An analysis and assessment of investor rationality
Much has been written about Australian housing, whether or not it is in a valuation “bubble” or rather been driven by “fundamentals” of supply and demand. At the core of both sides of the argument is supposedly some form of valuation. It is clear that the current debate centre’s around various quasi-valuation metrics and measures such as a variety of consumer affordability concepts, house price/ disposable income ratios, or various debt service ratios, either compared to history or compared against other countries. Bubble-talk is implicitly linked to the idea of investors making irrational or illogical assumptions of future cash flows, however this does not appear to be analyzed within the mainstream discussion.
However, particularly from a property investor’s perspective, basic finance theory provides far superior tools to value assets - primarily the Discounted Cash Flow (“DCF”) model. The key missing piece from the current debate appears to be any reference back to first principle valuation tools, something explored in this article.
Utilizing a fairly basic DCF framework, we can shed understanding on the level of irrationality in housing investor forecast assumptions. Our analysis indicates that while current investors require somewhat optimistic growth assumptions to derive reasonable returns from investing in housing, these assumptions are not completely irrational. This may simply imply that the “bubble” has not yet reached critical stages and may continue.
Valuation and Pricing of Housing: “consumer good” or “asset”
Housing is a relatively unique asset class, in that it is really both a durable consumer good and a cash-flow producing financial asset. With the Australian housing market consisting of roughly 2/3 owner-occupiers/ consumers and 1/3 investors, there are two relevant assessments of value – the value as a consumer good and the value as a pure investment.
On the consumer good side, valuation and pricing of consumer goods is driven factors such as income elasticity’s, preferences, supply/ demand drivers, availability of substitutes, affordability & access to credit and so forth. Important to the consumer good side of the property market is a variety of non-financial influences - such as the perceived importance of home ownership in the community, the intangible feelings of safety of one’s own home. We do note that a large proportion of owner-occupiers do consider the investment value and options in their purchasing decision. The Analyst expects to be writing more on these topics going forward.
For the pure investment side of the property market, the valuation of any cash-flow producing asset, including housing, should be based on first principle ideas of assessing the stream of futures cash flows and discounting back into today’s money.
The Primary Components of a DCF forecast model for Australia Housing
Initial Cash Flows
- Initial Purchase Price
- Stamp Duties (state based transaction taxes)
- Government incentives/ purchase subsidies (eg First Home Owners Grant)
- Financing mix (debt/ equity combination).
There is no significant complexity in any of these factors.
Ongoing Cash Flows
- Rental income (with appropriate adjustments for assumed occasional vacancies/ search costs for new tenants)
- Inflation/ increases in rental income over time.
- Maintenance costs/ depreciation, body corporate fees, real estate agent fees, land taxes & local council rates.
- Interest and principal payments on debt.
- Tax payable or receivable including negative gearing effects.
The two key assumptions that have the potential to be volatile or “at-risk” are the change in rental income over time and any change interest rates, noting that in Australia most housing debt is “variable interest”.
Realistic assumptions for the change in rental income should be based roughly on CPI, noting that long run (100+ yrs) evidence shows that rents rarely increase by more than inflation for more than a short period, and inherently cannot increase by more than inflation for sustained periods due to the fact that rents are a major factor within the CPI calculation. In Australia, that implies a forecasting assumption of 2-3% inflation increase per annum, in line with RBA inflation benchmarks.
Interest rates can be relatively volatile, noting that in the last 3 years variable interest rates on mortgages have ranged between ~4.5% up to nearly 10%, as the benchmark rate has moved and the global financial crisis impacted banks borrow costs. In terms of modeling this volatility, there are several complex methods, however a basic and fair method is to use current interest rates for a short initial period (say 1 or 2 years), then have a “mean reversion” assumption that interest rates will ultimately balance out at long run averages over the life of the investment - in Australia that number is around ~7.5%.
Importantly, there is also a logic relationship between rental inflation and interest rates - simplified, if one assumes Australia is going to have higher than normal inflation in the forecast period (say, 5-6% instead of long run ~3% average), then inevitably the Reserve Bank will increase interest rates to attempt to cool off the inflation. A forecast model should reflect this logic relationship (eg a model assuming high inflation + low interest rates will, all else equal, indicate a higher return to the investment, however this model is logically inconsistent and unlikely to reflect how the real world will play out over time).
Terminal Cash Flows
- Capital value/ sale price at “maturity”
- Capital gains taxes
- Real estate agent fees
The most difficult forecast component is what the estimated future capital value/ terminal value of the house is going to be. This is the key assumption and sensitivity on the entire investment decision.
Evidence and personal experiences of discussing this issue with investors, developers (include very senior executives at major property developer companies), financial planners and real estate agents suggests that the primary assumption made for this key sensitivity is usually a very basic “x% per annum increase in house price”, often based on some sort of near term trend extrapolation.
