here is some good news
PORTFOLIO POINT: House prices are softening now, but the supply-demand imbalance means the uptrend will resume.
What does the future hold for house prices? Like any other asset, house prices are determined by two key factors: demand and supply. Accordingly, plotting the future of house prices means forecasting the course of demand and supply. One of the critical – and really unforgivable – mistakes the doomsayers make is in trying to value Australian residential property using a model that only includes demand-side factors, particularly by using the ratio of Australian house prices to household incomes. Sometimes you also see an analyst use an affordability measure, such as the share of household disposable income that is being spent on servicing mortgage repayments, used to value current prices.
There are many flaws with these methods. The first is that incomes and interest rates are “demand-side” factors. That is, this analysis takes no account of housing supply, which is the other key variable that determines prices. It is akin to asking a commodities trader to forecast oil prices by only using demand-side variables, such as the production of new cars, but taking no account of the supply of oil. We know, of course, that the value of intrinsically scarce goods such as houses and oil is crucially influenced by their supply.
Anthony Richards, the Reserve Bank’s head of economics analysis, recently acknowledged this point, noting: “We must recognise that housing prices are not set exogenously, but reflect the interaction of demand and supply … This suggests that the run-up in real housing prices may not be fully explained by demand-side factors and that supply-side ones – especially policies on land usage – may also have played a role.”
The second problem with these demand-side measures is that there has never been any historically stable relationship between house prices and incomes, or house prices and measures of affordability; precisely because there are other factors (such as supply) that also play a critical role.
To take one example of this: consider some recent Reserve Bank analysis that flips the whole affordability debate on its head. The bank asked the question: “How has the typical first-time buyer (aged 25–39) fared between 1982 and 2007.” The bank’s analysis measured the average household’s income that was left over after paying off a 90% home loan. It can seen from the chart below that based on the Reserve Bank’s affordability measure, many Australian households in 2007 have – in contrast to what some would have you believe – more disposable income after paying off their home loan than at any other time in recorded history! (Note these figures only go to 2007, before the recent run of interest rate rises.)
In a similar vein, there is much hyperbole in the media about the level of mortgage rates. Yet inflation-adjusted interest rates in Australia are actually quite low by historical standards and certainly less than they were in the late 1980s or mid-1990s (see chart).
nFigure 1: RBA affordability measure
Real gross household income after loan repayments
Source: RBA
nFigure 2: Real interest rates
Source: Rismark International, ABS, RP Data
One final issue is the misleading tendency to compare house price/income ratios across countries. There are, however, fundamental differences between most countries’ property markets that result in divergences in their relative performance. That is, there is no reason to believe house price/income ratios should be constant across nations.
These differences include:
Their tax treatment of housing (in the US, for example, capital gains tax is levied on owner-occupied housing while mortgage interest repayments are tax deductible; neither applies to Australia).
The size of their public housing markets (the public housing market share in the UK is far larger than Australia, which in turn has a much bigger private rental market).
Their rates of home ownership (54% in the Netherlands, 42% in Germany, and 35% in Switzerland, but about 70% in Australia).
The responsiveness of housing supply to changes in demand (low in heavily supply-constrained countries such as Australia and the UK, but higher in many countries such as the US, which has excess supply).
The share of the nation’s population living in its largest cities (very high in Australia but lower in the US, UK, Russia, Japan, India, Germany and China).
So how to determine the underlying course of demand and supply. Thankfully, a number of leading economists and government agencies, such as the Commonwealth Treasury, have recently produced detailed forecasts for both these variables.
Although building approvals in Australia have been plummeting, and housing starts are running at only about 145,000 a year, Treasury projects that Australia’s demand for housing will rise to well over 200,000 homes a year by 2010 driven (in order of importance) by record immigration, natural population growth, and a decline in the number of persons per household. In contrast, Treasury is forecasting that the supply of new homes will be about 150,000–160,000, leading to a major demand-supply imbalance.
Treasury’s analysis is consistent with recent forecasts by ANZ Bank, which is predicting the “mother of all housing booms” (see chart). Like the Treasury, ANZ believe that housing demand will rise to about 200,000 homes a year in 2010, while starts will fall to less than 140,000 properties.
nFigure 3: ANZ Bank, forecast housing demand less supply
Source: economics@ANZ
ANZ’s economists point out that unlike previous construction cycles, where the downturn was characterised by a lot of “spare capacity”, Australia’s building industry looks like it is already suffering from capacity constraints (measured by volume of work still to be done) due to labour and materials shortages.
The supply-side situation has got so bad in NSW, Australia’s biggest housing market, that building approvals for private houses are at a 44-year low despite the state’s population more than doubling in that time.
Based on their published research, other forecasters such as BIS Shrapnel, St. George and CommSec have similar positions on the long-term prospects for house prices.
The bottom line is that any objective analysis of independent forecasts of housing demand and supply will lead to the conclusion that the Australian residential property market is likely to deliver strong capital gains over the medium to long term.
Chirstopher Joye is chief executive of Rismark International, a quantitative real estate funds management business. Graphs supplied by RP Data .
