The overvaluation of the NZ economy – 26 January 2014

Two weeks ago, the Economist newspaper published its quarterly survey of global house prices. In most countries surveyed, house prices are starting to rise again which is regarded as being very positive for some places as they struggle to move out of recession.

For its house price survey, the Economist measures whether houses are overvalued or undervalued in each country relative to the long-term average. New Zealand features in the Economist’s list and it is probably no surprise to most of us that our houses are overvalued by both of the methods of measurement that the Economist uses. In fact, by one of the measures, New Zealand houses are 71% overvalued while the second measures shows that we are 26% overvalued.

With these sorts of figures you can certainly see why the Reserve Bank is 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 stay much the same, house prices become more highly valued. However, if incomes rise at a faster rate than house prices, house prices are of lower value. By this measure, New Zealand is 26% overvalued.

The second measure compares rents to house prices. I think this measure is more important because all investments should primarily be valued for the income that can be derived from them: this is true whether we are considering businesses, shares, bonds or property.

The principle of this measure is that people purchase a house for the rents that that are earned (in the case of property investors) or the rental costs that are saved (in the case of owner occupiers).

Clearly there are other benefits for owning a house, but from a financial point of view, a couple who is looking to buy a house has a choice: they can carry on paying rent or they can substitute rent by home ownership. For this couple, the amount that they are saving in rent and the amount that they will have to pay for the house are important numbers and the relationship between the two is critical – and it is that relationship which the Economist measures.

This is no different from the analysis that investors constantly make: if they pay a certain price for an asset (be it shares, bonds or a property) they want to know that the income they will receive is enough. In the case of a potential home owner, instead of receiving income they are substituting the cost of rent – they need to consider if the rent that is being saved is sufficient to justify purchase.

Therefore the relationship between rents and house prices is critical. If you were buying a business you would certainly look at the profits that the business was projected to make 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 are 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 is different: for a business we usually use something called a price:earnings ratio; for bonds we look at yield. However, although the language is different they are all doing the same thing: comparing the price that they pay to the income that they will receive (or, in the case of owner occupier house, the costs that they will save).

Of course this does not take into account capital gain – and one of the reasons that people own houses is to hedge against major increases in house prices. However, investment analysis looks first at income compared to price before any estimate of capital gain. True investors are looking for income (or cost substitution) and they hope that the investment is a valid one from income alone. After all, income is relatively certain but capital gains much less so.

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 is well out of line with its long run average – 71% 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.