Incomes a step ahead in the property game

This analysis is based on both 'average' and 'median' dwelling prices, calculated using all home sales recorded across the country during the March quarter. The quarterly income estimates are extracted from the ABS's national accounts data, which publishes a regular 'disposable household income' aggregate. To translate this figure into a 'per household' unit, Rismark divides through by the number of households each quarter.

It is important to remember here that this income estimate reflects that there are multiple income earners per household, and is an 'average', not a 'median', and likely to be biased upwards somewhat due to right-skew in the distribution of incomes.

The second chart, below, seeks to remove one of the main 'non-cash' items that is captured in the ABS's disposable household income series: 'imputed' owner-occupied rents, or the rents you effectively save by buying a home rather than renting it. As you can see, this boosts the dwelling price-to-income ratio to about four-and-a-half times.

The exact levels of the price-to-income ratio are relatively trivial: it is the change in the ratio over time that affords much more useful insights.

From the analysis above we can infer several things. First, disposable household incomes in Australia have grown as quickly, if not more quickly, than nominal Australian house prices over the last nine years. Indeed, when we measure changes in house prices more precisely using a 'hedonic regression' technique, we arrive at even lower house price inflation numbers. In particular, we find that disposable incomes have actually out-paced house prices by about 15 per cent over this period.

A second learning is that the price-to-income ratio seems to have risen by about one-third, from circa three times, to four times since 1993. In fact, there was a very distinct regime change in the late 1990s and early 2000s.

There is a sound explanation for this innovation: the long-term cost of mortgage debt in Australia declined by north of 40 per cent between 1980 and 1995, and 1995 and today. This was largely a function of the long-term reduction in realised inflation and measured inflation expectations, which in turn allowed Australia's central bank, the RBA, to permanently lower its cash rate.

The radical reduction in the day-to-day cost of mortgage debt permitted Australian households to significantly increase the amount of debt they were servicing without a noticeable rise in underlying mortgage default rates. Notwithstanding a peak in headline mortgage rates of around 9.5 per cent in August 2008, system-wide arrears have remained no higher than their last spike in 1994-95.

Here we are able to document another development. The striking rise in Australia's household debt-to-income ratio from the mid-to-late 1990s onwards ceased altogether in about 2006, a year or two prior to the onset of the GFC. That is, credit growth started tracking income growth, which is what you would expect through the cycle. Households evidently discovered that they had maxed-out their debt servicing capability, and rationally stopped leveraging up.

Rismark's price-to-income ratio analysis does not, of course, account for changes in interest rates. Today mortgage rates are well below their long-term averages. You can get discounted variable rates as low as 5.6 per cent per annum, and three-year fixed-rates at about 5.8 per cent per annum.

Factoring in the change in both incomes and interest rates is important. As one exercise, Rismark took the median Australian dwelling price in 1985 and indexed it up by changes in per household disposable incomes and adjustments in borrowing capacity afforded by changes in mortgage rates (ie, holding the repayment-to-income ratio constant).

Rismark found that it could explain 93 per cent of the actual increase in median Australian house prices over the 1985 to 2011 period simply referencing these two variables.

Christopher Joye is a leading financial economist and a director of Yellow Brick Road Funds Management and Rismark. The author may have an economic interest in any of the items discussed in this article. These are the author's personal views and do not represent the opinions of any other individual or institution. This material is not intended to provide, and should not be relied upon for, investment advice or recommendations.

This article first appeared Property Observer on June 28. Republished with permission.