How Bad Would a Property Bubble Bust Really Be?

Analysis firm LF Economics thinks there’s a serious property price bubble. And it might pop in 2017.

According to a recent statement they’ve released, the current percolate is much worse than the types we’ve had in the past. They said:

‘Housing prices across all capitals remain grossly inflated relative to rents, income, inflation as well as GDP. What event or even set of events triggers the beginning of the end of the housing percolate is not yet known.’

‘…A bloodbath in the housing market, however, appears a close to certainty due to the magnitude associated with falls required for housing costs to again reflect economic fundamentals.’

So how bad would the actual ‘bloodbath’ really be?

Where would prices go?

The authors think house prices should ‘reflect economic fundamentals‘. To do that, they might have to fall back in line with income, rent, inflation and GDP growth rates.

For the actual sake of simplicity, we’ll just look at one of them: income.

Dwelling price to income ratio is a popular way of measuring whether real estate is overvalued. It’s simply the percentage of household income towards the price of the dwelling. Exactly how overinflated housing is depends on that set of data you look at. There’s public data and private market intelligence, as well as info gathered by industry peak bodies. But for the sake of simplicity, let’s use these charts produced by the RBA using earnings of data from a variety of sources.

Source: rba.gov.au
[Click to enlarge]

In the chart on the left, you can see that the national average price to income ratio stayed within a range of 2 to 4 up until the late 1990’s. And in capital cities, that range gets larger — around 3-6. To put that in perspective, all over the world, it’s about four.

So what’s the average household income at the moment? Nicely again, that depends on whom you ask. But just say you decide to use the ABS’s latest stats on weekly earnings, released in February. Then say there’s an average of two grown ups in the household, and they each make the equivalent of ‘all employees average every week total earnings‘. And that they’re not obtaining income from other sources. Their annual household income would be about $117,300.

So if home prices went back to, state, three times average household earnings, the average house price around australia would be $351,900. Currently, it’s about $571,500 according to stats launched by the ABS in February.

That’s a 32% drop.

Then again, that changes with different variables like employment levels and higher typical salaries in capital cities.

For example, the report authors believe that Melbourne will be amongst the most detrimental hit when the bubble pops. If you look again at the charts above, Melbourne has the third highest dwelling price to income ratio. If the ratio dropped to 1 / 2 of what it is now — back in the 3 to 4 range — house prices could go the same way.

But the national average is still a good indicator.

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Eva Mellors
Factor, Money Morning