Saturday, 14 February 2015

Property valuation and the bubble economy

The story of how the global debt ponzi started is surprisingly simple. In western democracies, a majority realized that, in addition to voting themselves into the treasury's coffers, they could vote themselves into their children's pockets too. This was done by deliberately inflating the price of property using debt, with one generation hijacking housing and ransoming it back to the next. Property is a significant determinant of a nation's wealth, its price movements considerably impact consumption, it underpins pensions and retirement plans. Most significantly, property underpins the banks and other financials, so inflating property prices artificially boosts stock prices too. The property bubble thus created a thousand further bubbles, metastasizing and eventually coming to threaten the entire real economy.

The price of property is always claimed to be set by a "market". In reality, a nation's property prices can be deliberately moved by changing tax laws, by restricting land and infrastructure supply, by repressing interest rates and changing lending rules. In reality, there are plentiful ways to manipulate property prices, that have nothing to do with "markets" or supply and demand for a place to live. In Australia, a prime example is the tax deductibility of losses incurred on so-called investment properties, in effect a government subsidy to property speculation. These are deliberate policies to ramp property prices, put into effect by political majority, creating a bubble economy that gradually has come to engulf other actually productive areas of society. As financials make up an increasing proportion of the economy, with more people and time spent, this constitutes an enormous drag on the actually productive.

The valuation of property is also surprisingly simple, and as always comes down to cashflows. Since the long term cashflows of property are much more stable than those of shares, calculating the fair value of property is in fact easier than valuing most shares. In the long term, average net rental cashflows follows average income closely, and in the very long term both are expected to converge with inflation. Just as the value of a stock is the sum of all future dividends discounted at an appropriate risk-adjusted rate, so the value of property is the sum of all future net rental cashflows discounted appropriately. Property value is thus equal to starting net rental cashflow, divided by the discount rate less the expected growth rate in net rental cashflows.

The rent that is or could be charged on a property, less all expenses and maintenance, is what determines value. Increases in the fair value of property can only be driven by a matching expected increase in net rental cashflows, any increase in price beyond that is a burgeoning bubble. Assume a model where the average property price at Year 0 is $100,000 and the net rental cashflow is 8,000, with both prices and net rental cashflows increasing by 3% annually. Over 30 years, price increases to $242K and net rental cashflow increases to $19K, with net rental yields constant at 8%.

In this model economy at equilibrium, long term property price growth equals long term net rental cashflow increase. (The model assumes constant increases each year purely for presentational ease, the conclusions are independent of this assumption. Also, note that a long term model of property prices need not include variations to the central bank interest rate, since in the long term the sum of central bank rate movements is zero.) But 3% capital gains are no fun and generate no bankster bonuses, no boom times or popping champagne corks, just boring sustainable growth. Assume instead that a political majority aided by banksters, a stealing generation if you will, decide to implement policies to deliberately inflate the price of property at a 7% growth rate. This growth is of course financed by debt, aka money created out of thin air.

In this scenario, net rental cashflows and the fair value of property remains the same, but property prices rise to $761K in Year 30, sending net rental yield down to 2.6%. Anyone buying property in Year 30 is paying $242K for the actual property, and a further $518K for a ticket to the state sponsored pyramid scheme that has been created. In Year 30, two thirds of property prices constitute a down payment to the government sponsored pyramid scheme. The only reason anyone is willing to pay $761K in Year 30, after years of unsustainable increases in price, is the expectation of further increases. In time and with enough "benevolent" intervention, future expected price increases become priced into the market, and the bubble fuels itself.

This is most clear in Australia, with more than 50% of house purchases going to property "investors" (actually leveraged speculators on the government sponsored pyramid scheme). The majority of these property "investors" incur running losses on their "investment", and are thus without question making the purchase based on expected future capital gains. This is an acknowledged fact. Meanwhile the presstitutes and analysts tie themselves into knots trying to explain why this is not at all a textbook bubble, when an asset is bought solely on the expectation of further rises. The latest explanation is the most humourous: it is not a bubble because Australia has many "coastal cities". Such a non sequitur could only pass as intelligent comment in an idiocracy, it proves not only the idiocy of the commenter but also the stupidity of the society that promotes said commenter to a position of power.

But how can bubble economists admit that lowering rates and changing tax laws boost asset prices, yet simultaneously claim prices are set by an efficient market? This is solved by circular thinking and the so-called wealth effect. Bubble economists believe that if we ramp up asset prices by lowering rates, the higher prices will inexorably lead to higher economic activity (the wealth effect), with the fair value of this increased economic activity perfectly matching and justifying the increased asset price. So if we ramp shares/property, this increases future cashflows for shares/property, so that the initial ramp was just a fair value movement by an efficient market. The initial manipulation of the market was therefore not manipulation. Because of efficient markets and the wealth effect, markets are essentially non-manipulable, therefore we should manipulate them as high as possible (this power should of course be yielded to only the most prudent and benevolent central bank bubbleheads). This is not meant as parody, this is what bubble economists actually profess to believe. If their premise were correct, i.e. if markets with absolute certainty always were and always will be perfectly efficient, their logic would be flawless. If you knew a car's speed gauge was perfectly correlated with vehicle speed, and could not for any reason ever be incorrect, it would make sense to try and move the car by pushing on the speed gauge with your finger.

Both political parties, all "respected" economists and every mainstream economic journalist fully support the bubble economy that western democracies have descended into. To challenge the bubble paradigm is to invite ridicule and revulsion. In Australian media it is forbidden to say that we have a bubble, likewise the bubblehead of the Reserve Bank and other banksters would never admit there is a bubble, regardless how grotesquely prices become detached from reality and cashflows. (At most they are permitted to say there is maybe a risk of future overheating.) Realistically, 2007 was the point of no return, the time when the west could have abandoned the bubble economy and dismantled the expanding beast of finance and debt-fuelled asset bubbles, but instead decided to inflate an even bigger bubble to cover up the losses that would have been necessary to face, if true price discovery had prevailed. The bubble has gone so far now that no politician could ever propose dismantling it. The campaign slogan "I'll crash house prices! (But it's necessary for our future)" is not likely to be popular.


