A dynamic cocktail for house prices

House prices may rise as much as 10 per cent this year, and will continue to climb in 2014. Higher household income, low interest rates and an increasing population are what's stirring the market.

House prices are marching higher again and are back on track for a 10 per cent rise this year.

After a temporary lull in April and May, where house prices fell 1.7 per cent over the two months, so far in June there has been a strong rebound with prices regaining those losses with a rise of 1.7 per cent. According to RP Data, house prices have now risen 2.7 per cent since the start of 2013 and will record a rise of a little more than 3.5 per cent in 2012-13 as a whole.

At the start of the year, I was forecasting that “house prices could rise by around 10 per cent this year” (All signs point to a house price hike, January 10). 

That forecast is more or less on track, despite the dip in April and May, with strong seasonal gains set to be recorded in the latter part of 2013. If house prices rise by around 1 per cent per month on average between now and year end, the gain for the year will be close to 10 per cent.

Whatever the exact amount, the conditions are in place for strong house price gains not only over the next six months, but into 2014 as well.

The key factor supporting house prices is the current low level of interest rates. While consumers seem intent, at the moment, to over-pay their mortgage payments, reduce debt levels and to rebuild savings, the very low interest rate climate is creating a tremendous opportunity for the household sector to borrow and bid up house prices.

Housing affordability is extremely favourable for other reasons. Compared with three years ago, house prices are broadly unchanged, but there has been an 11 per cent increase in household incomes which has seen the price to income ratio fall. This, plus the low interest rate climate, is a dynamic cocktail.

At the same time, employment growth remains solid and while the unemployment rate has edged up from around 5 per cent to 5.5 per cent in the past year, it is still very low which is supporting house purchaser confidence.

The Housing Industry Association – Commonwealth Bank Housing Affordability Index has improved for nine straight quarters and is near historically favourable highs.

Amid this, underlying demand for housing is being fuelled by ongoing strength in population growth, both in the form of strong immigration inflows and natural increase. While these demographic trends tend to take a considerable time before they work their way through to house price changes, over the past few years there has been a cumulative population increase of around 1 million people.

Whether these people rent or buy their home, household formation rates suggest it has created an underlying demand for around 450,000 new dwellings. Over that time, there have been only 425,000 new dwellings built, which includes a significant proportion that are knock-down and rebuilds which do not add to new supply.

In other words, there have been fewer houses built than required for underlying demand.

Of course, the starting point for this comparison may have been, and probably was, from a position where the stock of housing was in oversupply. If so, this suggests that the recent imbalance was merely mopping up some of that excess supply. If this is the case, the excess supply is rapidly turning to a position of a housing shortage.

While there has been a recent upturn in new housing approvals, they continue to be at a level that lags behind the likely increase in population over the next year or so. Simple supply and demand interaction suggests that house prices should continue to rise until either affordability becomes stretched again, a point unlikely to be reached until either the Reserve Bank hikes interest rates or house prices themselves rise.

The Reserve still has a strong bias to cut interest rates with the most likely scenario being a further one or two 25 basis point cuts between now and year end. If these are passed on to mortgage holders, mortgage interest rates will reach levels not seen since the 1960s. This would, in concert with ongoing household income growth, provide the final impetus for what should be a surge in house prices.

Whether or not house prices rise 10 per cent this year or not, there have been very few times in the past three or so decades where conditions have been better for those wanting to get into the property market and it seems a no brainer to make a forecast that house prices will rise strongly over the next couple of years.