Australia, meet Dubai

The property market is Dubai is crashing and burning as we speak.  It was inevitable of course, but never underestimate the perseverance of a property boom.

On that note I want to talk about the future here in Australia.  In 2010 and beyond I foresee the following sequence of events.

1. Rate hikes of another 0.5%
2. Property prices will flatten and fall in some areas
3. The government will run out of ways to keep housing demand propped up – we had more cash injections and foreign buyers (although as yet I can’t imagine what else may be dreamt up).
4.  Inflation will be a major concern again – the USD will recover and the fuel price here will head up.
5.  September 2010 will lead to another correction on the share market, taking the ASX200 down below 4000 again.
6.  But then a strong rebound in November up to 4400
7.  House price will stabilise at 10% below their peak (in nominal terms) but real growth in house prices will not occur until 2015.
8.  A Current Affair and Today Tonight will has specials about house prices crashing in certain areas and people being forced out of their homes by mortgagees.
9.  Even while this is happening, people will continue to shout and scream about a housing shortage and argue for reduced taxes on developers (even though we have the world's biggest houses)
10.  The 2011 census data will show that demolition rates were less than expected and that the total number of dwellings in Australia is higher than expected (the remarks by the RBA’s Ric Battellino seemed a bit pushy on the supply constraint issue).

It’s not a catastrophic forecast, but it seems reasonable to me. Anything I've missed?

Why all this property market discussion from an ‘environmentalist’?

I’ve been thinking of changing the title of this blog - mostly because the term environmentalist is associate with fairly extreme views on the protection of ‘natural’ environments and other species, and partly because I also have a keen interest in the property market.

But in my mind, understanding property is the key to a reasoned approach to preserving our quality of life by preserving environmental amenity. Maybe I am more of a ‘quality of life’ economist who believes there are many non-market goods, including the quality of, and accessibility of natural environments, that are major contributors to our well-being.

However the increasing fanaticism I have observed in some areas of the climate change movement, the lack of ability for some environmentalists to see the forest for the trees (pun intended), has lead me to distance myself from some of the core environmentalist views.

Take the topic of the moment, climate change. Why don’t we hear about

- Any potential benefits of climate change
- The statistical reality behind some of the conclusions
- Other important environmental issues that are cheap to address and provide immediate direct benefits

I feel like climate change is crowding out other local environmental concerns that will immediately contribute to quality of life of Australians.

In my mind, a quality combination of land use and environmental controls in our cities and towns can contribute far more to the well-being of society than other popular environmental issues.

So what then of the blog title? Any ideas? Or does the economist part imply a rational approach?

Is road congestion the best allocation mechanism?

Congestion is the darling of politics and the media, and a topic of many conversations around the barbeque. But what is it? Is it a bad thing? Do we want more of it or less of it?

I define congestion as a condition of a network (of roads or other conduits) whereby the existence of extra users slows the rate of progress of all other vehicles. Given this definition, there can be a little congestion, where progress of road users is slowed a little, or plenty of congestion, where progress is greatly slowed.

The basic assumptions required for this brief analysis are that travel on the road network consists of a number of costs including vehicle capital and maintenance, fuel, and time, and that congestion affects road users by adding to the time cost of road transport.

However, given that people still choose to drive during times of peak congestion, and assuming that congestion is known in advance, we must assume that each traveller still receives a net benefit from their trip.

We end up with a situation where congestion results in the allocation of road space to users with a higher value of use, and a road system that still provides net benefits to each road user.

So where do the figures about costs of congestion originate?

The other way to look at congestion is that each extra individual who uses the road network incurs a cost to all other users in terms of increasing their travel time. Thus, there is an incentive for people to ‘overuse’ roads, as they receive all their benefits, without incurring all of their costs.

Thus if we have 100 road users and their trip time is 20 minutes (before noticeable congestion begins), and each extra road user after this amount increases everyone’s travel time by say, 1 minute (obviously the relationship is non-linear), then we can estimate the cost of congestion as follows:

With 5 hours per day where 120 users are on the road, we can estimate the cost as 5 hours of the value of time to 120 people, minus the benefit of undertaking the trip to 20 road uses.

