The housing market is cyclical and at some point, given the tendency for some over-shoot, a correction in prices normally follows a boom. The debate is over timing and magnitudes, and there will be varying views. In terms of “fundamentals”, the two drivers of prices are rents (or demand /supply factors that drive rents) and interest rates. Both have contributed to the rise in house prices in the Sydney and Melbourne markets. Both are expected to provide less support for prices in the period ahead.
Rents – key variable to watch
Rents are sensitive to the vacancy rate which is a product of the rate of growth in population (key driver of underlying demand) and the rate of growth in the dwelling stock (supply). Until 2016, NSW/Sydney has experienced a 10 year period in which population (/household*) growth had been faster than stock growth. (Figure 1) This lead to a tightening in the vacancy rate and a period of historically high growth in rents. (Figure 2)
The rate of growth in stock is a function of completions which in the case of units lag starts by much longer than detached houses. The high level of units in this cycle does make it different to past cycles.
In 2016, the rate of growth in dwelling stock (1.6% pa) marginally outpaced population growth (1.4%). In 2017 and 2018, completions will catch up with the previous high level of starts and this will see the rate of growth in the housing stock increase to about 1.8% per annum for the next 2-3 years.
While rents are sensitive to changes in the vacancy rate, to date rent growth has continued to be positive. However, as the period of high stock growth causes the vacancy rate to rise, rent growth can be expected to weaken. This will be a KEY variable to watch.
In the post-GFC period, the quantitative easings by world central banks has seen interest rates fall to low levels and this has been a significant factor in asset prices rising worldwide (share markets but also house prices). We would note that the RBA avoided following with its own quantitative easing and interest rates in Australia are higher than those in other developed economies, e.g. the US or Canada.
During the second phase of the resources boom (2009-12), interest rates in Australia were substantially higher than in other developed economies. The RBA was tightening and this was acting as a constraint on housing activity and prices. Then, in response to the end of the resources boom, the RBA cut interest rates aggressively, looking to housing to help fill the growth gap created by the collapse in mining investment. This strategy appears to have succeeded.
On reflection, the RBA appears to regret the two 0.25% cuts in interest rates it made in 2016. It now almost certain that the bottom in interest rates has been passed. Recent increases in interest rates for owner-occupied loans by the banks, coupled with increased margins applied to investors, mean that interest rates will be marginally higher in 2017. In addition, the pressure applied by APRA on loan growth, on top of a natural caution by the banks, means that the effective cost of money in 2017 will be higher.
The question is whether prices have overshot?
In asset markets, the past tends to be an influence on expectations for the future. This is certainly the case in the housing market. Investors/buyers observe past price movements and, if they persist for a time, build that into their expectations for the future. And those expectations feed into buyers (for a time) continuing to bid up a market.
The original movement in prices might have been justified by the change in interest rates or change in demand (population/income) leading to a change in rent growth, but the momentum it builds up can lead to over-shooting. Robert Shiller would describe this behaviour as irrational exuberance. If the over-shooting has prices substantially out of line with equilibrium, then we can say that “irrational exuberance” has lead to a bubble.
Reserve Bank View
The RBA sees the housing market as cyclical in terms of both activity and prices. It is comfortable with periods of rising and falling prices. What it would not like is an extreme cycle which is disruptive to the aggregate economy and, related to that, to the financial stability of households and banks.
While there have been many alarmist reports forecasting major downturns in the housing market (including plenty preceding the 2012-16 rise), the Reserve Bank of Australia has until recently been largely comfortable with the rise in prices. That is, it has seen the rise in the Sydney and Melbourne markets as very largely explainable in terms of fundamentals (rents up, interest rates down). Figure 3 indicates the relationship between (declining) interest rates and the rent-price ratio (yield) – the relationship is not precise but the broad trend in both can be seen. Comparing rent-price ratios with their past average, and not accounting for lower interest rates, is a fairly basic error made in a lot of the more alarmist reports.
More recently, the flavour of RBA comments indicates that the rise in prices which has occurred since mid-2016 is causing it some concern. That is, it now sees a higher risk of some over-shooting in the market.
Our view of the market is we would have been much happier if the market had peaked in late 2015/early 2016. We expect the market to lose its current momentum in 2017 as it factors in the end of the easing cycle and the increase in supply coming into the market, with potential for a correction. A fall of 5-10% would not be outside historical precedents and any further rises will add to the downside risks.
We do not expect the RBA to follow the US Federal Reserve in lifting interest rates this year. The RBA’s path to higher interest rates will be dictated by domestic conditions. It will only lift interest rates if the economy proves to be much stronger in 2017 and 2018. And, if that were the case, the stronger economy would be positive for the housing market. That is, interest rate changes do not happen in isolation.
Nonetheless, all cycles are different, and the end of the boom will create its own uncertainties and risks for players.
*Note. In the period 2001-11, there has been no material change in the ratio of persons per household, so population growth = household growth is a sensible assumption.
NSW – Growth in Dwelling Stock and Households 2000-2016
Sydney House Rent-Price Ratio vs Measures of Real Interest Rates 1986-2017
About the author:
Dr Nigel Stapledon Chief Advisor
Nigel has a PhD in Economics from UNSW and a Bachelor of Economics with Honours from the University of Adelaide. He started his career in Canberra, where he worked in the Commonwealth Treasury, following this he worked at Westpac where he was Chief Economist. Nigel has been at UNSW Business School since 2003 where he completed a PhD on the long-run history of house prices in Australia. Nigel is a regular commentator in the media on macro-economics and housing., contact Nigel on 02 9221 5211 or email@example.com