  1. Nice diagnosis of the problem Dr.

    Yes, the prescription is a house price crash, long overdue, but seems as far off as ever, even with the insane rate of change in Sydney prices.

    I see at 3.2 ‘Imposing Losses on Creditors’ the nice folk at the RBA are preparing for one however:

    They have their sights on depositor’s money it seems!

    I’m sure they must get a warm and fuzzy feeling being able to force others to pay for their banking buddies mistakes.

    1. Yeah I agree. The dourfaced bubblehead of the RBA will shamelessly go to any length to maintain the bubbles, including destroying the prospects of future generations. It's all the west makes these days; debt-fuelled asset bubbles. I'm not so optimistic as to envision a crash though, but rather a long slog in the form of decades or centuries of slowly declining average real income and living standards. It's already happening.

  2. I don’t know the likelihood of a crash,

    But it’s absurd to think that the simple act of wanting to buy a family home has now seemingly turned into one of the most risky gambles one can make.

    Especially, if one is leveraged up to the gills.

  3. Good article. However, like most analysis of the Australian housing bubble you forget to mention arguably the single biggest factor behind unsustainable price growth - welfare police.

    There are about 2.5 million Australians receiving the full (or partial) Age Pension of which 2.26 million (90%) are home owners. A couple can enjoy the full Age Pension if they have assets under $286,500 and a partial pension up to $1,145,000 EXCLUDING the value of the family home. The full Age Pension for a couple if $33,500 a year without factoring in the PBS benefits, discounted rates and utilities, discounted car registration and so on.

    The bottom line? The political-majority (stealing generation) is enormously incentivized to remain in the houses on quarter-acre blocks they bought 20/30/40/50 years ago for < 3x annual income. They have no reason to sell up and downsize to release equity to generate income or reverse mortgage their homes. Do not underestimate the effect this has on supply availability and prices.

    1. Good points, dancitron. A plethora of ways to skin an economy and fleece the unborn, a multitude of recipes for eating the seedcorn.

  4. Came across this today, nothing new I guess, just thought I’d mention it:

    ‘Surry Hills wreck soars over reserve’

    I particularly like the quote: "It's a rising market and this will be for long-term gain…”

    My market bet is on long-term pain; soon enough.

    1. Thanks for sharing this, TheForms. Long-term pain indeed. Our entire economic system now relies on using debt to inflate asset prices at a higher rate than underlying cash flows. To abandon the bubble economy would necessitate a complete rethink of our society, not to mention collapsing property prices, stock prices, pension plans. Hundreds of thousands of people employed by banks/financials would have to find actually productive jobs that simply no longer exist in Australia. People would find they own but a fraction of the wealth they thought they did, and millions would be entirely wiped out.

  5. They could fix this, they could simply -
    Release more land.
    Scrap NG and CGT concessions.
    Scrap SMSFs buying IPs.
    Enforce FIRB laws.
    There are lots of ways to solve this problem...but THEY DON'T WANT TO!
    Our politicians personally own about three investment properties each!
    They answer to a baby-boomer electorate that couldn't give a stuff about the generations to come. They simply want younger Australians to pay for their retirements with rent.
    Given the opportunity, they'll take even more... maybe the kids should sacrifice their superannuation to the property bubble!
    Liberal, Labor, RBA, APRA... none of these abbreviations actually mean anything.
    They're all in it together.
    This is not a 'problem' they are failing to solve, it's their design.
    If you're young and you're holding an Australian passport, LEAVE.
    The current system is designed to suck all of the blood from your system to feed the elderly.
    Leave, and don't come back till it collapses.

    1. Rachael, I'm with you on this and I think I've seen you comment on other blogs about this before. I've seen this all before (when I lived in Europe for a short while), it's a shame that young Australian's are being screwed to pay for the retirement of older generations.

      I have thought about leaving again, but not sure where I'd go that isn't also experiencing a crazy bubble. Cape Town comes to mind but has it's own problems.

    2. Your comment is spot on, Rachael, that is an excellent summary of the situation. But like Gavin points out, the bubble is global (albeit the most ridiculous here in Australia). There is nowhere to go.

      Bubbleblowing has not just hurt the economy, it has become the economy, to the detriment of any and all actually productive enterprise. So even if the politicians wanted to stop the bubble, they wouldn't dare, it would be their end. This explains the recent bleatings from the RBA, and their sage "warnings" about "risks" in the "market". They are preemptively trying to deflect responsibility for what they have done.

  6. Not only was the bubble economy not abandoned Dr, the government doubled down. Since November 2013 the RBA has gone into overdrive in its monetisation of mortgage debt, the rationale being the lack of 'AAA' government debt means banks cannot meet the new Basel 'standards' in capital requirements.

    Leaving aside the fact that government debt is itself a colossal credit bubble, this is akin to turning water into wine, more specifically, shit into money. Everybody shits, so turning shit into money is a popular trick popular with the mindless voters.

    The end will only come with the realisation that government debt is junk & thus the central bank will no longer be able to bail out the commercial banks when their scams go belly up.

    I'm actually an optimist, but the future is bleak. Economic dysfunction inevitably leads to war.

    1. Hi Central Scrutinizer, thanks for your comment. I agree, it's looking bleak, and sadly, war might not be the worst outcome imaginable here. I'm thinking centuries of falling real incomes and living standards for the average person (read debt slave)