Housing Takes a Break

KEY POINTS

• Stronger housing sales and finance have sparked hopes of a recovery in the national housing market.
• House prices may have a bounce but don’t expect a strong recovery. Australian housing remains 20% overvalued and is among the world’s most expensive.
• Expect house prices to bounce up and down for several years until the overvaluation is worked off.
• Low yields make housing unattractive for investors.

Weak national average house prices over the past two years have masked divergent regional trends including softness in the east coast cities, particularly Sydney, a loss of momentum elsewhere and boom-time conditions in Perth and Darwin. This divergence reflects a combination of factors, including the 1996–2003 housing bubble being most intense on the east coast, with Melbourne and Sydney leading the charge, and the resources boom helping drive prices higher in Perth and Darwin.

So where to now? A steady recovery in housing finance (mainly for owner-occupiers), a tightening rental property market, signs of a stronger start to the year in sales and/or auction clearance rates, and a December quarter bounce in house prices on some measures have led to optimism that maybe the Australian housing market (excluding Perth and Darwin) has seen the worst and is now recovering.

The tightening rental market is evident in low and declining rental vacancy rates nationwide, as seen in the next chart. Clearly the Australian housing market is not suffering from a big oversupply problem (although there is still an oversupply problem in some areas, such as inner-city apartments in Sydney and Melbourne).

The big picture – extended period of range trading. While house prices may well have a bounce, this is unlikely to mark the start of a recovery or return to boom-time conditions. In broad terms, the Australian housing market is expected to bounce up and down around a pretty flat trend over several years as it works off the excesses of the last bubble. There are several reasons for this:

First, Australian housing is still very overvalued:

• National average house prices remain well above their long-term trend. Since the 1920s, Australian house prices have risen on average 3% a year after inflation. The chart below shows periodic swings above and below this long-term trend, with the 1997–2003 upswing taking us well above trend. If house prices were to revert to their long-term trend they would need to fall 18%.

• House prices need to fall about 29% to bring the ratio of house prices to rents (the P/E ratio for housing) back to its long-term average (after adjusting for inflation).

• House prices need to fall about 18% for the ratio of house prices to wages to return to more normal levels. This overvaluation is reflected in OECD estimates that found Australian housing to be the most overvalued in the member countries it reviewed. See the next table.

The relative overvaluation of Australian housing is confirmed by a simple comparison of house prices to wages. While it takes 390 weeks of average wages to buy an average house in the US, it takes 480 weeks in Australia (ignoring tax). Clearly, the recent US house price boom has been modest compared to that in Australia a few years ago.

Second, housing affordability remains too poor to support a strong rebound in house prices. The key drivers of affordability are house prices, interest rates and household income. These have been combined in the chart below into a housing affordability index (where a fall indicates a deterioration in affordability and vice versa). Affordability has improved over the past two years (thanks to stagnant house prices and rising household incomes) but it remains very low. The housing boom of the 1990s occurred after several years of strongly improving affordability as incomes rose and mortgage rates fell. So far we are yet to see this and, as a result, it is hard to see owner-occupiers coming into the market in a big way.

Third, housing rental yields remain extremely low, making them unattractive to investors. The average gross rental yield is just 3.2% for houses and 4.1% for units. This compares to a 5% grossed-up (for franking credits) dividend yield on shares and a 6.5% or so yield available on non-residential property. See the next chart.

Even if low vacancy rates were to result in a 10% rise in average rents, this would only push up the average housing rental yield to 3.5% (assuming flat house prices), which is still low. As a result of the low yield, it is difficult to see investors rushing back into housing in a big way.

Finally, any whiff of a return to boom-time conditions in the housing market would most likely be met by the Reserve Bank lifting interest rates. The last housing boom was associated with surging household debt and upward pressure on inflation (partly as homeowners borrowed against their rising wealth levels to finance consumer spending). The Reserve Bank would be keen to avoid a rerun of this. As we have seen over the past two years, Australians’ very high debt levels mean they are now very vulnerable to even talk of higher interest rates, so it would be easy for the RBA to snuff out any emerging recovery.

Conclusion: There is potential for short-term bounce, but in the context of extended stagnation.

After a couple of years of flat/falling house prices in several cities, it is possible prices will experience a small bounce. However, it is doubtful this will be the start of a sustained recovery or a new boom. Australian housing remains very overvalued and it is among the world’s most expensive. Housing affordability remains poor, low rental yields will keep investors away for some time and even if prices do pick up it will only invite another interest rate rise from the Reserve Bank.

The experience after the 1930s and 1970s house price bubbles and the late 1980s mini-bubble suggests several years of weak house prices is likely until house prices return to their long-term trend. We continue to think a long drawn-out period of essentially stagnant house prices is more likely than a 1930s/Japanese-style crash. For a crash to occur, forced selling by home owners would be required and this seems unlikely in the absence of much higher interest rates or unemployment, both of which seem unlikely. So far there has certainly been no sign of the crash many feared a year or so ago.

Within this adjustment, though, it is likely house prices will experience occasional bounces up and down. Of course national trends will continue to mask regional variation. As long as the commodity boom remains in place, house price gains in Western Australia and the Northern Territory will likely be stronger than the national average.