Myths - An interesting article.

From: Anony Mouse

Every Reserve Bank cut in official interest rates signals good news for Australia's residential property market. Cheaper finance encourages first-time and repeat buyers alike to purchase a home or investment property. And the more buyers competing for a property, the higher its value becomes-shoring up the property market as a whole.

In short, while the Reserve Bank cuts interest rates to cushion the blow of an economy in decline, they're also providing a springboard for its subsequent upward climb. Why, then, do so many Australians (lay people and specialist commentators alike) believe that a softening economy equates to a lousy outlook for the residential property market?

Myth No 1-Property and the economy are interdependent

Residential property accounts for a substantial proportion of Australia's economic activity. This is why governments use housing finance (representing property's demand side) as a key indicator of the nation's economic health. On the supply side, property also plays a significant role in the economy. Residential sales in Melbourne, for example, totalled $16.33bn in 1999 alone (source: REIV).

However, the fact that residential property and the economy are strongly linked, doesn't mean that the fortunes of one are identical to the fortunes of the other. The property market benefits from a softening economy because its fortunes revolve around supply and demand-i.e. the number of purchasers relative to the number of properties available for sale. So when the economy slows, interest rates usually drop and buyers become more active-stimulating the property market.

Furthermore, property always enjoys an underlying 'baseline' level of demand, regardless of the state of the economy, because everyone needs somewhere to live! Therefore this demand is influenced, not solely dictated, by interest rate decreases in a slowing economic environment.

This is quite a different scenario from shares, for example, which are not essential to everyone's welfare and rely to a large extent on investor sentiment and the fortunes/confidence of private enterprise; both of which are profoundly influenced by the economic situation. If the economy slows and there is less business activity and/or confidence, the value of shares will suffer.

In fact, given the significant financial contribution residential property makes to the economy, and the fact that property values can thrive when the economy is softening, it's probably fair to say that the economy needs residential property more than residential property needs the economy!

Myth No 2-the property market is homogenous

While the residential property market as a whole benefits via interest rate cuts when the economy softens, not all purchasers are equally affected. Their stage of life has a substantial influence on the extent to which economic conditions influence their purchasing decisions.

First homebuyers are the most affected when the economy softens. Usually aged in their 20s and 30s, they are in the formative stages of their career and earning capacity. This means they have a small deposit, and little, if any, equity in other assets. The result? The size of their borrowings, and the value of the property they buy, are considerably greater than their income.

Interest rate cuts (along with the First Home Owner Grant) may encourage some first homebuyers to borrow more for a larger or more desirable property than they could otherwise have afforded. It also means that a larger portion of their loan will go into paying off principal-enabling them to build up equity more quickly.

As time goes on, these buyers 'hit their straps' career-wise and increase their earning capacity. At the same time, they've built up considerable equity in their first home. As lifestyle changes dictate (e.g. having children; wanting to live in more appealing surrounds), they use this equity to enter the middle sector of the market and buy their second home. While the value of this home is often much higher, the equity from the first property minimises their borrowings. At this point in their lives, the gap between their income and borrowings begins to narrow, while their overall equity grows.

Because lifestyle factors are the primary determinants of homebuying decisions for these purchasers, a minor interest rate change here or there is of comparatively little significance to them. Unless interest rates increase or decrease dramatically, activity in this sector remains relatively consistent. This is why the middle sector is the 'stable backbone' of Australia's residential property market.

By the time these buyers reach the top end of the market, however, a softening economy again makes a strong impact on their purchasing decisions. Now at the peak of their careers and commanding a high income, they are likely to have significant equity in assets outside their home. Unlike the first homebuyer and middle sectors of the market, the homes of these purchasers are no longer a key wealth-building vehicle.

However, buyers at this level of the market often understand something that others do not. They know that when regulators cut interest rates, it's because there has been too much money flowing through the economy, increasing inflationary pressures. They know that, contrary to popular belief, interest rate cuts are a concerted effort to make the economy sustainable in the long-term-not a sign of impending doom! So when interest rates drop, confidence increases at the top end of the market and buyers are more likely to borrow to buy an even larger or more prestigious home in a highly sought after area.

Myth No 3-a drop in median values equals a decline in the property market

Once the economy softens and interest rates drop, so do median values published by bodies like State Real Estate Institutes and Valuers-General. So over the next few months of this year, commentators will say that the property market is on the decline. In fact, the opposite should prove true! Heightened activity among first homebuyers off the back of lower interest rates (assisted by the First Home Owner Grant) will increase the number of sales at the lower end of the market, and therefore the proportion of these sales relative to the market as a whole.

Because median values do not distinguish between different sectors of the market, they will indeed drop for a period of time, particularly in suburbs with a high concentration of first homebuyer activity. But this will be a sign of a stabilising economy and a healthy property market-not the gloom and doom so widely predicted.

Furthermore, doomsayers who persist in their doubt will be reassured to know that the drop in median values is only temporary. Once the economic cycle moves to its next (upward) stage and interest rates stabilise or increase, first-homebuyer activity will do likewise-reducing the 'skewing' of median values towards the lower end of the market.

Median values will once again be restored to their exalted (if only partially valid) status as an accurate guide to the strength of the property market in a given locality. Peace will be restored…until the tide turns and the economy changes once again…

By Paul Nugent, Richard Wakelin Property Consulting

© Australian Property Investor magazine. Reprinted with permission

"A government that robs Peter to pay Paul can always count on the support of Paul."
Of course, Paul's support is obvious, but it is equally obvious that to rob from Peter to pay Paul will make Peter
very, very angry.
My question is this: "How can you run a good government with a sore Peter?"
Last edited by a moderator: