Introduction

In the property market, it is not rare to hear something like 30 weeks of consecutive declines or increases. Below is a snapshot of weekly price movements in Australia provided by Corelogic.

People may have grown used to news like this, but in reality, this is a remarkable level of momentum that most other capital markets do not have. As far as I’m concerned, property is probably the asset class with the strongest momentum in returns. When I think more about it, I believe it is supported by many structural factors in its market design.

The Noise Trader Approach

One of my favourite papers in finance is called The Noise Trader Approach to Finance written by Andrei Shleifer and Larry Summers in 1990. This paper provided concise and yet powerful arguments against the Efficient Market Hypothesis (EMH). The majority of its arguments are still relevant in today’s markets, including the property market.

It is no secret that momentum prevails everywhere, including liquid markets like the public stock market. As AQR founder Cliff Asness famously put it, “Value and Momentum Everywhere.”

There are plenty of behavioural reasons behind momentum, including slow information diffusion in an imperfect market, anchoring bias where people hold onto their current position without actively making adjustments based on the latest information, and herding where buys attract more buys. Many social norms change, but human biases are embedded in our genes; hence, we see momentum continuing to exist after many centuries.

Why don’t smart money (aka speculators) counter the irrational trend? Because there is no risk-free arbitrage. When positive feedback trading exists, speculators actually prefer to jump on the bandwagon themselves. Eventually, arbitrageurs sell out and help restore fundamentals, but in the near term, they actually inflate the bubble rather than dissolve it.

Similar observations exist during market downturns, for slightly different reasons. Lasse Pedersen proposed an interesting framework that explains how mutually reinforcing market liquidity and funding liquidity lead to the liquidity spiral in a downward trending market.

Similar underlying dynamics of price reactions probably exist for the majority of asset classes; hence momentum is so prevalent everywhere, including the property market.

Pro-cyclical Regulatory Policy

Apart from behavioural reasons, there are also regulatory reasons specific to the Aussie property market. Property is among the most leveraged asset classes. It is crazy to think that an average person is allowed to leverage 400% with a 20% initial deposit, not to mention first home buyers, who are allowed to leverage 1900% with an initial deposit of 5%.

Leverage is highly related to credit, so macro-prudential policies can play an important role in shaping the dynamics in the property market. The Australian Prudential Regulation Authority (APRA) scrapped a fixed 7% serviceability test in 2019 and set basic serviceability assessments for banks to operate with a buffer of at least 3% over the loan interest rate. This is a pro-cyclical policy. In a rate-decreasing environment, asset prices will be inflated naturally. But with the serviceability floor dropping, people are allowed to borrow more, and this boosts property prices further. On the other hand, in a rate-rising environment, lower borrowing capacity would definitely not help struggling property prices. Essentially, this type of pro-cyclical policy has the potential to increase the volatility of property prices and increase the correlation of property prices with macro-economic cycles. Even if it has only been a few years since this policy took effect, it could still account for some of what happened from 2019 (rate dropping from 1.5% to 0.1%) to 2023 (rate rising from 0.1% to 3.35% at the time of writing).

Land Value Plus

With the rise of house & land packages in Northwest and Southwest areas, an increasing number of buyers have started to value property prices as the price of the land + the price of the building. Land prices can be found from the Valuer General in the case of New South Wales, and building prices can be reasonably estimated.

It seems like house prices can be estimated much more scientifically than equities, but is it true? Not exactly. Based on the valuation methodology provided, land value is determined by house prices of houses with similar characteristics.

Effectively, the land value can be seen as a function of the house value. What we can infer is that if house prices drop or increase this year, land values will drop or increase next year. This relationship is typical auto-correlation. When an insignificant number of people start to use this methodology to price houses, momentum will be the result.

What I want to explore next

In general, the extent of momentum is much less in the public market compared to the property market, due to the fact that transaction costs are relatively low. The high transaction cost of the property market might be a reason why its momentum is strong and has not been largely arbitraged away. Another factor is that each house is unique, so it is not possible for buyers to act promptly even if they want to.

The property market is a fascinating market with a lot of research potential. What I want to look into next are:

1. Performance of metropolitan houses and regional houses

Metropolitan houses have much lower rental yields compared to regional houses. In the public market, this is similar to carry, value, and/or dividend factors. However, there might be more to it, including liquidity discount or simply mispricing.

2. Real property return predictability

If we see the relationship between real properties and listed properties the same as private equity and public equity, then technically the listed property price can be a forward-looking indicator for real properties. If the listed property has recovered and the real property is still tanking, is it likely that the bottom is already close for the real property?

3. Quantifying the option to avoid margin call

Negative equity is when you owe more than what your property is worth. Most of the time, people hold onto the property for the price to recover. Different from the public market, banks don’t generally issue margin calls. If one can hold onto negative equity, time diversification will kick in, and eventually, the returns could be significant due to the highly leveraged nature of property investing. Is there value in the option to avoid margin calls? If we construct a 400% leveraged stock portfolio and can hold onto it without being margin called, does it have better return potential than property investments?

4. Momentum crash

Is there a natural break-point in the property return momentum, or do breaks tend to be induced by regulators?

These are just a few random thoughts. I am fascinated by the property market because it is probably one of the purest forms of complex systems where co-movements of millions of simple agents create a unique market. The stock market is much harder to model given its speed of evolution and sophistication of some players. My bold assumption is that huge values can be extracted from approaching the property market from the complex system lens. I hope I can get to explore more of it this year.

Until next time.