National average house prices are up about 9% over the last year, with even Sydney on the rise. However, the outlook is messy. The main positive for house prices is an undersupply of housing. Against this, Australian housing remains very overvalued, affordability is poor, mortgage stress is at record levels and interest rates are still rising, not falling.
Recent sharemarket falls have not yet been enough to drive a 1987–89 style investor rotation into housing. The current problems in US housing, where housing is cheaper than in Australia, highlight the risks.
With spring upon us, auction clearance rates running well above levels of a year ago, house prices re-accelerating in all capital cities (except Perth and Darwin) and shares having a case of the shakes, it is natural to wonder whether the boom-like conditions of a few years ago are set to return.
Over the past year or so national average house prices have been rising at an annual rate of about 9%. But this masks divergent trends. Whereas the boom cities of the past few years (Perth and Darwin) have been slowing down, all of the other cities that had a soft patch through 2004 and 2005 have started to accelerate again, including Sydney. Within cities big divergences also remain. For example, Sydney’s coastal suburbs, inner city and North Shore are experiencing solid conditions compared to very weak conditions in the western suburbs.
National house prices up, but this masks divergent trends
While recent trends have been favourable the outlook for house prices remains pretty murky.
The big positive for Australian house prices is the chronic lack of supply. Housing construction is currently running around 25,000 dwellings a year below annual underlying demand. In Sydney, the shortfall is about 10,000 dwellings a year. The shortage of housing is evident in very low rental vacancy rates and rising rents.
Low vacancy rates are pushing up rents (average of six capitals)
In addition to this, it is possible that Australians have become used to living with the rise in mortgage rates over the last few years. Low unemployment, solid wages growth and tax cuts have also provided an offset.
The combination of strong economic conditions and demand for houses exceeding supply is supportive of further gains in house prices. Sharemarket wobbles might also be helpful for house prices if they are sustained.
However, while there are a number of positives for house prices there are a few negatives, too.
First, Australian house prices still haven’t corrected the overvaluation from the housing boom earlier this decade. This took them well above their long-term trend and they are now about 28% above trend. See chart below.
House prices remain well above trend
Similarly, house prices remain very high relative to household income. Median Australian house prices are running around 6.6 times median household income compared to about 3.7 times in the US. And the relatively high ratio of house prices to income in Australia can’t just be put down to low interest rates compared to, say, two decades ago; US mortgage interest rates are actually lower than Australian interest rates.
Second, housing affordability is very poor. The key drivers of affordability are house prices, interest rates and household income. The interest rate increases of the past few years, along with the recent rises in house prices relative to wages, have pushed housing affordability back down sharply. It is now at record lows in terms of the Commonwealth Bank/Housing Industry Association Housing Affordability Index shown in the chart below.
Poor housing affordability will contrain house prices
Third, despite rising rents housing rental yields remain extremely low. The average gross rental yield is just 3.3% for capital city houses and 4.5% for units. This compares to a 5.2% grossed up (for franking credits) dividend yield on shares. With housing rental yields so low, investors are very dependent on capital growth to get a decent return.
Finally, the risk on interest rates is still on the upside, assuming the US credit crunch resolves quickly. The problem is that mortgage stress is already at record levels and is threatening to get worse if interest rates rise again, which runs the risk of a rise in delinquencies and forced sales at some point. It’s also likely that the current turmoil in credit markets will result in a reduced availability/higher cost of capital for non-bank mortgage lenders. This is likely to result in less competition in the mortgage market, which in turn may see less discounting on mortgage rates by the banks.
The 1987 share price crash and the bear market in shares earlier this decade (global markets fell 50% between March 2000 and March 2003) contributed to house price booms in 1987–89 and 2001–04 as investors switched from shares to real estate.
The sharemarket and house prices
Given the current wobbles in shares, it is reasonable to wonder whether we may see the same happen again. So far the weakness in shares is modest. Sharemarkets would need to fall a lot further and stay down for a while to be comparable with the earlier episodes and we think this is unlikely. But beyond this, there are several more fundamental differences between the situation today and that prevailing prior to the 1987–89 and 2001–04 house price booms.
The earlier boom periods got under way when interest rates fell significantly whereas at present there are few signs of local rate cuts.
Real house prices were running just below long-term trend levels in 1987 and 2001, whereas today they are well above trend. See Fig 3. Similarly, the ratio of house prices to wages was running below trend in 1987 and 2001, whereas today it is well above trend. Reflecting this, housing affordability was far more favourable prior to the last two housing booms than it is today.
Finally, in 1987 the rental yield on housing was well above the dividend yield on shares and earlier this decade they were about equal. Today the rental yield on housing is well below the dividend yield on shares. In other words, housing is now expensive relative to shares. See the chart below.
The yield on housing is well below the yield on shares
So for these reasons – and particularly in the absence of a further sharp sustained fall in sharemarkets – we think a big swing from shares to housing investment driving a housing boom similar to the 1987–89 and 2001–04 episodes is unlikely.
An ongoing undersupply of housing is clearly supportive of house prices. However, ongoing strong gains or another housing boom are most unlikely as Australian housing remains very overvalued, housing affordability is very poor, housing rental yields remain low and the risk for interest rates is still on the upside.
The recent weakness in sharemarkets – at least so far – is not enough to drive an investor rotation back into housing as occurred after the 1987 stockmarket crash and earlier this decade. Further, conditions in the housing market are far less favourable today than prior to the last two housing booms.
The most likely outlook for house prices is for modest gains on average, with this masking a very mixed picture, depending on the area. To borrow from the lexicon of share investors, this is likely to remain a house pickers’ market.
Shane Oliver, Eureka Report
Dr Shane Oliver is head of investment strategy and chief economist of AMP Capital Investors.
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