many owners. “The idea of a property crash happening or a US-style drop in values happening is not likely from a national point of view,” says Coburn.
There are risks that people may not be aware of, such as the influence of China on the domestic economy, but generally that means capital gains from property are going to remain flat rather than fall dramatically. In assessing future mortgages, Coburn says banks would continue to focus on formal valuations of individual properties as well as a borrower’s ability to service the loan.
“The bank looks at overall property indices but also the specific circumstances of the property including its location, the size of the property, purpose of use, the state of the property, including whether there have been renovations, and its proximity to areas which might be considered high-risk,” says Coburn, noting that the global financial crisis has helped property investors focus on some of the risks that property carries, including the possibility that prices fall as well as rise.
Coburn says retirees relying on the proceeds of their principal place of residence to fund their retirement could face challenges if prices do come off. But if people are downsizing as a way of accessing disposable income, buying and selling in the same market might even things out a little. Coburn says most people who downsize may not buy in the same area, which can place them in a better financial position provided the property they are purchasing is in a cheaper location. “People are definitely thinking about prices more than they did. Location, location, location has always mattered but possibly now more than ever,” she says.