House prices and debt – Achilles heel

OPINION: HOW house prices behave over the year ahead will likely be a key determinant of how well Australia weathers the global financial crisis and recession now embracing the rest of the world.

Introduction

In several ways, Australia is better placed than many other countries to withstand the global recession now underway. We have plenty of scope for fiscal and monetary stimulus, our financial system is still operating comparatively well and growth in our trading partners is slowing but will be above that in the US, Europe and Japan. However, there is one area where Australia is particularly vulnerable and this is the intersection of high household debt levels and high house prices. If house prices slide too much, then we risk entering a sort of debt-deflation spiral where sliding house prices trigger further falls in spending which in turn trigger further increases in unemployment, further falls in house prices, and so on. So far this year the Australian housing market has started to slow with house prices off by two to four per cent from their recent high.

US and UK house prices on the slide

The last decade has seen a massive surge in house prices in many countries. The surge in Australian house prices relative to income levels has gone hand in hand with a massive rise in household debt, as evident below.

Source: Thomson Financial, AMP Capital Investors

This has been the same in other countries, except that the rise in household debt has been much faster in Australia and so we have gone from the bottom of the pack in terms of comparable countries to the top. See the chart below.

Source: OECD, ABS, Thomson Financial, AMP Capital Investors

Similarly, the gains in Australian house prices have been greater than in many other countries. See chart below.

Source: Case-Shiller, Nationwide, ABS, AMP Capital Investors

From their highs, US house prices are off 20% and UK house prices have fallen 12% or so and they are still falling. The slump in house prices is weighing heavily on consumer spending in both countries because it leads to a loss of wealth and has stopped the phenomenon of mortgage equity withdrawal.

The case for optimism on house prices

Despite all this, many would argue that there are good reasons for optimism regarding Australian house prices.  Firstly, while America’s housing boom ended because of an oversupply of housing, Australia has a huge shortage. This is reflected in 1% or so vacancy rates for rental properties and 10% pa rental growth.

Secondly, whereas the US housing boom saw a huge reduction in lending standards with more marginal borrowers getting finance, in Australia the surge in borrowing was focused on existing home owners trading up who tend to be older with higher incomes.

Thirdly, the slump in US house prices may have been accentuated by non-recourse mortgages which result in a strong incentive for home owners to hand over the keys once the house value falls below the value of the loan. This is not the case in Australia where full recourse mortgages provide a powerful incentive to keep servicing the loan.

Fourthly, it’s argued that the fall in mortgage interest rates of nearly 2 percentage points since early September combined with increased first home owners’ grants will spur an upswing in Australian house prices.

Finally, if the economy is better able to withstand the global recession for the reasons noted in the introduction then demand for housing should be underpinned.

Reasons for caution on house prices

However, against this there are several reasons to expect further weakness in house prices going forward.

Firstly, despite the turn in the cycle to falling mortgage rates most housing related indicators remain very weak. Housing finance is continuing to fall, new home sales are falling and weekly auction clearance rates are running 20 to 30 percentage points below year ago levels even two months after the first rate cut.

Secondly, past periods of house price strength have commenced when housing affordability is good, whereas affordability today is poor despite falls in mortgage rates. This is because house prices remain so high. 

Source: Commonwealth Bank/HIA. REIA, AMP Capital Investors

Thirdly, despite recent softness Australian housing remains very overvalued – by an average 23%.

·       In real terms (ie, after inflation), Australian house prices remain well above their long term trend (by 23%). Over the last 80 years or so the trend rate of growth in real house prices has been 3.1% per annum, which is consistent with long term real GDP growth around the same level. But since the mid 1990s house price gains have been well above trend growth. See the next chart.

Source: ABS, AMP Capital Investors

·       Average Australian house prices remain very high relative to average weekly wages and need to fall about 22% to return to more normal levels. The ratio of house prices to median household income in Australia is more than double what it is in the US.

·       Despite strong growth in rents, rental yields remain very low. Gross rental yields of 3.6% for houses and 5% for units are well below the 6.5% plus net rental yields available on directly held commercial property, the 10% distribution yields on listed property trusts and a grossed up dividend yield of over 7% available on Australian shares. House prices would need to fall about 25% to bring the ratio of house prices to rents (adjusted for inflation) back to its long term average.

Finally, at a time when housing affordability is poor, household debt levels are high and house prices are overvalued, rising unemployment poses a significant threat to house prices. Into 2010 we see the unemployment rate rising to 6.5% or higher. This is likely to result in an increase in mortgage delinquencies and greater caution on the part of prospective new home buyers who are likely to be less certain about their future employment. The chart below shows the relationship between real house prices in Australia (house prices adjusted for inflation) and the unemployment rate. It can be seen that the rise in unemployment associated with the early 1980’s and early 1990’s recessions contributed to significant falls in real house price. Although this was masked by much higher inflation back then, real house prices fell 12% in the early 1980s and by 20% in the early 1990s.

Source: Thomson Financial, REIA, AMP Capital Investors

This time around we don’t have the same high level of inflation to mask falling house prices in real terms. More importantly, while the quality of Australian mortgagees may be higher than in the US, the level of indebtedness underpinning the housing market is far greater than prior to the last two recessions and house prices were not as overvalued. This would suggest house prices may now be much more sensitive to rising unemployment than was the case in the early 1980s and early 1990s.

Concluding comments

Earlier this year it was rising interest rates threatening the housing market. Now it’s the economic downturn and rising unemployment. Coming at a time when affordability is poor, housing is overvalued and debt levels are very high, our assessment is that house prices are likely to fall further over the year ahead. Barring a very deep recession or depression, 40% falls in house prices are unlikely. But with the economy on track for a mild recession, and if not then a very serious slowdown, house prices are likely to fall 10-15% over the next year or so. This in turn will put further downwards pressure on consumer spending going forward and drive further sharp interest rate cuts.

By Dr Shane Oliver, head of investment strategy and chief economist with AMP Capital Investors.*

Australian Property Journal