The main shortcoming of this traditional approach is that it is assumed the costs borne by other road users are unavoidable, and thus it fails incorporate the benefits accrued by road users even when congestion occurs.

This is where my (I think) realistic assumption of prior knowledge of congestion is important. All 120 road users will know before embarking that their trip will take 40mins instead of 20mins. Other road users are prepared to ‘pay’ the extra time cost of travel, thus we still have a net benefit to society from congested roads.

Congestion charges essentially aim to replace the increased time cost with a hip pocket cost, to keep some users off the road. However, since the time cost of different individuals is greatly different, a congestion charge will benefit the wealthier road users and hinder those who place a lower value on their time.

Alternatively, congestion could be reduced by offering more/better alternative modes of transport, to attract marginal road users to trains, buses, cycling and such transport alternatives.

In my mind, congestion is an extremely functional and efficient mechanism for allocating our finite road space.  I have no problems with introducing a congestion tax, as long as it is complemented with signficant investment in alternative modes of transport.

Real Estate Review

My colleague is looking for a real estate agent to manage her house after downsizing to an apartment, choosing to keep the house as an investment.

She is facing a conundrum I have faced before. How does one go about comparing the performance of property managers before committing to a management contract?

Can the market for property management services be competitive without reasonable access to information?

I have written before about the lack competitiveness amongst real estate sales agents. A similar trend can be observed in the property management area of the business. I have never heard a property manager claim they can provide better services for a lower price. They all appear to have set a fee around 8.5% of the rental price, with $5.50 ($5 plus GST). Some divide their fee as 5% management, 3.5% rent collection, but in the end, I get the feeling there is some serious collusion, whether intentional or not.

One major piece of evidence for the lack of price competition is the fact that management fees have not declined in a period where rent increases have dramatically outpaced the costs of doing business. Surely in a competitive market one property management agency in an area would reduce their fee to 6% and attract a much larger market share (assuming they all provide the same level of service). This doesn’t happen.

Assuming there is no price competition, is there at least some competition for providing value – same price, better service. Well actually no. And the reason is that the quality of service cannot be measured, nor can reasonable impressions be gathered prior to entering into a management contract. How do I know if the property manager has any knowledge of common maintenance issues? How do I know if they have good relationships with tradesmen, and that repairs are undertaken promptly and at a reasonable price? How do I know how they treat tenant complaints and requests?

To summarise,

1. There is no accessible objective information about the quality of the service provided.

2. It is time consuming to change agents, and you risk getting one equally poor or perhaps even worse (as you don’t know whether they are good either).

3. Landlords generally get very little feedback from the tenants as to how the agent is performing from their perspective.

4. There are barriers to entry. To start an agency you need a rental role, to have something to offer to tenants. Starting from scratch and attracting landlords to shift to your agency may be quite risky.

Given I believe property management agents are not acting competitively, and therefore we are all losing out, I should really offer some suggestions to improve the situation.

My first and only suggestion is some kind of survey system administered by the State, local government or even the State industry association (such as the REIQ) that gets all landlords and tenants to rank the performance of the agent in a number of areas each year. It might consume about 1 minute of time for each landlord and each tenant annually and could be compulsory is agents want to be REIQ members.

The results of this survey can be published against the property manager’s schedule of fees on a simple website – the Real Estate Review. I would think this might spur one some better performance in this industry.

Any other ideas?

Are Chinese buyers affecting house prices?

Respected economist Alan Wood notes here why he believes small increases in foreign investment in the Australian real estate market will not have a tangible impact on home prices.

While it is nice to have a little calm to a situation that is sure to encourage exaggerated media spin, I’m not sure whether Wood’s claim holds - that because Chinese investors are a small percentage of buyers there will be little to no impact on prices. If we make one assumption, that Chinese buyers are willing to pay more than local and other foreign buyers, then his claim completely breaks down.

The following stories might help explain why.

Imagine an auction. In the scenario without the Chinese buyer it will sell for $500,000, which is $1,000 more than the second bidder was willing to pay, but is actually $10,000 less than the winning bidder would have paid had they needed to.

