SMH synopsis of why house prices rise

From: Michael Croft


What follows is a pretty good article on why house prices have risen and the likely future outcome. One thing not mentioned in the article is household formation and heads per house hold. In the last 40 years as a nation we have gone from 3.3 heads per house hold to 1.7. What this means is that we need nearly twice as many dwellings in 2002 to accommodate the same number of people - this has been a huge influence.

Sorry about the long post.

Michael Croft

It's true: location is still the bottom line

Ross Gittings, Sydney Morning Herald

House prices in capital cities have been rising rapidly for 30 years or so. Ross Gittins asks why.

For the property-owning burghers of Sydney and Melbourne, the age of miracles hasn't passed. You just sit back and watch while the skyrocketing value of your home turns you into a millionaire. (Not there yet? Be patient - it may take another year or two.)

There are few economic topics of more absorbing interest to the urban middle class than the value of their homes, and most of us like to think we know a fair bit about the subject.

But have you ever asked yourself why it is that house prices have been rising so rapidly? And I don't just mean the remarkable increase over the past year or two. Capital city house prices have been rising way faster than most other prices for at least the past 30 or 40 years.

Why? After all, the cost of actually building new homes hasn't been rising at an extraordinary rate. Figuring out why property prices have risen so much in the past is the first step towards answering the burning question of whether they can keep it up in future.

In what follows, I'll be drawing heavily on a most enlightening article by Chris Richardson in the February issue of Access Economics' Economics Monitor.

His key insight is that it's not so much the value of homes that's been rising as the value of the land they stand on (or, in the case of units, the air space they occupy).

The fundamental explanation is that we've had a growing population with ever-rising real incomes competing for a relatively fixed supply of land. What happens when growing demand meets fixed supply? The price rises.

The supply of ordinary goods and services is completely flexible. Businesses can produce as many or as few haircuts or motor cars as their customers demand. So the prices of such things don't rise all that much over the years. But land is different.

You may find it hard to accept that the supply of land is fixed in a country as vast and lightly populated as ours. And you'd have a point if we were indifferent to where we lived.

In fact, we have strong preferences about "location", as the estate agents call it. Most of us want to live in the big, coastal capital cities. And, generally speaking, the bigger the city, the more desired it is.

Over the past 15 years, established-house prices have risen 230 per cent in Sydney and 190 per cent in Melbourne, but 140 per cent in Brisbane and Perth, and by only 70 per cent in Adelaide and Hobart.

Within a particular city, we want to live on the harbour or near the beach and, above all, not too far from the CBD. So you see how our preferences limit supply. Supply is less of a constraint on the outskirts of a city - but that's because few of us want to live that far out.

The supply of land within a set distance of the GPO is fixed - though, to a limited extent, we can increase the supply of dwellings by turning old warehouses into loft apartments or knocking down bungalows to build blocks of units.

Competing for this relatively fixed supply of desirably located land has been an ever-increasing population. Richardson reminds us that, over the past 40 years, Australia's population has grown by 9 million - a 90 per cent increase.

But it's not just more people, it's more people each with more to spend. Australians' real income per person has grown by more than 45 per cent over the past 20 years. How? By our higher productivity - by the steadily improved efficiency with which we produce our goods and services.

What do Aussies (and most other nationalities) think when they realise their income's increased? Not, now I can eat bigger meals, but, now I can afford a bigger and better home.

When more people spend more money on a relatively fixed supply of desirable housing, however, you get a certain amount of improvement in size and quality, but a lot of the money goes on bidding up the prices paid for established homes.

One factor that's done a lot to drive the present boom in house prices is the fall in mortgage interest rates to their lowest level in 30 years. Richardson estimates that, compared with 1996, the dollar cost of a home loan has fallen by almost 30 per cent. If you allow for inflation, the "real" cost has fallen by about half.

So, many of us have taken advantage of the lower cost of borrowing to borrow a lot more. Over the past five years, the size of the average new mortgage - nationwide - has grown by 40 per cent to about $150,000. But much of that increased borrowing power has served merely to push up the prices of established homes.

It's a similar story with the trend to two-income households. When the first couples decided it would be a good idea for the wife to take paid employment, this gave them a considerable advantage in the housing status race. Their combined incomes allowed them to afford the repayments on a much bigger and better house than other couples.

But once most other couples joined in, the advantage was lost. The main effect of two-income couples' greater purchasing power was to force up the prices of the sorts of houses couples buy. Now, couples who want to keep up with the Joneses have less choice about whether the wife takes paid employment.

So what does all this tell us about the future of house prices? Can they keep rising at the rate they have been in the past year or two?

No, of course not. We know that house prices have always moved in cycles of boom and bust. They grow like mad for a couple of years, then stop dead and maybe even fall back a bit. After a few years they start rising moderately, before eventually going mad again.

The present boom has been fuelled by the very low mortgage rates, which have also prompted a great burst of investment in rental properties - so much so that vacancy rates for rental properties are high and rising.

The boom may bust this year - or it may roll on until, sometime next year, the Reserve Bank starts putting interest rates back up towards more normal levels. Richardson sees rates rising by about 1.5 percentage points next year.

But if we raise our eyes beyond the next few years and we average out the cyclical ups and downs in prices, the answer to the question of whether house prices are likely to continue growing significantly faster than prices for goods and services is, yes, of course they will.

Population growth will be slower - about 4.5 million over the next 40 years, according to Richardson's projection - and the rise in real income may be more modest, but we'll still have the classic situation of more people with more money pressing on a relatively fixed supply of desirable land.

Within that general climate, it will be a matter - as always - of making sure you've picked the right location, location, location.
 
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