Pete Wargent blogspot

CEO AllenWargent Property Buyers, & WargentAdvisory (institutional). 6 x finance author.

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Wednesday, 10 December 2014

Euclid's Conclusion


Not a fan of Xmas shopping at all, but as a necessary pain I thought I'd brave the mass hordes of British shoppers in the historic city of Lincoln yesterday. 

Some fascinating history in the city including the Jew's House (built 1150) scene of ugly hysteria in the 13th century on the aptly named Steep Hill.

Lincoln Cathedral (1088) is home to one of the copies of the Magna Carta (signed in 1215, some 800 years ago next year), and perhaps even more importantly, played host to movie scenes from the Da Vinci Code in 2005 where the cathedral was used as a stand-in for the out-of-bounds Westminster Abbey. Heady days indeed.

Cheap Land

Being located absolutely miles from London, and indeed, absolutely miles from anywhere noteworthy, Lincoln for some years held the envied title of being the cheapest city for house prices in the UK, although since the financial crisis crash other cities have taken on this hallowed mantle.

While there is some new demand for housing in Lincoln from immigration, in part driven by an influx of foreign students to the University, there is certainly no scarcity of land available and lot prices remain remarkably cheap. 

Each year a new fringe housing estate seems to have sprung up (with upwardly mobile sounding names like "A-Spire" - actually I just made that up, but usually something similar to that), with new build 2 bedroom houses today starting at a little over £100k and brand new 3 bedroom houses available in the city from around £140k.

Peak Debt

The British housing market has seen prices declining in real terms since hitting "peak household debt" around 2007. 

Prior to that time the UK had undertaken the interesting experiment of lending money to absolutely anyone and everyone, regardless of whether they had actually saved a deposit (or in fact, saved anything at all), with kamikaze loans being issued in many cases of up to 125 percent of the value of the property

The experiment didn't end particularly well, unsurprisingly, but there was a widely held view at the time that people should not need to save deposits to buy houses (cf. "what choice did I have?").

Since 2007, despite very lazy media talk of a "housing bubble", house prices have been have declined in real terms by 30-40 percent outside London and the areas which immediately surround the capital with its heavily restricted "green belt" land.

London has a genuine scarcity of prime location land and with more than 20 million people and rising sardined within the green belt area and interest rates stuck at the zero bound, house prices in the capital have inevitably continued to rise.

Unfortunately plenty of homebuyers and investors were head-faked by the "property always goes up over the long term/invest for high rental yield" mantra and seminar rhetoric of those heady pre-financial crisis days, but once household debt peaked it became clear than this was a fallacy. 

Only land in high demand and with genuine scarcity value has increased in real terms since late 2007, everything else in the regions meanwhile...

Magical Mysteries

Anyway, back to the Xmas shopping, it always seems to be impossible to know what to buy people these days when they already seem to have everything that they could possibly want, so the default choice of gift is usually a new book from the Waterstones store.

My sister-in-law is a numbers geek like me, having studied maths at Oxford Uni, so I bought her the brilliant Casebook of Mathematical Mysteries (she'll never read this blog, so it can be disclosed here that obviously the plan is to read it in full from cover to cover before wrapping the gift). 

"Euclid's Doodle"

If you've ever been interested in subdivision or the rezoning of land you may be at least indirectly familiar with one of the great mathematical mysteries, the Euclidean Algorithm, which has been known about for two millennia since ancient Greece. 

The "bearded mathematician" look has clearly not dated in 2000 years and neither has Mr. Euclid's ingenious algorithm.

Suppose I take my large rectangular plot of land and subdivide a new rectangular plot, then logically enough, I'm left with two smaller rectangular plots of land. I can then subdivide a third and fourth plot from the land if I so choose (not that you need any algorithms to know this much).

So what happens I keep doing this to my rectangular plots of land? 

As the final diagram below shows, the answer is that I am ultimately left with some very small squares of land, with two sides of my smallest plots equal in length to one side of the next largest plot. 

You probably know all this if you've ever subdivided a garden or a plot, and you've probably even drawn something like Euclid's doodle, though you may have given it another name...

Some rather interesting patterns can be found within this series of subdivisions.

The Euclidean algorithm - an algorithm effectively being recipe for solving an calculation - calculates the Greatest Common Divisor ("GCD") of two natural numbers. 

For example if I have a 24 x 60 squares block of land (24 x 60 = 1440), I immediately know that if I want to create the largest square plots that I can, I should aim for 10 plots.

How so? Because the Greatest Common Divisor or "GCD" of the integers 24 and 60, and therefore my block of land, is 12. And thus I am left with ten 12 x 12 square plots as follows (12 x 12 = 144 squares).

Et voilĂ !

Diminishing Returns

While Euclid's doodling might seem at first blush to be a whole load of theoretical nonsense, there is one important logical conclusion to his algorithm, that being that there is clearly a finite end to how many times we can subdivide an area successfully.

This must be so, because the numbers or integers that we are using are positive and we are dividing them, so the figures quickly begin to approach zero.

In terms of rezoning land, there can also be a law of diminishing returns at work here since there is not a great deal of demand for tiny plots of land.

Peak Household Debt in Australia

Australia reached peak household debt around 2006, so it's not surprising that these days I get plenty of emails from people wondering why they have ever invested in property since their returns have been so wretchedly poor...or in many cases even negative! 

Household Finances graph

Many investors have seen little or no real returns in 6 or 7 years because they invested in outer suburban properties, regional centres or small cities outside the four major capitals where land often has little or no scarcity value at all.

If prices do go up then more land is released, rezoned or developed which takes any upwards pressure off house prices again.

To be blunt if you haven't seen strong returns from over the past 7 years it's probably because you have invested in the wrong type of property, because land prices have demonstrably increased in many locations (but only noticeably of late in the main capital cities).

The total value of residential land in New South Wales increased by 37 percent in the six years between June 2008 and 2014, so if you invested in the right type of property (hint: with locational and land value) you have seen dramatic returns.

The problem with so many regional and outer suburban $200,000 properties, which seem appealing and to make good sense because they are cheap and therefore could appreciate, is that median lot prices are worth somewhere around $50,000 with the building value comprising the other $150,000.

$50,000 + $150,000 = $200,000.

Supposing using your outstanding research skills you have invested brilliantly and found a location where land prices surged by a massive 50 percent in that time (unlikely, but let's go with it)!

You would then have a property with land worth 50 percent more or $75,000 and if you are lucky a building still probably worth around $150,000, equating to a total property value of $225,000. 

$75,000 + $150,000 = $225,000.

Hmm. Real estate suddenly doesn't look like such a smart investment in this example since the compounding return from capital growth on the total value of the property is below inflation at only 2 percent. 

Even where land prices have spiralled by an astronomical 50 percent in only 6 years, the investment has failed to match inflation.

The point is that above inflation returns from capital growth for most Australian residential real estate ended quite abruptly with peak household debt in 2006 and returns in most areas have been rubbish ever since.

Investing in cheaper property with low land value is often the equivalent of investing in the future price of bricks, because the replacement cost of property on greenfield sites in outer suburban locations is very low. 

Indeed, it has actually been becoming cheaper in real terms, because the price of project homes has actually been declining in real terms.

Beating Inflation

The flip side to this story, of course, is that houses that sit on plots in inner Sydney have seen land values escalating from below $600,000 to $900,000 or above delivering enormous returns to owners, because they own something that is both scarce and in high demand.

We haven't subdivided our way to the logical conclusion of Euclid's doodling in Sydney in terms of rezoning land, but, heck, we're not very far from it. In inner locations there are no vacant plots, while high land remediation costs means that replacement cost per property are very high, even for blocks of apartments.

The zoning map above is for the lower north shore, but we might just as well have copied here the LEP zoning map from the eastern suburbs or the inner west. 

There is a small amount of green space zoned for recreational public use, some railway and commercial zoning, and a bit of white space at the bottom which tends to be good for yachts, Sydney Ferries and 18ft skiff racing, but not so good for actually building on.

The remainder of the council LGA is fully built out and can be subdivided no further. The only direction left to build is up, but in the leafy green suburbs this will never be allowed by NIMBYism and a pent-up tsunami of potential complaints to planning agencies.

This is not exactly true everywhere in Sydney, of course. In the inner south and around the airport much industrial land has been rezoned for new apartments, and this will also be the case in a number of Urban Activation Precincts (UAPs) located around certain transport hubs. 

Investing in those new developments is unlikely to be such a smart idea since prices are sky high and there is little or no scarcity in that property type.

In the inner west occasionally a greyhound track is pulled down for redevelopment, or an industrial park is sold to a Hong Kong developers for an absurd $350 million. Shamefully on the odd occasion we even build a few blocks of flats on the small islands of green public space. Effectively, though, the inner suburban land supply is all but fixed. 

It has genuine scarcity value and demand is growing in Greater Sydney by around 90,000 persons per annum.

Holding Costs and Attached Dwellings

Of course entry costs can be a tough hurdle in cities like Sydney or even Brisbane and the holding costs on expensive houses can be painful, despite forthcoming record low mortgage rates.

This is why most investors look at units and apartments in Sydney, but a glance at quarterly movements in median unit prices should immediately tell you that you need to be careful what you buy if you want to secure solid returns.

As a very general rule, the more your apartment block is similar in nature to a house (i.e. smaller apartment buildings with lots of land value and not too many individual units), the better. 

On the other hand, the more your apartment looks like a skyscraper, the more likely you will also be scraping together paltry returns in the same way that investors in outer suburbs and many regional areas have been since Australia hit peak household debt in 2006.

Median capital growth on units can often appear to be quite inferior, but if you have owned the right type of Sydney property, you should have seen exceptionally good returns in recent years - asset selection is absolutely the key.

Is There Another Way?

Is this unfair and skewed towards those of us who bought inner city properties years ago or those who can afford to do so now? 

I guess, though it certainly never once felt like it at the time of buying. When we were buying properties in the inner west years ago it was all about the eastern suburbs - everyone wanted to be by the beach and the city and the inner west was considered by many to be uncultured, uninhabitable or even a "ghetto".

Today prices continue to rise, but this is largely because Australia has developed and encouraged a flawed obsession that we can cram ever more people to within a tiny radius around four main capital cities.

Thus we see regular articles from journalists lamenting that they can't afford to buy houses in the inner west despite $1 million budgets (which would buy a mansion further to the west, south-west or north-west of the city), or close to Bondi Beach, or funky terraces in Surry Hills.

We shouldn't all need to live in a handful of suburbs, of course, and t
here is a solution which is more investment in regional business, jobs, transport and infrastructure, but if we all keep trying to buy houses in the same few areas, prices will inevitably go higher (and human nature is surprisingly predictable in this regard, with some years of practice). 

Instead Australia is adopting precisely the opposite approach to what is needed with jobs growth and population growth increasingly focused on the inner and middle-ring areas of our largest four capital cities, as concluded by independent studies carried out by the Grattan Institute, AHURI, the Reserve Bank and countless others.


The ABS Housing Finance data will be released at 11.30am today. This will be closely watched by markets and regulators.