Now in the same scenario add a single Chinese buyer also willing to pay $510,000. They will bid up the price to $510,000 against the winner in the previous scenario. There is a chance they will buy it, but also a chance the winner from the previous scenario will buy with a token small bid.

So we can clearly demonstrate that 1) a single buyer entering a market willing to pay more than other potential buyers can drive up prices, and 2) these new buyers do not necessarily have to buy, simply 'bid up the market' to have an impact.

How about another scenario?

Imagine you have a train ready to leave the station. There are one hundred queues (one at each door). Each person must pay the market rate for a ticket which has been established over time to be $5. If they aren't willing to pay the market price, there are plenty of other people willing to pay the market price to take their place.

Now one of those queues (1% of the market - the Chinese buyers perhaps, maybe the first home buyers) decides they are willing to pay $6 so that their queue will move faster and they will get more seats on the train. Now, the market price moves to $6, and any other person from any other queue will have to pay $6 to get on, or let the train fill people from the Chinese/FHB queue. Some people from the remaining Aussie queues pull out, but there are still plenty who are willing to pay the $6 for their spot on the train. Indeed some even believe if they pay $6, they might be able to scalp their ticket for $7 a bit later if the price goes up again.

I believe there is no theoretical basis for the assertion that because buyers willing to pay more are small % of the market they do not impact prices.

Of course, this all rests on the assertion that the small number of Chinese buyers are in fact willing to pay more than other buyers.

Some empirical support for land economics

There has been a paper recently published by Andrew Leigh, Economics Professor at ANU, which empirically estimates the impact of stamp duties on the housing market.  I found out about this paper through Chris Joye’s blog at Business Spectator, although I regularly read the Core Economics blog, where it was also linked with some added thoughts from Andrew.  I mention this only because I have now been involved with discussions about the paper at these sites.

I need to quickly summarise Leigh’s findings before moving on to the important theoretical and political implications.

His main finding is that if stamp duties are raised, house prices will fall by more than in the increase in the tax.  Did you get that?  If you increase stamp duty, the total price of housing (price plus stamp duty) will fall.  Sellers suffer, buyers benefit.  It’s a classic land tax - there is no deadweight loss, as shown in the figure below.

How can such a thing occur?  For any other product, assuming a competitive market, if you add costs to production, prices will have to go up (even if quantity sold goes down), or margins will go down (temporarily at least). 

Land, however, has some characteristics that make it quite different to other goods

1.     1.  There is a fixed supply (vertical supply curve), and

2.   2.  It is costless to produce (the producer surplus starts at a price of zero)

Some would argue that land available to be developed is not in fixed supply, and that town planning regulations can change that supply.  I agree.  But these are regulations, they are not market players, and that does not make supply of land price elastic (although I would suggest the supply curve for serviced residential lots above the intersection with demand is quite elastic as land parcels are brought to market).  I think both sides would agree that from a theoretical standpoint, the supply curve is vertical below the intersection with the demand curve.

It is the second point that is far more important to understanding the land market.  Land itself is costless to produce.  That means that the level of demand determines the price of land at any point in time.  Not supply, demand.  So when you increase a tax on land the total land and tax price stays constant, but the underlying value of the land declines (as shown by the reduced producer surplus in the figure above).

I have been quite baffled by the success of Christopher Joye’s argument that the supply of housing is a major factor determining prices.  He maintains two contradictory positions.  The first is that we have a land price boom, not a house price boom.  The second is that we should elastify the supply of housing to avoid further unnecessary price increases.  Hang on chap.  We don’t have a problem supplying housing. Our problem is that we all decided to pay ridiculously high prices for land.

There are two more characteristics to the land market that make analysis difficult.  There is competitive behaviour in the market for buying land, both development sites and serviced land parcels, but not a competitive market for the sale of land.  

Once a serviced land parcel is developed, there is no price competitiveness exhibited when selling to the final consumer market.   The problem with land is that if prices fall, they can gather momentum as people sell to avoid further falls.  Also, if developers seek to undercut the market price, it reduces the value of all their other land holdings.  There is no incentive to release below market prices.

