Update No. 164 – 24/05/14

We closed the gap on the market this week, now trailing by only 0.25% since January 1st. You could be forgiven for suspecting we hold a portfolio that closely resembles the ASX200, given how closely we’ve tracked the market in 2014 – never more than a couple of percent above or behind. Believe me when I say, our portfolio looks nothing like the ASX200 and you should expect wider variations (hopefully positive ones) in the second half of 2014 and deeper into the future.

As I watched whether (or how rapidly at least) the US economy would rise out of the GFC, one of the statistics I watched most keenly was US housing starts. The rise in housing starts has pretty neatly tracked the fall in unemployment and the general improvement in the world’s largest economy. I don’t spend a lot of time worrying about ‘macro’ conditions, but I don’t ignore them completely either.

US Housing starts have levelled off in 2014, at a level a little over 1 million starts per annum. The figure widely regarded to be the ‘business as usual’ or ‘replacement level’ for US residential construction is around 1.5 million starts. From the last release (.pdf), building permits and housing starts are now approximately level-pegging (starts at 1.07m & permits at 1.08m). This would indicate it will be some time before housing starts rise very much (permits need to rise first – obviously)

As mentioned previously on this blog, a large part of the big bounce-back in US home prices can be attributed to ‘under-building’, simple supply and demand dictates that if less new supply is becoming available, existing stock of homes will change hands at higher prices. If the under-supply is large and long-lasted, truly distorted prices can start and sustain.

This is the problem Australia has faced for the longest time. We have all heard Australian houses described as being in a bubble for more than 10 years. The thing I despise in ‘bubble commentators’ is how they will call a bubble at X=100, bleat about the coming despair and destruction as prices grow to X=200 and then declares themselves ‘all-seeing’ and indisputably correct when prices fall to X=150. If you choose to be a bubble commentator, acknowledge you were wrong until the day prices return to lower than they were before you called bubble.

I have through this period always agreed that Australian prices were above their ‘fair-value’ level, but remained ever-sceptical that there would be a meaningful fall, supply and demand factored dictated that the likeliest scenario involved an extended stall in rising prices (as happened through 2010 – 2012).

Conditions for a meaningful stall in Australian housing prices are starting to take place in my view. There is an explosion in unit construction (.xls), up about 36% year on year, while overall housing construction is up about 25% (though still well below previous construction peaks). Combine this with Australian wage growth at the lowest level in 15 years and I would think a levelling off in Australian house prices is a near certainty.

One would hope prices will level off anyway, according to RP Data (.pdf), Sydney median house price reached $680,000 (up 16.7% year on year) at the end of April. Australian Capital Cities median house price reached $550,000 (up 11.5% year on year). These rises are clearly unsustainable – the underlying value of housing prices closely track household earnings, as linked above, they have not grown at anything like double digit rates in the last 12 months.

I think the Australian property market is probably best avoided at the moment, the growing flood of new supply and moderating wages make for a muted outlook (or a levelling of the supply/demand condition, depending on your view). I always like to consider investing in terms of binary choices though. In terms of binary choices between the 8 capital cities in the RP Data sheet above, if I were forced to purchase a home in any one of these 8, with a 5 – 10 year view, it would have to be Canberra. Median home price in Canberra have risen only 1.2% year on year, I suspect because everyone expected the incoming Federal Liberal Government to cut a swathe through the public service. Canberra prices have lagged the national average for a few years too. Times of depressed sentiment are when you want to be active/vigilant as an investor. Also, the average wages in the ACT are higher than any other State or Territory, because of the generous public service salaries, yet homes in Canberra rank fifth of the Capital Cities in terms of price.

As to which market I would avoid most, it would be a close run contest between Sydney and Darwin. Sydney has had a largely (based on fundamentals) unjustified re-rating in the median price over the last 2 years, based on the median Sydney salary, it is the most expensive city in terms of the number of years of median salary to purchase the median home.

Darwin is different, median prices are inflated due to investors hunger for yield, Darwin houses yield 5.8% and units 6.1% at current prices due in large part to some major gas projects. Betting against the Darwin market will probably take a few years to play out, a couple of the large projects underway in Darwin will run for a number of years, but once complete the distortions (price insensitive contracting companies etc.) currently driving yields up will substantially fall away and the natural consequences of that is median prices will fall. If I had to pick one Australian Capital City market where the current median house price was likeliest to be the same or lower in ten years’ time, Darwin would be my choice. Investors buying in Darwin will need to hope the current very high rental yields stay elevated over the next few years to justify current prices and ensure an economic return.

Having said all the foregoing about the general condition of the Australian housing market, I would add one caveat. Buying housing is not unlike buying shares in one very important respect. No matter the general level of valuation, astute purchasing can be done at almost any time to ensure better than market performance. As with shares, however, it is astute purchasing at times of depressed general valuation that ensures really good results – Tony Hansen 24/05/2014

EGP Fund No. 1 Pty Ltd. Up by 4.34%, trailing the benchmark by 0.25% since January 1^st. Since inception, EGP Fund No. 1 Pty Ltd is Up by 71.42%, leading the benchmark by 40.40% all-time (April 1^st 2011).

^{*1 after 31May 2013 dividend of 2.333 cents per share plus 1 cent per share Franking Credit}

^{*2 calculated based on dividends reinvested}