October 20, 2022 by Dymphna

How the “ratchet effect” works in property

Property is unique, which is why the bottom of the cycle is closer than people think.

I think we’re probably getting pretty close to the bottom of the cycle now.

That might seem like an ambitious call. It’s a bit ballsy.

And it might seem premature. Nationally prices are down about 5%. That follows 25% on the way up so it certainly seems like there’s a lot of room for prices to fall further.

But this is the way the property market tends to operates. It ratchets. You have big gains followed by relatively small downturns.

I mean, remember in the GFC – on of the most epic financial moments of the past 50 years. For all that, property prices only fell 5% peak-to-trough.

And so if we leave aside the timing (because the ramp up during Covid was very quick, and current correction has been so far too) – but if we leave aside timing, I’d say a property cycle of 25% up, 5% down is probably pretty standard.

It’s par for the course.

But why is that? Why do we see this “ratchet effect” in property markets.

Well, there’s a few things that make property different. For starters, people need somewhere to live. For most people, you don’t cycle out of property into other asset classes.

For most owner-occupiers, falling prices are really neither here nor there. They’re not going to sell just because prices are going down. They still need somewhere to live.

And you only see this dynamic of owner-occupiers selling their house and entering the rental market – you only see that in the worst of times.

Things have to get pretty bad before people liquidate the family home, and re-enter the property market.

And so you very rarely see unwilling or forced sales in property. They only tend to happen in the worst of times – in deep recessions – during times when the unemployment rate is an awful lot higher than it is right now.

When you do get forced sales, then you might start to see a downward spiral in prices. People are forced to sell, which puts more properties on the market, which changes the supply and demand balance, forcing prices to fall further.

But unless you have a deep recession and a surge in forced sales, then you typically never get the supply response to really drive prices lower.

What you tend to get is what’s called in financial terms, a “blow off”. That is, at the end of the cycle, people over pay. They get ahead of the market. They’re overspending because they’re afraid of missing out.

And so that froth gets blown off the beer, if you will.

Which is why you see this ratcheting – modest declines after large upward swings.

And all this is why I just don’t see prices falling much further.

The unemployment rate is 3.5% – miles below anything that’s going to be causing forced sales.

And the number of listings on the market is actually falling not rising, which means the demand supply balance is moving against further price falls.

So look, it sounds logical that we might give up all the gains that we picked up through Covid.

But it probably won’t happen.

The ratchet is in effect.