Are Australian house prices really 30% undervalued?

According to Peter Tulip, an official at the Reserve Bank of Australia (RBA), Australian house prices are now 30% undervalued.

In the original research paper he and colleague Ryan Fox published last year (available at the RBA website), they concluded that house prices were then fairly valued. But after updating the analysis to reflect the subsequent decline in real long-term interest rates, Tulip and Fox have concluded that house prices are now 30% undervalued, even after the rise in prices since then.

On first hearing of this claim, I thought it was a joke. Apparently not. This is a serious claim and one due a considered response.

Firstly, the methodology strikes me as flawed. To determine which is better value the authors compare the annual cost of owning a home to the annual cost of renting. If it is cheaper to own a home, then house prices are 'undervalued' and vice versa.

This is a great example of using relative values to come to a conclusion without anchoring them to some absolute measure of value. If both the cost of buying and renting a house are inflated, then this methodology leads to an incorrect conclusion.

Instead, metrics like price-to-income and debt-to-income ratios might offer a better guide. While imperfect, they do offer some idea of the absolute cost of houses. The authors, however, dismiss price-to-income as 'not obviously a part of any individual's decision-making process'. If true, then I'd suggest there's an even higher likelihood of houses currently being overpriced.

While Tulip and Fox acknowledge that interest rates and rents 'have been more important determinants of house prices at other times', they believed last year, and presumably still do now, that they are determined by what buyers are willing to pay. In other words, based on their expectations of capital gains.

Yet those expectations of capital gains are generally based on prior experience. As such, they're not really relevant to the future without also considering the level of current prices and other factors including the future direction of interest rates, future wage growth and the impact of high prices on future supply.

In my view, both the authors and Aussie home buyers are making a potentially dangerous mistake. All things being equal, the more expensive an asset becomes, the lower your expectations of future capital gains should be, not the other way round.

If the authors are correct, then you could use their logic to justify any price, however absurd. It would have justified betting the farm on internet stocks in late 1999, purchasing an apartment in Las Vegas just before the US housing bust or even purchasing tulips (sorry – I couldn't resist) in early 1637.

Needless to say, doing so wouldn't have been a wise decision.  

While I'm not suggesting Aussie house prices will experience a bust of similar magnitude, with price-to-income and debt-to-income ratios at record highs and interest rates already at very low levels, I'd suggest the chances of generating the same capital gains in future as in the past are slim.