Why house prices aren’t on the chopping block

A third major structural change I highlighted was the extra growth in disposable household incomes over the last couple of decades resulting from the emergence of multi-income families (and the rise in the female participation rate) and the decline in Australia’s “non-inflationary” unemployment rate, which is thought to be around 5% today (see the blue and red lines in the chart below).

If, as discussed, these structural shifts have run their course, household earnings will be the main driver of future dwelling price changes. This in turn implies a long-term house price growth rate of about 4% to 5% per annum, assuming normalised productivity growth and more investments in the supply-side (the absence of which could produce higher growth). This is notably less than 7.8% per annum pace that has applied since the mid-1980s.

We tested this position by surveying the top 21 market economists, including the major bulls and bears, on their own outlook. As it happened, the average and median of the forecasts for Australian house price growth over the next 10 years was 4.4% and 5% per annum, respectively.

Another way to resolve this debate is by working out what proportion of Australian house price growth can be explained by incomes and interest rates.  To address this question, Rismark’s research group took the median Australian dwelling price in June 1985 and indexed it up by:

(1) the change ABS disposable incomes per household before interest repayments; and

(2) the change in household borrowing capacity that resulted from movements in mortgage rates (assuming a fixed, 80% loan-to-value ratio and a constant disposable income-to-mortgage repayments ratio).

This “income- and interest rate-adjusted” median dwelling price can then be compared to actual median prices over time. The next chart presents the results of the analysis.

Observe how the confluence of rising household incomes and declining mortgage rates over the 1990s meant that “purchasing power-adjusted” median house prices (black line) rose to be well above actual median prices (red line) for the entirety of the period between 1993 and 2003.

It was only in the years after 2003 that the median price implied by changes in purchasing power and actual prices started to diverge, a trend that was brought to a halt by the 2007-08 crisis.

Today we find that around 88% of the change in Australian housing costs since 1985 can be explained by mortgage rates and household incomes.

Here it should be noted that these are two “demand-side” variables, and asset prices are ultimately determined by the intersection between demand and supply.

Demand- and supply-side factors not accounted for in this work include shifts in household preferences – there is, for example, evidence that families are willing to spend more of their incomes on buying housing services because it is a “superior good” – and, of course, the availability of housing assets (i.e., supply) to satisfy demand-side needs. The latter refers to both the quantum of homes listed for sale (ie., effective supply) and the number of dwelling required to practically accommodate the resident population (underlying supply).

ANZ’s economists recently completed a similar exercise using capital city median prices (in contrast to our all regions price) and a slightly different treatment of mortgage rates. In particular, ANZ “smoothed out” movements in mortgage rates over time to capture the underlying structural change.

ANZ’s results are nevertheless very similar. They find that the median house prices imputed by increases in purchasing power (via incomes and interest rates) sat well above transacted prices between 1993 and 2003. As at 2011, ANZ’s analysis could explain 93% of the total change in dwelling prices since 1986 (see the next chart below).

While the powerful long-run relationship between house prices and household purchasing power will continue to hold, there is inevitably significant year-on-year variability.

In 2007, Australian capital city dwelling prices rose by 13.6%. In 2008 they fell by 2.5%. In 2009 and 2010 they appreciated again by 12.1% and 5.3%, respectively. Yet if we look over the span of the last seven to eight years, we find that the average growth in housing costs and incomes has been nearly identical.

This year dwelling prices look like they will be down a bit, unless the RBA starts cutting rates, as Westpac, Goldman Sachs and Deutsche Bank expect they will.

In addition to the fact that in November 2010 the RBA boosted rates to a level above their historical average, the principal driver of the soft conditions in 2011 has been the exceedingly “hawkish” Australian consumer.

In February Australians expected, on average, more than three further rate hikes (i.e., an 8.5%-plus mortgage rate), according to Westpac-Melbourne Institute analysis.

Even in the midst of the recent financial market turbulence, consumers were still banking on two more rate hikes when surveyed in August. A remarkable 29% of all respondents thought there would be more than four future hikes.

When Australians eventually buy into the idea that rates are not heading higher, housing market conditions will likely improve.

Christopher Joye is a leading financial economist and works with Rismark International. Rismark and RP Data provide house price analytics products, and solutions that enable investors to go long and/or short the housing market. The above article is not investment advice.

This article first appeared on Property Observer.