Australian property good investment? Part 3?prospects of capital appreciation

April 29th, 2007

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For today?s article, we will continue from our previous 2 articles: Australian property good investment??Part 1: how money printing distort the property market and Australian property good investment? Part 2?Rental & affordability crisis.

These days, we often get to hear about the looming social crisis caused by housing un-affordability and rental crisis. From the news media, we get to see articles like Is the great Australian dream out of reach? and Rents continue to rise, but no relief is in sight. These issues are most likely going to be hot topics in this election year, with politicians and special interest groups arguing, blaming each other and giving their own versions of the causes and solutions to this problem. Make no mistake about this: the root of all these issues are caused by monetary inflation (see How to secretly rob the people with monetary inflation?), which will eventually spill over to price inflation in due time.

No doubt, there are some people who are thinking of ?investing? into property. Is that a good investment decision? Of course, for truly sophisticated property investors with the knowledge, skill and experience, it is possible to profit regardless of the timing and state of the property market. But for the purpose of today?s article, we will talk about property ?investments? from the context of the mum and dads investors.

First, how do property ?investors? profit from their property ?investments?? There are two perceived sources of profit?capital appreciation (i.e. buy low, sell high or buy high, sell higher) and net rental income. Today, we will examine the former.

What drives capital appreciation of property? Traditionally, it is the rising income levels that drive property prices upwards over the years. Naturally, as people?s general income level increases, the prices paid for property will increase as well. Recently, we have another phenomena that drive property prices upwards?the sudden availability of easy credit and low interest rates, which are manifestations of monetary inflation (?printing? of money). The result is a short-term property price bubble, which is currently deflating slowly. Japan, on the other hand, had their property price bubble burst, which led to a long painful recession and continuous deflation of property prices for around 17 years.

In Australia?s case, what are the prospects of capital appreciation? As we said before in Australian property good investment? Part 2?Rental & affordability crisis:

Eventually, the ever increasing amount of debt required to finance a price bubble will result in a debt burden so heavy that no more additional borrowings can be made. As such, the price inflation will sooner or later be halted.

The current housing affordability and rental crisis is a sign that at the current level of income, the strain of debt burden is too heavy to support higher property prices. Until income levels catch up with current property price levels, we will not see income as a driver for property prices. How likely is income going to fulfil this role? Remember, we are currently at the turning point of the business cycle (see Where are we in the business cycle?). Any accelerating economic ?growth? will lead to price inflation (see Pitfalls for businesses in ?accelerating? economy). Given that the Reserve Bank of Australia (RBA)?s mandate is to control price inflation, it will step in to raise interest rates the moment it sees threats of price inflation in the horizon. A rise in income levels without the accompanying real economic growth is highly inflationary in nature.

If current income levels cannot drive property prices upward, then this leaves the availability of credit as the next candidate. In other worse, why not loosen credit standards so that more people can borrow more money? Indeed, this is what happened in the US and the results are ugly (see How did the US sub-prime lenders get into trouble?). Well, if the Australian economy becomes a runaway credit machine running, we can be sure the RBA will be very keen to force feed more bitter medicines into the economy. But what happens if credit standards get tightened instead? When that happens, less people can borrow less money, which means it is harder for property prices to rise further. Anecdotally, our personal experience tells us that credit standards seem to be tightening across all board.

The next thing to consider is price inflation. Suppose headline price inflation is swelling in the absence of wage increases. This means that the debt repayment burden is going to rise, which means that the affordability of property is going to fall. Furthermore, with rising expected price inflation, people are going to perceive that their housing stress is going to increase. At the same time, the RBA may be pressured to raise interest rates (see Price inflation expectation will pressure RBA to raise interest rates). Either way, price inflation is a threat against property prices rising.

Next, there is always the threat of debt-driven asset price deflation caused by an external economic shock. See Can Australia?s deflating property bubble deflate even further?.

Thus, for those who are hoping profit from their property ?investment? via capital appreciation, be prepared to be disappointed.