The end of a house price hiatus

After 18 months of falls, house prices seem to have turned the corner in recent months. And with unemployment low and interest rates heading down, the outlook is favourable for more rises.

House prices are climbing higher, reversing what were steady falls from early 2011 through to about May this year.

According to the RP Data series, house prices have risen 1.2 per cent so far in September to be 2.7 per cent higher than levels at the end of May. Even though the data are not seasonally adjusted, it is building to an impressive rise in a relatively short time.

There are sound reasons to think that house prices will continue to move higher. The fundamental underpinnings of housing demand and house prices are extremely favourable and are likely to stay that way for some time.

The prior falls in house prices, which totalled around 7 per cent, helped to improve affordability for those potential house purchasers who previously judged a new house as just out of reach because prices too were a little too high. Economics works – lower prices brings in higher demand.

There has been another strongly positive influence. Household incomes have been rising at an annual pace of around 4 per cent which means incomes have risen by around 6 per cent over 18 months in which prices fell, which boosted housing affordability through an ability of householders to spend and borrow more.

Think of it in this example. Let’s go back to early 2011. There was a $500,000 house that you wanted to buy and your annual household income of $100,000, but the house was just out of reach. Fast forward to the middle of this year and in that 18 month period, the house price has dropped to $465,000 while your income has risen to $106,000. Clearly, it is increasingly attractive for people to dive in and buy that house and that is happening now.

Making the house purchase equation attractive has been the additional fact that the unemployment rate has been steady at a low rate, just above 5 per cent, for more than two years. While growth in employment, hours worked and the participation rate have slowed, the labour market is still in excellent shape. This gives borrowers – and lenders – confidence in entering the mortgage market. While it may not be easy to service a large mortgage, it is impossible to service your mortgage debt if you don’t have a job.

The various stress tests on the banks in relation to their quite concentrated exposure to housing shows that the biggest threat to bank profitability is a rise in the unemployment rate. Those stress tests suggest the mortgage market would easily cope with any fallout if the unemployment rate hit 8 per cent or so, but that there would be noticeable problems if the unemployment rate exceeded 10 per cent. All of which implies the ongoing 5.25 per cent unemployment rate is extremely favourable for housing.

From a cyclical perspective, the level of mortgage interest rates is clearly another positive factor supporting demand for housing and with that, prices. At the start of 2011, the standard variable mortgage interest rate was around 7.9 per cent, meaning an average monthly repayment of $2276 on a $300,000 mortgage. The mortgage rate is now 6.85 per cent meaning that the monthly repayment has dropped to $2092, some $184 lower than a year ago. Or put another way, for a repayment holding at $2276 a month, the borrower can boost the size of the mortgage by over $25,000 which can possibly be used to bid up house prices in the process.

The current pricing in financial markets is for a further 100 basis point of cuts in official interest rates in the year ahead. This is based on the sluggish global economic environment, ongoing low inflation, the decline in commodity prices and the contractionary impact of tighter fiscal policy.

If the market is correct, the standard variable mortgage rate will fall to around 6 per cent in a year, further boosting the borrowing capacity of households. This will undoubtedly underscore house prices.

At this stage, a moderate lift in house prices is neither here nor there, especially in the context of the price falls over the prior 18 months. It is also vital to note that the RBA does not target house prices, even if it does consider them in its economic assessments, so rising prices will not stop the RBA form cutting interest rates for other reasons.

The outlook suits further gains in house prices at least in the next year or so. If the current favourable influences start fuelling house price growth that is too strong, say around 10 per cent per annum, the RBA would view this unkindly and if other circumstances allow, it may react to cool them with higher interest rates. But that is a hypothetical issue for the moment – let’s first see if these recent rises continue before getting carried away.

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