No bubble but no boom for house prices

After falling 6% from their peak, average capital city house prices seem to be on the way back up again in Australia. The slump in mortgage rates has drowned out the impact of rising unemployment.

While the housing correction has been headed off, with Australian housing remaining very expensive it’s hard to see the housing bubble starting up again.

It seems that Australian house prices have defied fears of big declines in the wake of sharp falls in US and UK house prices. My expectation was for national capital city average house prices to fall 10% or so this year.

After falling 6% or so from their peak around the beginning of 2008 to the March quarter this year, house prices have since started to recover again, with ABS data showing average gains of 4.2% in the June quarter, confirming the rise already seen in various private sector surveys.

The question is – where to from here? Why has the Australian housing market been so resilient? Are we going to see another unsustainable surge in house prices or is the 30% to 40% slump in house prices some were warning of still to come (or both)? And how does housing compare to other potential investments?

Why the resilience?

Despite Australian house prices having had a stronger run up than those in the US and UK, they have fared remarkably well by comparison over the last couple of years. From their peaks US house prices have fallen 32% and UK house prices have fallen 19%.

By comparison, Australian house prices have only had a modest dip and seem to be already on the way back up. Several considerations explain the relative resilience of the Australian housing market. These include Australia’s housing shortage as well as the fact lending standards were far higher in Australia than in the US with the surge in debt focussed on older wealthier Australians and the use of full recourse loans in Australia which provide a powerful incentive to keep servicing a mortgage even when the value of the debt exceeds the home value.

These considerations, along with the view that Australia was not going to have a US style recession, led us to reject the view that house prices would fall 30% to 40% as some were suggesting. Rather, we thought that prices might fall 10% or so, but even this now looks too pessimistic. The big surprise has been that Australia’s economic downturn has turned out to be even more modest than earlier thought.

The economy is yet to have a technical recession and the rise in unemployment has been mild. As such, the generational lows in mortgage rates and the increase in first home owner grants have dominated the housing market.

Outlook

While house prices seem to have turned the corner, we find it hard to see a return to boom time conditions. The positives are that affordability is much improved (see the next chart), Australia is still suffering from a housing shortage and the upswing in most housing related indicators, such as auction clearance rates and housing finance, suggest that confidence has returned to home buyers – both owner occupiers and investors and at the top end as well as the bottom end of the market.

Against this, several factors are likely to constrain the upswing in house prices. Firstly, despite the correction over the last 18 months Australian housing remains expensive.

• In real terms, Australian house prices remain well above their long-term trend. Over the last 80 years the trend rate of growth in real house prices has been 3% per annum, which is consistent with long-term real GDP growth. But since the mid 1990s house price gains have been well above trend growth (see the next chart). The historical experience has been that after a run up in house prices to well above trend, they then spend many years working off the excess (such as in the 1930s or from the early 1970s). This has in fact been occurring in Sydney with average prices having been stagnant for the last five and a half years now.