It seems to be cool to be a bear. For the contrarians among us, that in itself is a concern. However, for once, we will side the majority view, heck, even The Australian Financial Review appears to have taken an entirely somber view about the Australian residential property sector.

Robert Harley, writing the influential Chanticleer column (Tony Boyd is on leave), yesterday stated “nearly every housing indicator in the country is pointing down. New housing finance is 30% below the first home frenzy of 2009. Housing sales have dropped, with leading Ray White Real Estate recording a 16% decline in the value of houses last month…at the same time, the number of houses and apartments for sale has soared.”

Boyd then pointed out the first link in the vicious cycle of a bursting bubble: “Price growth has evaporated. In Brisbane and Perth, prices are in decline. On the Gold Coast, the Sunshine Coast and Cairns, the decline has turned into a rout.”

Today, Ben Hurley in the AFR noted “Australia’s wealthiest investors have lost interest in residential property, speaking a sell-down that could keep property markets weak for years to come”.

The problem with a bubble is that the price of an asset class becomes separated from their intrinsic value. The intrinsic value is loosely the value of an asset which gives it a commensurate cash return to compensate for the relative risk of holding that asset. Currently, the net return (after all expenses) on residential property is around 2%. That may be a good return if the “risk free” rate (a good proxy of which is government bonds) is zero. Currently, the risk-free rate is around 5% — more than double net rental yields. Property returns are even worse when you consider the substantial entry and exit fees (often around 10% of the price).

That means, a risky asset like property (which can go down in price as well as rise) is yielding less than an asset which is guaranteed by all taxpayers.

The reason for the low returns on property is due to people (investors and owner occupiers) bidding up the price of property. This is common in a bubble. Be it tulips, or stamps, or technology companies or commodities. There are few things more infuriating than to see someone else get rich (or appear to be rich). This causes people to make decisions based on emotion, rather than logic.

As property prices increased in the late 1990s and early 2000s, people saw their neighbours getting rich. This encouraged them to pay more for property. This caused property prices to rise further (aided by inequitable government policies like negative gearing, CGT discounts and the first home owner’s grant).

As property prices rose, the yield on the asset fell. But that didn’t matter, as people expected the price of the housing to continue to rise, simply because they had known nothing different. It actually began to feel like property prices simply could never fall.

But they can. And in some places, like Noosa, they already have.

The added problem with bubbles is that they are inevitably funded by debt. Debt is a particularly insidious beast — friend during good times, bitter foe during bad. While debt will magnify the returns of equity, it will also quickly wipe out that equity when prices fall. This is what happened to thousands of highly leveraged clients of Storm Financial

Australian home buyers are a very leveraged bunch. And even worse, that leverage is not evenly spread. While the CBA last year blithely attempted to appease investor concerns by noting that the “average” loan-to-valuation ratio (LVR) for its portfolio is 43%, that is grossly misrepresentative. Properties which have been owned for a longer period would tend to have a far lower LVR, as the borrower would have repaid part of their principal. For more recent loans, especially on properties bought during the bubble, the LVRs would be far higher. It is these loans and borrowers who are most at risk, or most “stressed”.

What that means is that a proportion of borrows are under severe risk of not being able to afford repayments should their circumstances change. Ruth Liew, also in yesterday’s especially bearish AFR, noted “one in 10 mortgage holders say they will not be able to make their repayments if interest rates rise by as little as a quarter of a percentage point”. Even worse, according to QBE LMI, the body that is most at risk should house prices fall dramatically, “if rates were to rise half a percentage points, nearly one in four Australians say they would be unable to pay their mortgages”.

If this were to happen, the price of property would quickly fall. And those falls would actually lead to even great falls. Just like a bubble can create a faux positive feedback loop, that bubble popping causes a vicious cycle. In a downturn, rational buyers hold off purchasing a property because (a) there was virtually no hope for a capital gain and it would take a true fool to purchase an asset yielding 2% and not rising in value; and (b) buyers expect lower prices in the future, so it makes sense to hold off purchasing now, because they would get more for their money down the track.

Falling house prices inevitably leads to slower growth and higher unemployment. This then causes struggling borrowers to default on their mortgage payment and forces mortgagees to sell off the collateral, further forcing prices downwards.

The cycle continues until the point where the cash yield is substantially higher than the risk-free rate. When property yields 7% or more, then it again becomes an attractive asset and the hope of capital gains returns.

In a final sign the bubble is popping, more than 80% of first home buyers believe the property market to be overvalued. Just waiting for that last 20%…