There are several logic problems with this approach. Firstly, it can internal justify paying almost any price upfront. Secondly, if we assume 10% per annum house price increase, but personal incomes and/ or rental incomes are only going up by 3-4% (in line with long run averages), then implicitly we are assuming that over the life of investment the rental yield will be decreasing or price-to-income ratios will be increasing. While Australia has had several historical periods where this has been the case, there is a point of logical exhaustion to this process (as has been discussed by many other bearish commentators).
An alternative view for determining a terminal capital value is to assess what the future buyer will be willing to pay. A future buyer may be either a owner-occupier, in which case analysis of growth in wages and debt capacity is appropriate, whereas if the next buyer is going to be a “2nd round” investor, the same style analysis used here should be repeated at that point in time and discounted back. Given the price is, theoretically, set by the marginal buyer, analysis of both should be conducted with the highest outcome used.
In either case, as discussed above, the future value of the property is the most important factor in the investment decision, with the investment outcome (i.e return on investment) highly sensitive to this factor. Given the difficulty in determining this, the suggested method is to conduct “scenario analysis” utilizing a range of outcomes with logic cross-check against other key variables and from that scenario analysis determine what the “break even” outcomes are needed to achieve an acceptable return on investment.
Cost of Capital and Internal Rate of Return
A DCF model requires analysis around the cost of capital which is used as the discounting rate/ factor. The cost of capital is related to the financing mix, but for our purposes, we are going to simply focus on the cost of equity only. The cost of equity can alternatively be called the “required return on investment” or “expected return on investment”.
In assessing the appropriate cost-of-equity, investors should be looking at the after-tax expected return on investment. Under current taxation arrangements, including negative gearing and capital gains tax discounts, housing offers significant tax advantages relative to many other investments.
Overall, for our purposes, we are going to assume as a basic starting benchmark that a rational property investor should be seeking in the region of 8% per annum after tax returns on equity invested. This number is somewhat arbitrary, and open to debate, but gives us a rational starting reference point. We do realize that many investor/ speculators are expecting far higher returns than this. Note for comparison, a term deposit in Australia will generate about 3.5%p.a after tax for those in the highest tax bracket. Again, for simple comparison, investing the in stock market may achieve significantly higher returns than this, however may also be more volatile.
Related to the DCF model is the internal rate of return (IRR). The IRR model is used in the exact same way as a DCF model, with the only real differences highlighted below:
Target return on investment
Initial asset value/ price
Asset value/ price
Target return on investment
All other forecast assumptions or outputs are unchanged.
While the DCF model should tell an investor what the maximum price they can pay for an investment to achieve the target return, the IRR model assumes that the price in the market is currently set, and will show the investor what the expected return on investment will be.
Integration, Outcomes and Sensitivities
Incorporating some basic assumptions, and utilizing a model of “assumed capital growth of X% per annum” (despite the flaws of that model as discussed above), we get:
Model 1 - Initial estimate
Model 1 indicates that that over a 10 year investment forecast horizon, assuming stable tax regime and inflation-like rental and capital growth of 3% p.a, and 85% debt financing, and initial rental yields of 4.8%. To achieve a rational 8% after-tax return on equity, the investor can pay up to $515k.
While the initial rental yield of 4.8% is arguably somewhat high for many suburbs in Australia, it is still achievable in many other areas. In addition, this forecast model implies that the house-price-to-wage ratio will probably be in decline over this period (i.e long run capital growth of 3% vs long run wage growth of ~4% implies wages growing faster than house price, meaning the price-to-wage ratio must be in decline).
Model 2 – Assuming slightly more aggressive rental inflation and capital gains
A more optimistic investor that forecasts rental and capital growth of 3.75% would be rational in paying up to $633k for this property (or analogously, have an initial rental yield of 3.9%). While these assumptions are on the high side of historical experience and slightly above RBA inflation targets, it is hard to argue an investor making such assumptions is being completely irrational (a key indicator in determining the existence of a bubble).
Keeping the same higher inflation assumptions, but adjusting the required return on investment to only 7% p.a after tax (noting again term deposit returns of only 3.5% after tax), the rational investor would be prepared to pay up to $705k.
Model 3 – price-to-wage ratio reverts-to-mean
This model assumes that price-to-wage ratio starts at 6x and reverts back to 4.5x over the life of the investment with wages growing at an assumed 4.5% per annum. We recognize there is much debate as to what the current price-to-wage figure, with some arguing that it is currently much lower than the 6x used here.
Under this reversion-to-mean scenario, annual capital gains reduce to ~2% per annum, which means that majority of the return has to come from rent yields. To achieve the rational 8% target, the investor can only pay $350k for this house which in currently generating $600 per week rent. Note, there is also an unrealistic assumption hidden here – at $600 per week rent is $31200 per annum rent – if wages at only 58k after tax (1/6 of house price), then residents in this area would be paying 60% of wages into rent – ABS stats evidence shows this is not the norm.
Based on current house prices far higher than this, this model is obviously not being used as a “base case” for the marginal buyer/ investor, however, highlights the a risk. Alternatively, if we assume house price of $515k with 2% per annum capital growth (keeping all else equal), then the return on investment drops to a measly 4.6%.
