The residential property market is notoriously inefficient. What that means is that current market prices exhibited for residential property will often deviate substantially from its intrinsic value. There are several reasons for this — first, a large proportion of property purchases are made using a majority of debt (so purchasers are spending far more of the bank’s money then their own). Second, property provides an emotional attachment for many purchasers, unlike other assets like shares or bonds. Third, in Australia, property remains a very valued status symbol for many, so purchasers remain happy to pay substantial premiums to own a home rather than rent. Due to these factors, property prices resemble a large ship — difficult to turn from its direction, but when it does, even more difficult to turn back around.

Auction clearance rates — usually a reasonably accurate leading indicator of demand for existing housing, have been steadily dropping during this year. Melbourne has seen its clearance fall from more than 80% throughout last year to about 60% — the fall came despite a drastic reduction in the number of properties being auctioned. RP Data reported than in June that house prices nationally fell by 0.7% — while merely a blip compared with the past 15 years of gains, but a rapid turnaround from the previous 12 months that encountered price rises of 12% nationally.

Even Macquarie Bank, whose leading economist Rory Robertson has been a relative housing bull, delivered a surprisingly bearish appraisal, noting that Melbourne would “experience an outright correction driven by slower migration and significantly deteriorating housing affordability”.

Meanwhile, housing bulls still desperately cling to the notion that capital gains will continue — largely on the basis of an apparent housing shortage. The problem with the housing shortage myth is that it is propagated by special interest groups, such as real estate agents or the Housing Industry Association. For example, the HIA’s Shane Goodwin, wrote in The Australian yesterday that:

There is a chronic and growing shortage of housing in Australia.

Over the past few years we have built substantially fewer homes than are needed. The housing backlog is approaching almost 200,000 dwellings and will multiply in the years ahead regardless of whether or not we have a “big” or “small” Australia.

Goodwin naturally provided no evidence for this shortage — in fairness, that’s probably because he doesn’t have any.

As this column has been at pains to point out — if there really was a housing shortage, it would be quickly exhibited in increasing rental costs. When it comes down to the choice between being homeless, relocating to a more reasonably priced rural area or paying higher rent, most people will (initially anyway) opt for the higher rent. The problem for the shortage proponents is that rentals have increased at a much lower rates than capital values — a little more than rate of inflation. Australian Property Monitors reported that rentals increased by 0.7% in the past three months — roughly equal to the increase in CPI. Over the past year, median rents have increased by less than 5% while median prices have rocketed by about 12% (and more in some cities).

Because of skyrocketing capital prices and stable rents, yields on most residential property are in net terms, often less than 3% (in calculating yields, many people forget to consider depreciation of buildings and maintenance costs). What that means is that the cost of renting a median dwelling is about $18,000 — the costs of buying the median property (including finance and other costs) would be approximately $36,000 — that is before depreciation is even considered.

The Daily Reckoning’s Bill Bonner put it best when he compared renting a dwelling to purchasing one, when he noted:

You can get a rough idea where the bottom in housing might be by doing a little math. You should be able to buy a house at a price where, financially, the decision to buy or rent is relatively neutral. There’s no particular reason why a person should invest in a house rather than in stock or in other investments. His goal is to maximise his quality of life … and his wealth. So, if he can rent a house for less than he can buy it … he should rent, because that gives him the same quality of life at a lower cost, leaving him more money to put to work increasing his wealth. On the other hand, if he can buy more cheaply, he should buy … for the same reasons.

If houses are going up, he’ll pay more for a house — in anticipation of the capital gains. But if prices are flat or falling — he’ll look only to the stream of income he can get from the house (or the enjoyment he’ll get from it personally) … and put on an additional discount to protect himself from capital losses.

Clearance rates are falling, stocks dwindling and even some real estate agents are expressing concerns about the prospects for the property market. It appears that the ship is slowly turning.