I also believe Leigh’s findings shed some light on my argument that changes to town planning rules, including increases in height limits and allowable building area, does nothing to affect home prices.   Any site with increased development potential will fetch a higher price, and the resulting dwellings will be released at the market price.

While Leigh’s paper is just one simple analysis of stamp duty rates and house prices, the theoretically sound finding should put to rest some of the illogical arguments of the supply side warriors, and the property development lobby in general.

In Japan you can glimpse the future

When I first visited Japan in 2004 I saw the future - trains, gadgets, vending machines - but most importantly, I saw some amazing toilets. Even now, when I have a conversation with people returning from Japan they always comment about toilets. If you’ve visited Japan you would know why – they range from traditional squatters, to high tech digital robots. The most best of them all will greet you, automatically lift the lid, warm your seat, wash and dry your backside, play your favourite music, and flush automatically.

Back in 2004 I saw one particular style that was simple and profoundly efficient, where the cistern was filled via a basin so that you could wash your hands with clean water, and then use that same water to flush the toilet.

At the time I saw a market for such a design in Australia. I visited Japanese kitchen and bathroom stores to see the price range for these types of toilets, and investigated possible shipping costs. Alas, I became distracted and never followed through with this idea.

Now it seems that popular toilet maker Caroma is making these very toilets in Australia and the US. Only 25 years after their invention in Japan.

For anyone who likes the idea but is not interested in buying a new toilet, you can get a step by step guide to retrofitting your own throne to have this functionality here.

As an economist I wonder why it took the market so long to adopt this simple innovation in our water starved nation.  Was everyone simply as bad as I am at following through their ideas?  Was there a stigma in Australia about washing your hands with 'toilet water'?  Now that it is available here in Australia, will it even catch on?

Unthinkable

I read a book that opened my mind recently. It is probably not on the best seller lists (is #53,525 rank in Amazon a best seller?). It is called The Unthinkable: Who survives when disaster strikes – and why.

This book examines the human response to fear in crisis situations and is presented in a very easy to read, non-scientific, yet analytical way.

The book is structured around the three phases of fear that people pass through – denial, deliberation, action.

Author Amanda Ripley weaves a story linking known human responses to evolutionary psychology. For example, the paralysis some people feel during fear is explained by people searching for a subconscious response. The less familiar people are with their environment, the longer it might take to finish searching for a learned response and start being able to think rationally again.

Ripley tells the tale of a school shooting survivor who ‘played dead’ on the ground and was the only one in the classroom not be killed that day.  I was shocked, because I had often thought playing dead might be a great way to survive a crazed shooting spree.

While I probably won’t do the book justice, I want to try and summarise some of the main points that stuck in my mind.

1.  If you are going to rescue a drowning person, you should yell and scream at them as you approach. Many rescuers are themselves dragged into the water by troubled swimmers desperately grabbing at them. You need to get their attention - swearing and threatening not to save them if they touch you is the recommended approach – and by doing so, you lead them into an obedient state of fear. Which leads me to my next point.

2.  People are mostly very obedient in a state of fear. If they do not have a plan of action that they are confident about, they will latch on to any suggestions by others. In many situations, people have been observed evacuating buildings like obedient lemmings.

3.  People are on the whole fairly calm in an emergency situation. In some cases it is due to denial, some cases due to paralysis of fear (their mind is whizzing away but can’t find a pre-programmed response to the emergency)

4.  People who undertake heroic actions, risking their own lives for others, generally do not make a conscious rational decision. They often say that images of their families pop into their mind, and the thought of facing them knowing they cowardly watched people dying springs them into action. Although some reference to evolutionary psychology is made, as males with no children are by far the greatest heroes.

5.  Overconfident people, who are a pain in the backside during normal times, are far more likely to survive a disaster. This is simply due to their ability to breeze through the denial stage and make a decision, no matter how poor, and follow it through with confidence (this reminds me of advice by Bear Grylls – that the secret to survival when stranded in the wilderness is to have a plan and act on it, rather than waste time thinking about it).

6.  The victims of disaster are play the key role in determining the survival rate.  First response teams such as fire fighter and medics generally arrive too late to make a major difference.