Note on all models: We, somewhat unrealistically, assume the 14k first home buyers grant is captured by the investor market. Practically everyone knows of specific circumstances where the FHBG has been “gamed” by investors living temporarily in the property or other similar scenarios. In any case, as we are assuming that the FHBG does not count as bankable equity (noting, for example, that other commentators such as Steven Keen generally do count FHBG as equity, either implicitly or explicitly), under our framework the impact is a simply 1:1 reduction in the price – and therefore somewhat immaterial.
Below we use our model to determine sensitivities of house price to multiple changes in only 1 forecast variable. We use “Model 2” as the initial base case forecast.
Sensitivity Analysis 1: Impact of change in After Tax Target Return on Investment
Key Assumptions: 600 per week rent, 3% rental inflation, 3% capital gains expectation.
Note: The sensitivity can be read both ways – for example, a price of 557k implies an investment return of 7.0%, or alternatively, an investor seeking a 7.0% return could pay up to 557k.
Sensitivity Analysis 2: What capital gain is required to generate returns, based on changes in initial rent yields (“breakeven capital gain”)
Key Assumptions: 550k house price, 8% target after-tax investment return
Note: While this analysis may appear simplistic, the primary factor one must consider here is the impact of negative gearing – achieving a higher upfront yield reduces the benefits from negative gearing substantially.
Sensitivity Analysis 3: Impact on changing debt-to-equity ratios (for example, a “credit-crunch”).
As would be expected, should the market experience credit contraction (such as the USA situation), and the banks are only willing to lend substantially lower amounts, house prices would have to correct significantly for investors to be able to achieve reasonable returns. Note, this analysis is somewhat akin to Steven Keens analysis, albeit from an investors valuation perspective rather than an owner-occupiers maximum affordability perspective.
Note: This article has not discussed sensitivities around changes in the current tax regime. The Analyst expects to write more on this topic in the near future.
Analysis and Thoughts – Bubbles and Irrationality or just a different opinion?
So, is Australian housing in a “bubble”, based on analysis of valuation under a first principles DCF framework? Talk of a “bubble” generally implies unrealistic expectations about future investment returns driving “irrational” valuations – with the commentary such as “investors are expecting unrealistic future house price capital gains”. However, under a DCF valuation framework, housing investors can expect reasonable returns on investment based on reasonable assumptions of capital gains in line with inflation/ wage growth only, and possibly even at slower-than-inflation growth rates.
Conversely, the analysis also implies that the price-to-wages ratio doesn’t need to go up further to generate reasonable returns, and in fact over time can even decline somewhat (assuming wage growth > inflation growth) and investors would still achieve ok, albeit not spectacular, returns. This would support one of the bull’s arguments that the price-to-wage adjustment over the last 10-15yrs is reflective of structural factors, such as the tax regime and changes in debt markets, and thus, the bulls argue, has low risk of reversing back to historical (much lower) norms.
Overall, this would suggest that while Australian housing is obviously expensive, investors buying housing at the moment can make reasonable forecast assumptions and expect reasonable after tax returns on investments – thereby implying that they are not being completely irrational. It may simply imply that the “bubble” may not have reached peak stages yet!
We recognize that other authors, such as Steven Keen, tend to focus models for Australian housing around total affordability and the impact of debt, and use assumptions such as leverage effects of the first home buyers grant. We recognize these models as useful also, with the DCF model used above to be used in complementing those models.
This topic inevitable creates heated debate, and obviously the analysis here is based on a very basic model that may not be reflective of any particular situation – we know personally that there are many specific situations of very-hard-to-justify house prices in Australia, even using aggressive forecast parameters, while conversely there may still be examples of cheap investments out there.
And, of course there are other factors to valuation of housing than just pure discounted cash flows, such as optionality to develop/ renovate/ add value to the property, acting as a hedge for unexpected inflation and/or value-in-use of living in it.
In conclusion, making a rational investment in property requires detailed analysis around a range of key assumptions, with the ultimate return on investment highly sensitive to a several key assumptions. The objective of this discussion was to provide an analysis of property valuations in the context of these assumptions from a first principles perspective, something every property investor should conduct prior to making a serious, rational investment.
Please feel free to contact the author for a copy of the model used in this essay.
Michael is a experienced professional in Australia's finance circles. Michael has recently accepted a new role with one of Australia's Big 4 banks as a Director of corporate finance for institutional customers, after having previously worked as a senior Portfolio Manager for a Australian based hedge fund (trading arbitrage, mean-reversion and event-risk strategies), and as a Director in corporate finance at another Big 4 bank where he has executed over $10b of deals.
Personal Bias: Most of the debate around housing valuation and bubble-talk appears to be biased heavily towards personal incentives. As such, an upfront declaration should be mandatory. This author is currently renting, in the belief that Australia housing is seriously overvalued, primarily due to Australian house-to-earnings ratios being at the upper end of developed world levels.
The views contained herein are those of the author alone and do not represent the views of any other organisation