Australian house prices have had a decent bounce over the last year or so, but this masks a mixed bag both across and within cities.
House price bounce, but a mixed bag nationally
According to ABS data national house prices rose 3.1% in the June quarter and have had a decent 6.4% bounce over the last year. This masks a mixed bag ranging from booming conditions in Perth, on the back of the resources boom, to subdued conditions in Sydney, in the aftermath of the bubble that ended a few years ago.
Even within cities there are divergent trends. For example, the ritzy areas in Sydney remain surprisingly strong as high income earners have continued to do well whereas the western and south western suburbs have seen some big price falls, probably reflecting a greater vulnerability to higher mortgage rates and petrol prices.
Bounce versus sustained recovery
Earlier this year there was a degree of hope that the national property market was on the mend. Housing finance was trending up, sales and auction clearance results were improving and there was hope that a tightening rental market would improve the investment property market. Our view was that whilst there may be a bounce, a sustained recovery was still some time off.[1] This remains our view. There is no doubt that the rental property market is tightening. Vacancy rates are very low, in contrast to the period after the late 1980s housing boom when high and rising vacancy rates only added to the property market’s woes. Low vacancy rates are now feeding into rising rentals and this will eventually lead to an improvement in the investment property market. However, we think the process is likely to be long and drawn out.
A long period of range trading remains most likely
House prices are expected to bounce up and down around a flat trend over several years as the excesses of the last bubble are worked off. There are several reasons for this:
Firstly, Australian housing remains very overvalued:
· Australian house prices remain extremely high relative to average weekly wage earnings. They need to fall about 20% for the ratio of house prices to wages to return to more normal levels. (Note that the chart below allows for a rising trend in this ratio to allow for the increased proportion of double income families.)
It is worth noting that Perth housing is now very unattractive on this measure. After doubling over the last four years, Perth house prices are now second highest to Sydneyamongst the nation’s capital cities. Two years ago average Perth house prices were equal to 6.6 times average Western Australian annual wages which was well below the national average. They now trade on 9.2 times wages which is just above the national average.
· National average house prices remain well above their long-term trend. Since the 1920s Australian house prices have risen on average by 3% pa after inflation. The chart below shows periodic swings above and below this long-term trend with the 1997-2003 upswing leaving us well above trend. To revert to their long-term trend, average house prices still need to fall 18%.
· House prices need to fall about 28% to bring the ratio of house prices to rents (the PE ratio for housing) back to its long-term average (after adjusting for inflation).
Secondly, housing affordability remains too poor to support a strong and sustained rebound in house prices. The key drivers of affordability are house prices, interest rates and household income and these have been combined in the chart below into a housing affordability index (where a fall indicates deterioration in affordability). The recent rises in interest rates, combined with still high house prices relative to wages, have knocked housing affordability back to its late 2003 lows. The housing boom of the 1990s occurred after several years of strongly improving affordability as incomes rose and mortgage rates fell. So far we are yet to see this.
Thirdly, despite rising rents housing rental yields remain extremely low making them unattractive to investors. The average gross rental yield is just 3.2% for houses and 4.3% for units. This compares to a 5.2% grossed up (for franking credits) dividend yield on shares and a 6.25% or so yield available on non-residential property.
Even if low vacancy rates were to result in a 10% rise in average rents this would only push up the average housing rental yield to 3.5% (assuming flat house prices), which is still low. As a result of the low yield it is hard to see investors rushing back into housing in a big way.
Finally, the Reserve Bank remains keen to avoid a surge in housing credit on a scale that would be necessary to get another housing boom underway. It has already lifted interest rates twice this year, citing growth in household debt on both occasions and is threatening to move again. Australia’s high household debt levels mean it is very easy for the RBA to snuff out any housing recovery with higher interest rates. The fall back in auction clearance rates over the last few weeks suggests this is exactly what has happened.
Conclusion
While national house prices have had a reasonable bounce since late last year, we doubt that this will prove sustainable. Australian housing remains very overvalued. Housing affordability remains poor and low rental yields will keep investors away. Rising interest rates with the threat of more to come will also serve to keep many buyers sidelined. The experience after past house price bubbles suggests several years of essentially stagnant house prices are likely until they return to their long-term trend and wages and rents catch up to levels that justify them. We continue to think a long drawn out period of essentially stagnant house prices is more likely than a Japanese-style crash. For a crash to occur, forced selling by home owners would be required and this seems unlikely in the absence of much higher interest rates or unemployment, both of which still seem unlikely. Tight supply and demand conditions evident in declining vacancy rates are also helping to ease the property market adjustment this time around in contrast to the early 1990s.
Within this adjustment it is likely house prices will experience occasional bounces up and down. Of course national trends will continue to mask regional variation and variations within cities. As long as the commodity boom remains in place house price gains in Perth will likely be stronger than the national average, but Perth housing is rapidly losing its attraction.
Dr Shane Oliver, head of investment strategy and chief economist, AMP Capital Investors.*
[1] See “House prices – possible bounce but long term stagnation”, Oliver’s Insights, February 2006.
