Home prices: careful with your calculations

05-08-2004

The debate still rages is the property industry in a bubble or a boom? In last month's edition of this publication, Rode warned that the overvalued residential property is poised on a knife's edge and that a currency or oil-price shock precipitating an interest rate spike could precipitate a price crash.

The two sides' proponents are still slugging it out, with Absa suggesting that a sharp rand depreciation is a far way off, and Cannon Asset Managers' Adrian Saville warning that market conditions could drive property prices to spiral lethally higher.

To be able to arrive at any sensible conclusion this way or that way, though, one needs to compare apples with apples, says Rode CEO Erwin Rode - or in this case, the comparison of price and replacement cost has to be done correctly. To wit:

"In Rode's definition of a property-market bubble, prices of reasonably new second-hand houses have to exceed the cost of replacing them. Replacement costs should include the market value of the land and the construction cost. In most cities and price classes, house prices already exceed the replacement cost."

Rode says it is imperative to correctly compare price and replacement cost. "The average South African house is probably three decades old. It would make no sense to compare these prices, which have depreciated through ageing, with the cost of building a new home. If you do this, you will come to a faulty conclusion that second-hand house prices are currently below the replacement cost.

"Further, when you consider the correct building cost to use, one must consider that building contractors' profit margins are now pretty fat and there is lots of scope for contraction in the event of a sharp construction slowdown."

This means that although building costs are very high, they could decline sharply in a crash scenario, thereby making new (and in their wake, second-hand houses) much cheaper.

Rode suggests that although there is a bubble, the most likely scenario is that the residential property market will cool down in an orderly fashion without the bubble bursting - unless of course the economy gets hit by a spike in interest rates. The reasons for this opinion are that prices seem to be decelerating already as a result of unaffordability and the stable SA economy (brought about by the stringent macroeconomic policies of the past decade).