We need to act now to keep the great Australian dream out of nightmare territory.

THERE is a widely held belief that Australian residential property cannot fall in value. While those bankrupted in the property crash of the late 1980s may not hold this belief, the rise upon rise of residential property value in Australia has left many economists scratching their heads.

It is hard to find any arguments to suggest that Australian residential property is not grossly overvalued. Rental yields are still at historic lows; the price of property, compared with income levels, is higher than any other place in the world. Eventually we will reach a point when people simply cannot afford mortgage repayments, especially if the economy weakens or interest rates rise.

The dream of owning property is unique to our shores; most of the world's population is comfortable renting. As interest rates fell in Australia, more people could afford to pay more for a property, and did so.

The long boom in Australia's economy has resulted in more people feeling secure in their employment and therefore, comfortable taking on larger debts. This was further fuelled by a deregulated banking system that made it much easier for the average Australian to acquire a mortgage.

If the market is overvalued, when will it stop? Unfortunately the answer to this can be scary. Bubbles in a sector of the economy can build over time and the longer they build, the greater the pain when they burst. If we see an increase in interest rates, many people will be forced to sell. However, most Australians would give up food and clothing to pay their mortgage.

The real hit will come if we have an economic downturn. If people lose their jobs they will not be able to pay the interest. Home owners will be forced to sell, property will decline in value, people will not have the confidence to take on loans and the banks will not be lending, so the buyers will dry up. If this is matched by a period of increased development and supply, this could be devastating.

Those who have built up property portfolios by gearing up on each property and buying another can see everything they have built wiped out in one hit if the banks foreclose on them.

The most commonly quoted price monitor for property prices is the median sale price. At times it can be way off market price levels.

Median pricing does not take into account improvement done to a property. If you buy a house for $500,000 and then spend $200,000 fixing it up and sell it for $750,000 there is a 50% increase in the sale price but a profit of only 7%.

It does not include properties that do not sell. I have been to auctions lately when no one bids and there is no interest at the vendor's minimum asking price. As most people do not sell in such a situation, it does not show in the median price figures. In reality, they may need to drop the price by 20% to sell, but this will not show up. Only the properties that have a few interested parties sell, and as a result the figures may only represent the cream of the crop.

Unlike shares, the vast majority of properties are not bought or sold on any given day. The median price can be unrepresentative as it only includes a small fraction of the properties owned.

To see a true picture of prices, we would need to see vendors that must sell at any price. This is usually reserved for defaults, where banks want to sell to get their money back.

I would caution anyone looking at the affordability of a home purchase to assume interest rates will be 3% or so more than current rates. We are often talking a 30-year mortgage, so is the current interest rate that relevant in determining if you can afford the loan?

If you have never been able to save for a deposit, why would you expect to be able to fund the interest? Interest rates are much higher than rental yields, which means that you will pay much more in interest on any given property than you would in rent. People don't like to think that they are paying money to a landlord, but the reality is they are paying much more to the bank. This will work out well for you if the overall property market is booming, but if it is static or even declining you would be much better off renting and saving the excess for a deposit in the future.

Putting too much of our hard-earned funds into property has negative economic implications for the country. These funds could be spent on building infrastructure or new businesses and industries that will create jobs, exports and long-term wealth for the country.

Bubbles and busts have very negative impacts on the economy. They put resources in the wrong areas. In addition, when the party comes to an end, panic can set in, with negative economic and social consequences.

Don't get me wrong. Property can be a wonderful investment, and a sound property investment strategy has been one of the best ways to build wealth over time. But when something goes up too fast, later it must fall, or grow at a sub-par rate.

Many of you will remember the 500/500 rule. This was the standard not that long ago. It referred to $500 a week equating to a property value of $500,000, or $26,000 rent a year on a $500,000 property. Now a property would need to be worth about $800,000 to generate $26,000 rent. Something simply does not stack up.

Government policies seem to show a lack of understanding of the fundamentals of economics. First home owners grants and the proposal to allow superannuation bank-style savings accounts to be used for home purchases add to demand and do nothing to solve the affordability crisis. They have the potential to push the bubble further.

What Australia needs is an increase in the supply of housing. If we have more people and no increase in places to live, there is upward pressure on prices. This increase will have to come from the release of more land, and greater high-density living. While we often see Australia as a small country, we are one of the most urbanised in the world. Not many cities of the size of Melbourne and Sydney are predominantly made up of multiple-bedroom homes with big back yards.

If we see an increase in supply followed by a long period without any price increases (at least five years), this will allow time for incomes to grow and rents to increase, so that prices are a lower proportion of incomes. This is how the affordability crisis can be solved, and it won't happen overnight (without a collapse in prices). It would be preferable for all concerned to see a slow deflation of the bubble, rather than a pop.

So next time you are sitting around the barbecue with your friends, pass this on. It is much more important for our future than any Buy Australia campaign.

http://business.theage.com.au/way-to-ease-the-housing-bubble/20080430-29u4.html?page=3

The AGE April 30th 2008