What makes this book so interesting is that the explanation of the human response to fear actually provides a solid theory for why different survival rates are seen in different disasters. For example, QUT researcher David Savage has statistically examined determinants of survival on the Titanic, and found that social behaviour, herding, and following the orders of dominant people probably led to high rates of survival for women and children. But in his study of another maritime sinking found that young fit male staff had the greatest survival chance. This boat sank in a mere 8 minutes.

Ripley’s explanation would be comprise a number of factors

a)  there was no time for a group leader to emerge
b)  in the absence of leadership, many people where struck by paralysis of fear
c)  those with the most confidence, maritime experience, and physical fitness got through the denial and deliberation stages much faster
d)  any hero behaviour may have not been successful

I can’t recommend this book enough for anyone who has wondered how they might react in a crisis, a natural disaster, or fire. It should be compulsory reading for legislators who deal with emergency plans, and for anyone involved in the first response team – the medics, firemen, police, and rescue teams.

A Redwater diverter for every new home?

Markets and opportunity. Peas and carrots.
Hand in hand go such things, and one would expect that in our new water conscious world, any device that can reduce water use in the home will go hand in hand with the phrase 'in demand'.

Here’s one device that has the benefit of being automatic and energy free.

It diverts the cold water sitting in the pipe between the hot water system and the hot tap to a storage (toilet, rain tank etc), then diverts the water back to the tap as it warms.
For all those whingers who need hot showers in Queensland it is probably a good water saving idea (yes, that's me).

I have, however, seen a nifty alternative. In Budapest I remember staying in an apartment that had a gas water heater bolted to the bathroom wall just one metre from the shower. Not only was the water in the pipe already warm from being inside, but there was hardly any water in the one metre of pipe anyway.

I’m not sure you can actually put gas water heaters indoors in Queensland, but one similar solution would be to have your water heater outside the shower wall.

Of course, if all that is a bit much and you still want to save water, you can just buy a diverter valve.

Psychologists at the RBA?

People have instinctual short sightedness. It is a primal trait. Each passing day adds risks to the realisation of future events. Our probability of dying increases, and the waiting time captures multiple risks of the event not occurring at all. In economese, that’s why we discount the future.

However, it is not all that simple. Behavioural economists have shown that people don’t discount in the expected rational way. Instead of treating each year into the future as capturing the same risk, each consecutive year is treated as less risky than the previous year – a concept known as hyperbolic discounting.

For instance, when offered the choice between $50 now and $100 a year from now, many people will choose the immediate $50. However, given the choice between $50 in five years or $100 in six years almost everyone will choose $100 in six years, even though that is the same choice seen at five years' greater distance

Why does the RBA need to know this?

The strategy of a gradual withdrawal of monetary stimulus by incrementally raising interest rates is meant to allow people time to adjust to higher interest rate levels. However, if people discount the likelihood and impact of each further interest rate rise, they will not adjust until it is too late anyway. The instinct of the masses will be to all but ignore the highly probably increases in interest rates in the near future.

This may be one reason for the long lags between execution and outcome in monetary policy.

A quarter of a percent increase in rates every month (1% over four months) is going to hardly register in our animal minds – each change is too marginal, and probability and impact of each future change is heavily discounted. A 1% immediate increase followed by no change for 4 months would actually change behaviour in the way the incremental approach is intended.

Have you heard people who have just bought a new house talk about the inevitable interest rate hikes – “We’ll deal with that when the time comes”. They are simply acting on instinct.

Fractal Finance

Ever heard of the Elliot Wave Theory? Maybe you have, but I hadn't until last week. Put simply, this theory suggests that markets behave is a predictable way which is not driven by fundamentals (actual production of goods, actual jobs, etc) but simply by human behaviour in the marketplace – the collective investor psychology.

The image below show the fundamental Elliot wave – 3 peaks (1, 3, 5) and two troughs (2, 4) on the way up, and two troughs (A, C) and one peak (B) on the way down.

While quirky (as an economist I like to think in terms of the fundamental patterns of production) this theory has a lot going for it.


1.  It is fractal and scaleless. That is, the pattern reoccurs over very small and very large time periods.
2.  The theory enables bulls and bears to be correct much of the time. It goes up and down.
3.  It seems irrational and predicable – a good reflection of human behaviour.

