Why weak house prices make a rate rise dangerous: Oliver

So far this year the Australian residential housing market is off to a poor start. House prices are down 2% or so, auction clearance rates are well below levels of a year ago, and housing finance is weak. Is this the start of the Australian house price crash some have been predicting or a correction after a near 20% gain in prices over the year to the March quarter last year? And what does it mean for interest rates?

Between a rock and a hard place

I don’t regard Australian house prices as a bubble. While there was probably a bubble seven or eight years ago, apart from overvaluation there has recently been little sign of the excesses that characterise a bubble: housing credit has been soft, investors have been sidelined, buyers have been restrained and lending standards have not deteriorated. Just as Australians have been sceptical about shares in recent years, they have also been sceptical about real estate, with only 16% of Australians seeing real estate as the wisest place for savings. Hardly the stuff of bubbles!

That said, I still regard high house prices as Australia’s Achilles heel. And the reason is simple. Reflecting a huge surge in house prices into 2003/2004 and solid gains since, Australian housing is way overvalued. This has gone hand in hand with a massive increase in household debt.

Signs of overvaluation are evident virtually everywhere:

• Despite recent softness, Australian house prices are still running around 25% above their long term trend.

• According to the OECD, the ratio of house prices to incomes is 34% above its long term average, and the ratio of house prices to rents is 50% above its long term average, both being at the top end of OECD countries.

• According to the 2011 Demographia International Housing Affordability Survey, Australian housing trades on a median multiple of house prices to annual household income which is double that of the US.

• To give some examples, in Los Angeles median house prices are $US345,600, whereas in Sydney they are $US634,300. In Austin, in oil rich Texas, median house prices are $US189,100, whereas in Perth in resource rich WA, median house prices are $480,000.

• Finally, housing looks expensive relative to other assets. It has been argued the surge in house price to income ratios over the last 20 years reflects the adjustment to lower interest rates, which have made higher debt to income levels possible. This is clearly part of it, but it’s worth noting that rental yields on housing have fallen much more than yields on other investments which have also adjusted to low inflation. Right now the gross rental yield on housing is around 3.4%, compared to yields of 7% on unlisted commercial property, 6% for listed property (or A-REITs) and 5% for Australian shares (with franking credits). So for an investor, these other assets represent much better value.

Related to this the debt to income ratio has gone up much more in Australia than in other comparable OECD countries which also went through an adjustment from high inflation to low inflation over the last two decades.

The overvaluation in Australian housing leaves it vulnerable to anything that leads to an increase in dwelling supply or threatens the ability of homeowners to service their mortages. At present there is no threat on the supply side.

Australia chronically needs faster land release to speed up dwelling supply. According to the National Housing Supply Council, Australia has a cumulative net shortfall of 200,000 dwellings. While underlying demand has slowed with the decline in population growth over the last two years, to around 160,000 dwellings per annum, the recent slump in building approvals suggests supply is now likely to run well below this over the year ahead, with little sign of any recovery. The undersupply is evident in chronically low rental vacancy rates and rising rents.

The two threats to watch out for are China and interest rates. A sharp collapse in Chinese growth could trigger reduced export income and higher unemployment. China has been battling an inflation problem, and there is a risk it could over tighten. While this seems unlikely given its track record of wanting to avoid the social unrest that goes with a hard landing, it’s worth keeping an eye on.

The interest rate threat is more worrying. The Reserve Bank has indicated interest rates are likely to rise “at some point” if the economy unfolds as expected. In other words, if the global recovery carries on and the mining boom continues to heat up, its likely rates will need to rise again to make room for the mining boom without causing the economy to overheat. Four interest rate hikes, as some are suggesting, would knock affordability to a new record low.

The problem is that the combination of poor retail sales, low levels of confidence regarding household finances and falling house prices suggests households are struggling with current interest rates. Australian banks are now indicating that while overall mortgage arrears remain low, they are rising, with older home borrowers rapidly reducing their debt while newer borrowers are starting to fall behind in their payments. Further interest rate hikes, particularly before the economy has recovered from the current soft patch, risk knocking households over the edge and with them house prices. It would be best for the RBA to wait a while and then assess.

For house prices, the most likely outcome is an extended period of constrained range bound prices so income levels can catch up, but the risks are on the downside, particularly if interest rates rise much further.

Thanks to massive overvaluation and poor affordability, Australian house prices remain vulnerable to further weakness. A Chinese hard landing and excessive RBA interest rate hikes are the key things to watch.