Your Home Is 56% Overvalued

It hasn't taken long. After last week's panic selling on the back of fears of a Japanese nuclear catastrophe, world …

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It hasn't taken long.

After last week's panic selling on the back of fears of a Japanese nuclear catastrophe, world share markets have recovered, and some.

Overnight in the US, the S&P 500 jumped another 1.5%. The VIX index, a measure of volatility, and widely known as the Fear Index, slumped 15.7% to 20.61, a level it traded around before the Japanese earthquake.

Risk is back off again. The Aussie dollar jumped back above parity, just few short days after some pundits were predicting it could slump to 95.5 cents against the US dollar.

And as for Libya, apart from the obvious spike in the oil price, as far as the share market is concerned, it's as if nothing much is happening.

We'll see. It still makes sense to keep some cash on the sidelines, in case some compelling buying opportunities arise. We'll have more in the coming days…

Bubblicious

Australian house prices are never far from the news, and something we'll consistently be covering here at The Motley Fool.

On his recent trip to Australia, Tom Gardner, The Motley Fool's co-founder and CEO, invented the word Bubblicious live on TV to describe Australian property prices.

We'll be running with Bubblicious for a while. Speaking of which…

'Hong Kong's price rises are the steepest in our index but it is not the most overvalued housing market. That honour remains with Australia, which is overvalued by about 56%.'

So said The Economist in a recent edition, setting off another round of this ongoing debate in workplaces and around barbeques across Australia.

The 56% overvaluation is greater than that of France at 48% and Spain at 44% in second and third (or perhaps it should be second- and third-last) places respectively.

The Economist has compared the current ratio of prices to rents in each of 20 countries against the long term average in that country to determine the degree of under or overvaluation. On this measure, Japan has the most undervalued property market, relative to their long-term average at -35%, with Germany the next most undervalued at -12%.

A One-way bet…until now

To a generation of Australian home owners who've bought their first homes, upgraded to bigger and better houses or purchased property as an investment in the past 20 years, ever increasing property prices have been a self-evident truth – it's as if every swing for the fences has been a proverbial home run.

Indeed, according to The Economist's figures, Australian property has increased 215% since 1997 – a compound annual increase of just over 8.5%.

That rate of increase is topped only by South Africa at 421%, and the next closest to us is Britain at 178%. By way of comparison, New Zealand's average price has increased by 111%, and the US increase has been 56%.

Ben Graham's 'Mr Market' has a somewhat less hyperactive, but equally emotional property-focused cousin.

Like shares, valuing property is an inexact science, with prices influenced by emotion and assumption. While we don't see daily (or more frequent) fluctuations, housing prices are just as susceptible to moods of optimism and pessimism as other investments – perhaps more so, given the emotional attachment most of us have to our own homes.

Bulls versus bears

The property bulls argue that the growth of personal income (both real and disposable) coupled with limited additional housing creation explains the growth in house prices. Undoubtedly, the absence of any significant economic downturn since the early 1990s recession has also allowed the growth in prices to continue unabated.

The bears suggest that prices have increased to an unsustainably high level, particularly when compared with average rents – the productive output of those assets.

With rents at a relative level the bears consider unsustainably low, the argument goes that investment will desert the asset class until the point at which the returns again become more attractive relative to other asset classes. The proportion of income devoted to mortgage repayments has also risen, increasing the risk of default when Australia next suffers an economic shock.

As John Maynard Keynes is famously believed to have said, 'the market can stay irrational longer than you can stay solvent'. It would be a brave person who bets against the weight of self-interested and optimistic money in residential real estate – the vast majority of which is controlled by owner-occupiers.

Something has to give

For my money, prices are at a level that I consider reasonably overvalued at best. On the Economist's numbers, housing prices and average income tracked within about 10% of each other between 1984 and 2000.

Since 2000, the gap has increased – quickly at first, with the rate of increase slowing over the past 6 years – to around 60%, with prices rising much faster than income over the past decade.

There may be valid reasons why this divergence has happened, and these reasons may well underpin a permanent change in the relationship between income and property prices. However, as Sir John Templeton noted, 'the four most dangerous words in investing are 'this time it's different.''

Zero margin of safety

At the current levels, especially with household debt at over 1.5 times annual income (up from 0.5 times in the early 1990s), any margin of safety that may have existed has surely evaporated, leaving home owners very vulnerable to economic shocks such as interest rate increases, an oil shock, a weakening of our terms of trade or any reduction in demand for commodity or other exports – any and all of which would likely lead to job losses and the inevitable mortgage stress that would result.

While the recent increase in household savings (to the very high single digits as a proportion of income) has moderated some of the risk, the balance is still on the downside.

Home ownership for owner-occupiers confers many social and emotional benefits, giving peace of mind to the householder through feelings of security and stability and engendering a sense of permanence and community. For those reasons, owning your own home can be a sound investment.

Safer investing

However, expecting prices to increase over the coming decade may turn out to be a bridge too far. I wouldn't bet against it, but there are much safer – and more rewarding – places for your money that don't have the same downside risk.

In investing, you don't need to swing at every pitch – you can take your time, and only swing when the odds are in your favour. I'm happy to step back from the plate on this one.

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