However there are some problems.

1.  It is impossible to be wrong if you simply say the market will go up and down (the most basic claim of this thoery).
2.  The theory has nothing to say about the speed and scale of each wave; it therefore does not add to the forecasting arsenal.
3.  It assumes that markets ignore all political and technological change, or it assumes these things change in a wave pattern.
4.  It assumes that markets actually measure something. Should Elliot wave analysts use prices in real terms or nominal terms?

So where are we on the basic wave formation? Did we just have a 3-4 crash, or a 5-A crash?

I have a chart of the All Ordinaries index from 1985 with my amateur attempt at using Elliot waves to forecast the next market move. Umm… down maybe?

While interesting, how anyone uses actually applies this theory to reveal anything useful escapes me. You can read up on Elliot wave analysis of the current market here, or do a google search for commentary by Robert Prechter, the current guru of Elliot waves.

Business stripped bare

This book is Richard Branson’s latest eye opener into the world of Virgin. The one man publicity machine takes the reader on a tour of his business philosophy and how the philosophy actually works in the realms of the Virgin empire.

I am a fan of Branson and the Virgin empire, for the most part because the company seems to bring competition to formerly uncompetitive markets. Virgin Blue is a classic case study – it revolutionised air travel in Australia. The budget carriers in Europe had already been vigorously competing for some years, and it was only a matter of time before the same thing happened down under. But without Virgin, would we have waited another 5-10 years for air travel competition?

Virgin is already in the mobile phone market worldwide, with India a growth area for them. Their entry to this market was launched on the back of simple pre-paid phones with simple prices. I have mentioned before how the complexity of phone and internet plans only benefits the supplier, and it seems that Virgin’s move into the mobile phone market was pinned on price competition rather than price confusion.

They are even moving into financial services and banking.

Richard tells how the Virgin group is now in the business of ‘branded venture capital’. They look to team up with emerging players and offer not only funding, but the goodwill of the brand to go with it. It works for them, but has the major risk that all businesses are exposed to the reputation of the brand. Some bad publicity could take a real toll.

But I’ve been thinking. What other industries need a shake up? I have a shortlist:

1.  Real estate agents – no price competition there. Somehow the industry acts as a cartel, setting commissions at the maximum legal amount. Maybe their slogan could be “Great service – even if it’s not your fist time”.

2.  Supermarkets – the entry of Aldi to the market was significant. But there is still plenty of room for a new entrant here.

Any other ideas?

Population caps: Social catastrophe or sound planning?

My favourite lobby group, the Property Council of Australia (PCA), have attacked South East Queensland Mayors for starting debate about limiting population growth in the region through town planning restrictions.  The PCA's argument is that restricting development in a region has disastrous social and economic impacts. They wield the crossed supply and demand swords to argue that house prices will sky-rocket in areas with restrictive planning regimes.

Not surprisingly, their arguments are flawed.  Here's why:

The price of housing can only rise relative to housing in other areas by the value added by its location in a restricted planning area.  This may be a small transport cost, or premium for desirable suburbs.  Do you think median value of Brisbane homes would reach $1million while you could live at Ipswich or Caboolture for $300,000?

I would also suggest that the PCA's position is detrimental to the development industry in the long run.  As I have mentioned before, when town planning rules are changed to allow new areas to be developed, these areas are now in competition with existing areas for the finite demand for new housing.  As happened in Noosa, developers began to use the potential population cap as a marketing tool to exact a premium on property prices.  Although experience suggests that this premium may be more marketing hype than reality.

Also, I have yet to find a city or country that has a restrictive planning policy to cap population that has had disastrous social impacts.  Cities across Europe have adopted greenbelt planning controls to limit urban expansion, and there appears to be no significant social problems, but significant public support.  South Korea appears to have adopted a restrictive green belt in Seoul, which appears to have had net benefits.

My gut feeling is that the development lobby is creating a terrible public image for itself simply because they lack a thorough understanding of the economics at play.  There is money to be made with or without planning controls for a population cap, and it gives developers opportunities to be the first mover in emerging areas outside the capped region.