Brian Easton: Blowing bubbles

By Brian Easton In Economy

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When commentator Jesse Colombo in business journal Forbes said New Zealand had a housing and credit bubble, Economic Development Minister Steven Joyce shot the messenger, saying, “His view on life is that the whole world is pretty much in a bubble.” That does not mean Colombo was wrong.

Shortly after, the OECD pointed out that our house prices were exceptionally high relative to rental prices. It seemed to be suggesting that whereas investors could get an annual return of, say, 6% from company bonds, they would make only 3.6% as landlords.

Thinkstock

Thinkstock

However, the OECD reported house prices rose 8.2% in the year. Added to rental returns, that was a whacking 11.8% compared with bonds’ 6%. The after-tax housing return is higher still since capital gains from house price increases are not taxed. If the landlord had a mortgage, the return would be even better.

That was for last year, of course; strictly, the calculation is only really meaningful if the landlord sold the house, although the transaction costs of selling can be quite hefty. If the capital gain is not realised, there is only the promise it may be one day.

Including capital gains, property investors seem to have made a good return on their outlay. But will house-price inflation continue? The short answer can be found in Stein’s Law: if something can’t go on forever, it will stop. Indeed, when the housing bubble pops, house prices may even fall, although probably not by as much as the 40% implied by the OECD.

More likely they will fall a little, then stagnate. That is already true in some regions. The biggest housing bubble is in Auckland; Christchurch house prices are rising because of the earthquake, but so are its rents.

During the stagnation, landlords will get only 3.6%, instead of the 6% annual return on company bonds. Some will try to sell their rental properties, which will push housing prices down, making the return even more miserable for those who stay in.

Does this analysis apply to house owner-occupiers? Not nearly as much. If house prices fall – even dramatically – it would not affect them immediately. House outgoings would remain the same, including mortgage payments. Even if the house was worth less than the mortgage, it would only matter if the owners lost their jobs so they did not have enough income to service their debt. Unemployment usually rises when a bubble pops.

Those without a house might find it easier to buy one. But the people who would be most hurt by a bursting bubble – landlords and the jobless aside – would be those who needed to change houses for practical reasons such shifting location, a change in household size or retirement. There would be fewer houses for sale and fewer buyers in the market. The market might seize up, as it tends to in winter, but in a post-bubble world winter could last for years.

Economists dispute whether the Government should do anything about a housing bubble. Certainly it would be better if it went down slowly, but some doubt whether the Government can deflate it with any precision. The Reserve Bank already monitors the trading banks to ensure they are not too exposed, so when the bubble pops the payments system will not be compromised.

There would be agreement among economists that Government actions should not contribute to inflating the bubble. The Treasury, the Reserve Bank, the International Monetary Fund and the OECD think good tax policy treats the return on all investment the same. They have not actually advocated a capital gains tax, however.

When will the housing bubble pop? Stein’s Law says only that it will – unless it deflates gently – not when. You would be wise to follow the banking system and make sure your downside is prudently protected if house prices stagnate or fall – especially if you are a landlord.

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