Opinion & Analysis
OPINION: The Economist newspaper's quarterly survey of global house prices has revealed house prices were starting to rise again in many countries, which was regarded as positive for some places as they struggled to move out of recession.
For the survey, The Economist measured whether houses were overvalued or undervalued in each country relative to the long-term average.
New Zealand featured in The Economist's list and it was probably no surprise to most of us that our houses were overvalued by both of the methods of measurement The Economist used.
In fact, by one of the measures, New Zealand houses were 71 per cent overvalued while the second measure showed they were 26 per cent overvalued.
With these sorts of figures you could certainly see why the Reserve Bank was concerned, and why it has restricted high loan-to-value lending.
So, how does The Economist measure whether a country's houses are undervalued or overvalued? After all, The Economist is a highly respected publication and their methodology must be of interest.
The first of the two measures that The Economist uses is a simple one - it compares incomes with house prices. If house prices move up in value but disposable incomes stayed much the same, house prices became more highly valued. However, if incomes rose at a faster rate than house prices, house prices were of lower value. By this measure, New Zealand was 26 per cent overvalued.
The second measure compared rents to house prices. I think this measure was more important because all investments should primarily be valued for the income that could be derived from them - this was true whether we were considering businesses, shares, bonds or property.
The principle of this measure was that people purchased a house for the rents that were earned (in the case of property investors) or the rental costs that were saved (in the case of owner occupiers).
Clearly there were other benefits of owning a house, but from a financial point of view, a couple who was looking to buy a house had a choice: they could carry on paying rent or they could substitute rent by home ownership.
For this couple, the amount that they were saving in rent and the amount that they would have to pay for the house were important numbers and the relationship between the two was critical - and it was that relationship which The Economist measured.
This was no different from the analysis that investors constantly made - if they paid a certain price for an asset (be it shares, bonds or a property) they wanted to know that the income they would receive was enough. In the case of a potential home owner they needed to consider if the rent that was being saved was sufficient to justify purchase.
Therefore the relationship between rents and house prices was critical. If you were buying a business you would certainly look at the projected profits of the business and compare that to the price you would have to pay; if you were buying a bond you would look at the amount of interest that you would receive compared to the price that you pay for the bond. If you were buying a house you look at the rent that you would receive (investors) or the rent that you no longer have to pay (occupiers) compared to the house's price.
Unfortunately, for each of these different assets in which you might invest, the language was different. For a business we usually use something called a price/earnings ratio; for bonds we look at yield. However, although the language was different they were all doing the same thing: comparing the price that they paid to the income they would receive (or, in the case of owner occupier house, the costs they would save).
Of course this does not take into account capital gain - and one of the reasons people owned houses was to hedge against major increases in house prices. However, investment analysis looked first at income compared to price before any estimate of capital gain. True investors were looking for income (or cost substitution) and they hoped that the investment was a valid one from income alone.
In New Zealand, house prices have risen (in some places a great deal) while rents have moved little. This means that the rent to house price comparison was well out of line with its long run average - 71 per cent out of line according to The Economist's figures.
Martin Hawes is an Authorised Financial Adviser and a disclosure statement is available on request and free of charge, or can be found at www.martinhawes.com. This article is of a general nature and is not personalised financial advice.
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