Why 1.7 Million Landlords Could be Wrong

30 March 2010
By Kris Sayce


Last week I wrote to you explaining how the world had turned topsy-turvy. How - thanks to easy credit and money-creating banks - the idea of working for reward had been replaced with the idea that you can have your reward now, and then work later to pay it off.

At other times we've argued that housing is not a productive item, that it's simply a very expensive consumer item.

Sure, it may be used multiple times but it is still a consumer item. It's just that it's 'consumed' over a very long time frame. The fact is, a house doesn't produce anything, all it does is provide a dwelling and shelter.

Proof of that is in the size of houses. As we've pointed out before, a 50 square house that provides a dwelling for one person isn't more productive than a 15 square house that provides a dwelling for one person.

In fact, it's less productive as it has drawn resources away from other areas of the economy.

But somehow, in the weird and whacky world of the Lifestyle channel, and the equally whacky world of what can only be called 'Lifestyle Channel' Economists, housing has taken on the guise of a productive good.

It has morphed from a consumer item into an item that is now seen as the lifeblood of an economy. Housing has been changed from being considered as a dwelling or as shelter, to becoming the fountain of wealth.

If you believe the 'Lifestyle Channel' economists, housing is the ultimate barometer of the health of any developed nation.

But what we ask is, how can this be true?

The fact is it can't be true and it isn't true. Let me explain in a way that should dispel the myth of productive housing once and for all.

Let's imagine a village of 10 people (a butcher, a baker, a shoemaker, a tailor, a barber, a builder, a doctor, a farmer, a cook, and a carpenter). Each of whom owns their own home. Each home is worth the same - $100.

All of these people earn an income from making and/or selling consumable items or from providing a service to other people.

Now we've set the scene, consider this. The carpenter offers to buy the shoemaker's house for $110.

The shoemaker has just made a $10 gain on his house. How easy was that? What's to stop him from making more money from real estate? In fact, he finds out the carpenter is in the market to buy more houses and is prepared to pay up to $120 for each house.

The shoemaker spots the opportunity to make a quick buck. Knowing this, he offers to buy the butcher's house for $105, which the butcher accepts. The shoemaker then offers to sell the house to the carpenter for $120.

The shoemaker is ecstatic, how easy is this? Cobblers to the cobbling, the shoemaker can make easy money simply buying a house from one person and selling it to someone else.

And it doesn't stop there, on he goes to the tailor and offers to pay him $105 for his house. Then quick as a flash he's off round to the carpenter's to collect the $120 from selling the house to him.

That's another $15 in profits, simply from buying and selling houses. In fact, the shoemaker is so happy with his new venture that he decides to completely pack in the shoemaking game and take up property investing instead.

Anyway, we could carry on with this example forever. But let's finish it there. We'll finish it on a happy note. Everyone seems happy, there is a boom in property prices, and no one has been harmed.

But here's the point. Take a look at the scenario above again. It's a very simplified version of what happens in any property market. If housing is as productive as we are led to believe, exactly where in the example has anything of any value been added to the economy?

To be honest, we can't see it. That's because there's no productivity from buying and selling houses. There's no more productivity in buying and selling houses than there is buying and selling shares.

Look, I'm not saying that everything that happens in an economy must be productive. It'd be a pretty boring life if that was the single driver behind every action. But what I am saying is that if something isn't productive it's pointless - and potentially dangerous - to pretend it is.

The buying and selling of things doesn't necessarily create productivity. Buying and selling shifts capital and goods. It doesn't automatically produce anything.

Making a pair of shoes is productive, or slaughtering animals for meat is productive. The shoemaker selling his house to the carpenter is not productive. It doesn't add anything to the economy that wasn't already there.

Sure, at this stage the buyer and seller of the property are both satisfied. The seller is happy with the price he's received, and the buyer is happy with the price he's paid.

However, as our example shows, the buying and selling of houses has actually had a negative impact on the economy because the shoemaker has packed in shoemaking. The town will now have to import shoes from another town - which isn't necessarily bad, but what can our town export in return? Not houses.

The shoemaker is now gambling on someone being prepared to pay a higher price for houses in the town. If they stop doing that, what happens?

So, not only is housing unproductive but it simultaneously takes resources away from elsewhere in the economy. Rather than the shoemaker investing in leather and shoehorns, he's using all his capital and resources on buying houses and selling them to someone else.

That harms the leather manufacturer and also the shoe buyer as there is no one in the town to take the leather and turn it into shoes.

The lure of making money from houses has taken money and resources away from the manufacturing industry and other industries and instead invested it in housing.

And that's exactly what Australia's banks have caught on to. You can see it in their lending numbers. They've tapped into the idea that property prices always go up and are therefore helping to pump up the property bubble.

