Don’t trust the RBA on housing

Despite Reserve Bank attempts to spook the housing market, conditions are very supportive of further strong gains.

Summary: A discussion paper released by the Reserve Bank this week sent a shockwave through the housing market by painting a bleak picture of subdued residential price growth ahead. When the central bank speaks people listen, but don’t believe what you hear. The foundations for its argument implying weak price growth ahead are pretty flimsy.
Key take-out: Higher population density, rising incomes and discretionary spending, and an outlook for very low interest rates over the medium term, point to continued good conditions for the Australian housing market.
Key beneficiaries: General investors. Category: Residential property.

The Reserve Bank of Australia put out a discussion paper this week, in which it was strongly implied that there was going to be, at best, little net difference between renting and buying.

Indeed, the paper inferred there was a good chance you’d be worse off buying. Throw in the constant attacks on negative gearing from everywhere - the Murray inquiry most recently - and the investment backdrop for housing doesn’t look great.

Admittedly, the RBA’s report was directed at would-be owner-occupiers. But the analysis was just as relevant to investors, as the scenario it painted was based on lower price growth ahead than we have experienced in the past.

It’s this expectation that price growth (however you choose to adjust prices - real, nominal, constant quality etc.) will be lower than the past that I have a problem with. I’m not going to get into an exact quantitative estimate. That would be pointless. In good conscience though, I can’t see it as being lower than what we’ve experienced since 1955 – or even in the last 10 years.  The question I keep asking myself is, why? Why would prices be lower?

The RBA’s agenda

Keep in mind that the RBA is actively trying to talk prices down.  So this latest report must be seen through that prism – although it has to be noted that the report does at least give the pretence of balance. I think it was anything but, though – subtly - and even its title was designed for maximum media interest.  So, in my view, I think we should recognise the RBA report for what it is – just another exercise in talking property down and managing expectations. At the very least, a high degree of caution should be used, noting its policy aims, when we look at any research the RBA produces on the housing market.

Otherwise the case for stronger price gains over the next decade is a simple one.  At a very basic level, the fact is land and housing is a scare resource – and getting scarcer. Not only has the population grown significantly from 1955 (9 million to 23 million today), but urbanisation rates have increased as well. So, for instance, in 1955 54% of the population resided in a metropolitan area – something regarded as abnormal at the time. In 2014, that’s closer to two-thirds of the population living in capital cities.  

I hate to be an economist about things, but supply and demand does matter. Higher population density exacerbates existing issues of scarcity. This is getting worse, not better, and will get worse over time, especially as recent policy and social trends tend toward even higher-density living. There is little chance that the regions will be ‘reopened’, for instance.

That means that while Australia itself has a very low population density of about 2.9 people per square kilometre, in many suburbs of our major capital cities population density skyrockets up to 50,000 people per square kilometre or more – and that is growing.  That’s up there with key boroughs in much larger cities such as London and not too far off Manhattan, where apartments can sell for around (mid-point) $30,000 per square metre (often much more). 

In Sydney , and based on data compiled by Australian Property Monitors, apartments in top range suburbs sell for around $12,000-$13,000 per square metre on average. These are ballpark figures obviously, but they highlight my point well. There is scope for property prices to push markedly higher as households and investors compete for an increasingly scarce resource.

Income and interest rates

The other issue, as I have discussed before, is that money is the benchmark to which we value everything. If you increase the supply of it relative to a fixed scarce resource, like land, there is only one outcome – inflation. How it manifests is anyone’s guess, but it always does. If one segment of the market cant’ or refuses (for whatever reason) to participate in that, then market forces will ensure that someone else steps in to take their place. It’s how a free economy works.

So, with interest rates at record lows, someone, somewhere, will take advantage of that.  Moreover, we know that central banks are loathed to tighten – interest rates will remain ultra-low for a very long time, even after banks start tightening. With that in mind, I don’t think I’m being controversial in saying that interest rates over the next decade will be much lower than what we saw through the previous 30 years.

Don’t get me wrong, I fully appreciate that household debt levels and ratios to disposable income are at record highs – much higher than they’ve been in the past (chart 1 above). I appreciate this.

But to then conclude that property prices couldn’t possibly push much higher because of record high debt isn’t a logical statement. The rebuttal is easy – why not? What will stop it? Higher interest rates? By the way, I know of chief economists at some of the world’s largest investment banks who were saying the same thing back in the early 2000s. You see, back then household debt was also at a record high – for the times – at 100% of disposable income. The argument then, as now, was that debt couldn’t possibly push higher as it was already at records.  Now it’s at 150% of disposable income.

What economists didn’t take into account then was the debt servicing ratio. Back in the early 2000s the debt servicing ratio was a little under 8% of disposable incomes; now it’s a little over – maybe 9%. At its peak the ratio was close to 14%, but who’s to say that couldn’t push higher still? Why not 20% or 25%? The country spends 18% of its income on rent! More to the point, this is a country that spends more than $20 billion on gambling every year. Another $8 billion on alcohol and cigarettes. I’m not suggesting these things should be cut, but you get the point. Our discretionary spend is very high – much higher than the last 50 or 60 years – and consumer preferences can change. So we may just decide that we don’t mind spending 20% of our income, or more, servicing debt.  A decision made a bit easier by a 10% savings rate!

Higher house price growth

These are reason enough, I think, to expect higher house price growth going forward than what we have seen in the past – on average. The time period that the RBA uses to calculate its long-run average reflects conditions – an Australia – that just don’t exist now. The population was smaller, population densities lower. Household incomes were comparatively lower, as was net household wealth. Consumers had lower discretionary spending etc. Perhaps, most importantly, the interest rate that we see over the next decade is likely to be much lower than what we saw, on average, over the last 50 years (close to 9% on the standard variable rate).

So is house price growth going to be lower now than in the past? I sincerely don’t see how. So I don’t think investors should be spooked by the RBA. Conditions are very supportive of further strong gains over time. The headwinds are few.

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