Australian property: overvalued but undersupplied

The Australian housing market has been heating up again. But can it continue? The outlook for house prices is very important for Australians and the Australian economy. Housing is the biggest investment most families undertake, poor affordability has significant social consequences and the unwinding of high house prices in the US shows the economic damage it can cause.

Australian house prices on the rise again

Australian house prices rose 13.6% last year and their strength seems to have continued into this year. House prices in Australia have performed far better than those in the UK and US over the last few years, thanks in large part to the stronger performance of the Australian economy. They are even stronger than China where house prices are up 10.7% over the last year. So where to from here?

Australian housing is expensive and overvalued…

On most measures Australian housing is very expensive.

Australian house prices are well above their long term trend. Over the last 80 years the trend rate of growth in real house prices has been 3% per annum, which is consistent with long term real GDP growth. But since the mid 1990s house prices have risen well above trend and remain there.

It’s possible to rationalise the strength in house prices over the last 15 years on the grounds that house price to income ratios have been pushed up by the growth of two income families, lower interest rates on the back of the shift to low inflation, and financial deregulation, all of which have increased the amount of money people can borrow and hence pay for a house. However, while this may be true it fails to explain why Australian house prices are so high on international comparisons, given these considerations also apply in other countries. According to the 2010 Demographia International Housing Affordability Survey, Australian housing trades on a median multiple of house prices to annual household income of 6.8 times, compared to 5.1 times in the UK and just 2.9 times in the US. According to the OECD using 2009 data the ratio of house prices to incomes is about 35% above its long term average which puts it at the top of end of comparable countries.

Similarly, house prices are high relative to rents. According to the OECD the ratio of house prices to rents in Australia is 58% above its long term average. This is well above most other comparable countries. It is reflected in a gross rental yield of just 3.5% on houses and 4.5% on units, which is well below the 7% plus net rental yield available on directly held commercial property.

Finally, the rise in house price to income ratios over the last 20 years has gone hand in hand with a large rise in household debt. In 1990 the ratio of household debt to annual household disposable income in Australia was less than 40% and at the low end of OECD countries. Now it is 155% and at the high end of OECD countries. Naturally, this has led some to fret that the Australian housing market is a giant bubble at risk of collapsing at some point.

… but it is also undersupplied

However, as has been apparent over the last couple of years, there are a number of positives underpinning the Australian housing market. The big positive for Australian house prices is a major undersupply of housing. The last few years has seen the supply of dwellings lag underlying demand. This reflects both a surge in demand on the back of record immigration levels but also restrictive development laws which have constrained supply, and the GFC which has constrained finance for developers. Cumulative under building over the last few years is probably around 120,000 dwellings. This year Australia will probably start about 165,000 dwellings but underlying demand will be around 200,000. The undersupply is reflected in continuing low vacancy rates in rental housing. Under building contrasts with the massive housing oversupply that arose during the US housing boom.

On top of this, the Australian housing market didn’t see the same deterioration in lending standards that occurred inother countries. Homeownership rates haven’t increased – in fact they have fallen for the typical first home buyer age group. Most of the increase in mortgage debt over the last few decades went to older and wealthier Australians and this is all reflected in a relatively low mortgage arrears rate despite the debt increase.

So these factors are helping to support Australian house prices despite the fact they are relatively expensive.

Outlook

The intersection of high house prices with high household debt levels leaves Australia vulnerable. However, in the absence of a big surge in the supply of dwellings or a serious threat to the ability of Australians to service their loans – either through much higher unemployment or interest rates – a sharp fall in house prices is unlikely. In fact, none of these seem likely any time soon.

In terms of the year ahead, strong auction clearance rates but softening housing finance present a mixed picture. Further gains in average house prices are likely as employment is rising and while interest rates are on the way up they are still well below previous highs. For example, the standard variable rate is currently averaging around 6.9%, compared to the 2008 peak of 9.6%. However, the ending of the first home owners boost and the renewed deterioration in housing affordability suggest gains will be constrained. Affordability improved dramatically into mid-2009, mainly due to a 40% collapse in mortgage rates. With house prices now back at record levels and mortgage rates on the rise again, affordability is pushing back to previous lows and likely to weaken further.

Our assessment remains that average house price gains will slow to around 5% over the year ahead. Middle to upper end housing could be a bit stronger as it is less sensitive to mortgage rates but will clearly benefit from higher employment and rising overall wealth levels. Low end housing could see prices soften given a greater sensitivity to mortgage rate increases, the ending of the first home owners boost and weakness in first home buyer demand after last year’s pull forward.

Concluding comments

High house prices and high household debt levels remain Australia’s Achilles heel. A renewed deterioration in affordability is also a big negative. However, given constrained supply, low levels of mortgage stress and the improving economy the most likely outcome is for constrained gains over the year ahead.

Dr Shane Oliver is head of investment strategy and chief economist at AMP Capital Investors