They've seen the soaring house prices over the last thirty years and are now determined to keep the market going. As far as they're concerned there's less risk in housing because they know what the attitudes of consumers are towards it.

But make no mistake, contrary to popular belief, that doesn't mean a bubble won't pop.

As the example above shows, the ability to make money from the buying and selling of houses is all based on the willingness of someone else paying a higher price - the Great Fool Theory we believe it's called. Without that the profits disappear.

Look, don't take my word for it, think about it for yourself. Think over the numbers. How does the buying and selling of a house contribute anything to an economy? I'll have something else to say on that in a moment.

But let's leave our fictional town and return to reality. Last Thursday's Australian Financial Review and The Weekend Australian Financial Review laid bare the desperate story behind property investing, and the confirmation of what we've said all along, that property investors invest solely in the belief that house prices always rise.

We were scorned by some investors who claimed that wasn't true, that income generation was a big part of it. Well, let's take a look at some of the numbers...

According to last Thursday's paper, there are 1,705,683 landlords in Australia. That's roughly 7% of the entire population. But here's the amazing thing, of those 1.7 million landlords 69.4% of them are making a loss based on the income received versus outgoing expenses.

That doesn't surprise us. We've pointed out before that rental properties are a money pit. More money goes in than comes out. And with average rental yields in Melbourne under 4%, it doesn't take a Doctorate from the Université Paris Sorbonne to work out that your costs will exceed your income.

The Weekend AFR, lays out the details. Based on the numbers, $22.9 billion of rent is received each year by landlords, yet total outgoings come in at $31.2 billion, creating a loss of $8.3 billion.

Call us mad if you will, but we're yet to find anywhere in our investing textbooks where it says making a loss from your investments is a good idea.

Now, we're assuming that property investors aren't dumb. They must be taking the hit on the income for a reason. And the simple reason is that they believe the price of housing will continue to rise, and that the rise in the price of the property will more than offset the loss from the income.

Therefore reader, it's unarguable that the primary reason that property investors invest in property is for capital gains rather than income. There's no denying it. In which case, prices have to keep increasing in order for the investors to make any money.

And there's the problem. As we know from every other asset class in Australia and around the world, it's just not possible for the price of an asset to continually rise without a major correction.

Take it from me, whatever excuses the property spruikers come up with, the Australian property market isn't immune from this outcome.

As you can see from our make-believe economy, resources have been skewed towards one area, the buying and selling of houses. All other industries are potentially suffering as no one wants to invest in those industries.

As we say, it's exactly what the Australian banks are doing, investing in houses and mortgages at the expense of other productive sectors of the economy.

But I wanted to mention one other thing. Referring back to the risk/reward attitude, housing is a perfect example of the cart being put before the horse. If you're like me, and you see housing as a consumer item then it makes sense you only buy the consumer item as a reward for your productivity.

It's should be the same with housing.

However, thanks to leverage and the ingrained impression that house prices always go up, housing has changed from being a 'reward' for productivity to being treated as the source of productivity - it is of course, nothing of the sort.

It's not helped by all the ridiculous stories about buying a home being the "Australian dream", and "rent money is dead money", etc...

But this attitude explains why housing is now seen as a leading indicator. How many times over the past year or so have you heard economists looking for positive signs from housing? Almost every month from what we can recall.

There's a simple reason for that. And it's exactly what happens with every asset bubble. Buyers overestimate future price rises and scramble to get in early. You saw it with the dot-com boom, and you're seeing it with the housing boom - "buy now before it's too late."

The overestimation leads to anticipatory buying. Only, not everyone can afford to pay up in advance to get onboard so they have to borrow in order to get a piece of the action. This pushes prices up further and necessitates further borrowing.

Again, does that sound familiar?

In reality and absent price and market manipulation, housing should lag the economy not lead it. Housing is the reward paid for by the productivity of the economy, it's not the driver of the economy itself.

The idea that the housing market can lead an economy out of recession, or to grow the economy is false. Housing is a consumable item. When it is bought or built it is consumed at that point. It provides no further benefit to the economy.

To claim it does is false.

If anything, a positive housing market indicates one of two things. Either people are rewarding themselves for their past productivity, or they are anticipating future productivity and price rises by buying houses now.

The trouble is, if the economy is skewed towards the buying and selling of houses, guess what? There won't be the necessary future productivity to pay off today's anticipatory buying of houses.

With all the credit and investment going into the housing market today, you have to wonder about the future state of the lopsided Australian economy. The simple fact is, buying houses today in the hope that others will pay a higher price for them in the future, isn't the recipe for a sustainable and healthy economy.

Rather, it's the recipe for a boom that is set to bust.

Cheers,
Kris.