Australian House Prices - at the extreme

Introduction

The case for the RBA resuming interest  rate cuts this year has been fairly clear: commodity prices have fallen more than  expected; the $A has remained relatively high; while residential construction  and consumer spending are okay the outlook for business investment has deteriorated pointing to overall growth remaining sub-par; and inflation is  low. This has seen the cash rate fall to 2.25%. While the RBA left rates on  hold at its April meeting, it retains an easing bias pointing to further cuts  ahead.

However, the main argument against further  rate cuts has been that the housing market is too hot and further rate cuts risk pushing home prices to more unsustainable levels resulting in a more damaging  eventual collapse. But how real is this concern? 

Housing construction doing its part…

Economic upswings in Australia rarely start without a housing upswing. Lower  interest rates drive housing demand resulting in higher house prices which  boosts consumer spending via wealth effects and drives home building. The  latter is happening with approvals to build new homes at record levels.

  Source:  Bloomberg, AMP Capital 

…but what about overheated property  prices?

But the big debate has been whether low rates are  just fuelling an overheated property market. Its long been known that Australian housing is expensive and overvalued. 

  
Real house prices have been running well above trend  since the early 1990s and are now 14% above it.  

  Source:  ABS, AMP Capital 

  
According to the 2015  Demographia Housing Affordability Survey the median multiple of house prices to  household income in Australia is 6.4 times versus 3.6 in the US and 4.7 in the  UK. In Sydney its 9.8 and 8.7 in Melbourne.
  
The ratios of house  prices to incomes and to rents are at the high end of comparable countries in  the OECD. 

While it's generally agreed Australian property  prices are high, the reasons for it are subject to much debate with many looking for scapegoats in the form of negative gearing and buying by foreigners  and SMSF funds. However, these don't really stack up: negative gearing has been around for a long time and while foreign and SMSF buying has played a role it  looks to be small and foreign buying is concentrated in certain areas. 

The shift to low interest rates since the early  1990s has clearly played a role. Consistent with this, the rise in price levels  from below to above trend has gone hand in hand with increased household debt.  The trouble is that other countries have lower levels of interest rates and  most have lower household debt to income ratios and house price to income  ratios. A more fundamental factor is constrained supply. Vacancy rates remain low and there has been a cumulative supply shortfall since 2001 of more than 200,000  dwellings. The main reason behind the slow supply response appears to be tough  land use regulations in Australia compared to other countries.

High house prices compared to rents and incomes  combined with relatively high household debt to income ratios suggest Australia  is vulnerable on this front should something threaten the ability of households  to service their mortgages. While this vulnerability has been around since the  house price boom that ran into 2003 – with numerous failed predictions of  property crashes! – the RBA is right to be concerned not to further inflate the property market. The renewed strength in auction clearance rates this year to record  levels in Sydney is a concern. 

  Source: Australian Property Monitors, AMP Capital 

However,  there are some offsetting factors. First, home price gains are now narrowly  focussed on Sydney. According to CoreLogic RP Data Sydney home prices rose  13.9% over the year to March. But growth across the other capital cities ranged  from 5.6% in Melbourne to -0.8% in Darwin with an average of just 1.5%. So, the  rest of the Australia is hardly strong. 

  Source: CoreLogic RP Data, AMP Capital

Second, growth  in housing debt is running well below the pace seen last decade, and there are some signs of a loss of momentum in the last few months.Investor debt is up  10.1% year on year but reached around 30% through 2003 and in the last few months has slowed to an annualised pace of 9.3%. 

  Source: RBA, AMP Capital

Finally, the RBA and APRA have pushed down the macro prudential path to contain risks around housing.Tougher APRA expectations of  banks were announced in December with the threat of sanctions if these expectations are not met.

So while the RBA is right to be mindful of the  impact of low interest rates on the property market, the concentration of the  property market strength in just Sydney, the signs of a possible topping in investor property loan growth and the heightened role of APRA indicates that  the property market should not be a constraint on further RBA interest rate  cuts. As the RBA has pointed out in the past it needs to set interest rates for  the "average" of the economy. And the "average"still points to the need  for lower interest rates as the slump in mining investment intensifies, non-mining investment remains weak, iron ore prices are down another 23% since  the February RBA cut, the outlook remains for sub trend growth and ongoing spare  capacity in the economy and inflation remains benign. This points to the need  for further rate cuts to provide a direct boost to spending and an indirect  boost via the inducement to a lower Australian dollar. Expect the cash rate to  fall to 2% in May with a strong possibility rates will fall below that later  this year.  

Housing as an investment

Over the very long term residential property adjusted for costs has provided a similar return for investors as Australian shares. Since the 1920s housing has returned 11.1%  pa compared to 11.5% pa from shares. See the next chart. 

  Source: ABS, REIA, Global Financial Data, AMP Capital  Investors

They also  offer complimentary characteristics: shares are highly liquid and easy to diversify but more volatile whereas property is illiquid but less volatile. And share and property returns tend to have low correlations with each other so  including both offers diversification benefits. As a result there is a case for  investors to have both in their portfolios over the long term. 

In the short  term, low interest rates point to further gains in home prices. However, this is likely to be constrained by the economic environment and the impact of  tougher prudential scrutiny of bank lending by APRA. Over the next 12 months  home price gains are likely to average around 5%, maybe a bit stronger in  Sydney and Melbourne (key beneficiaries of the post mining boom rebalancing) but staying negative in Perth and Darwin (as the mining bust continues). 

The residential property outlook for the next 5-10 years though is messy. Housing is expensive on all metrics and offers very low rental yields compared to all other assets except bank deposits and Government bonds. The gross rental yield on housing is around 2.9% (after costs this is around 1%), compared to yields of 6% on commercial property and 5.7% for Australian shares  (with franking credits). See the next chart. 

  Source: Bloomberg, REIA, AMP Capital

This means that the income flow an investment in housing generates is very low compared to shares and commercial property so a housing investor is more dependent on capital growth to generate a decent return. So for an investor, these other  assets continue to represent better value.