Why house prices will hold

Following my analysis of the widely covered, yet intrinsically flawed Demographia housing affordability survey, I thought that it would be worthwhile taking stock of what has happened to Australian house prices during 2008, in advance of the end-of-year index numbers that will be released shortly.

First, dwelling prices across Australia clearly fell by a margin of circa 2 per cent over the first 11 months of 2008, according to the RP Data-Rismark Hedonic Indices. I expect that the final end-of-year index numbers will show that the overall housing market fell in value by about 2-3 per cent during 2008.

While some folks will no doubt get excited by these price changes, it is important to put them in perspective. While Australian property prices will likely have tapered slightly by 2-3 per cent over the past year, the ASX All Ordinaries Index has fallen by circa 45 per cent and Listed Property Trusts (LPTs) have declined by about 55 per cent (see chart below). Indeed, the Australian equities market has registered losses on single days that are three to four times greater than the price decline experienced by the Australian housing market over the entire year.

You might then hear the rejoinder "but equities leads the housing market (and GDP)” – ergo, all future losses are now fortuitously priced into shares while the housing market has a long way to go because of its inherent illiquidity. But this is a complete furphy. The RP Data-Rismark Hedonic House Price Indices utilise over 20,000 property sales a month, and this is just in the capital cities. Nationally, there are around 30,000 home sales each month. So we are seeing nearly 1,000 sales a day, which sounds like pretty damn good liquidity to me.

The likely 2-3 per cent price contraction during 2008 is pretty much exactly what you would have expected ex ante, based on what happened last time the RBA aggressively ramped up rates. Between August and December 1994, the RBA marched off on an inflation warpath and lifted the cash rate by a stunning 2.75 per cent. According to the RP Data-Rismark Hedonic Index, Australian house prices fell by 2.6 per cent between November 1994 and August 2005 (see below).

Importantly, the 1994-95 rate hikes were very similar to the total rate increase worn by borrowers between March 2005 and the middle of 2008 (if you add the circa 0.55 per cent worth of "de facto” rate hikes imposed by lenders in 2008 as a result of heightened funding costs).

We have previously stated in other outlets that we believe the RBA made a material policy mistake jacking up rates six to seven times in the midst of the global financial crisis (noting that it could have offset the banks' de facto rate rises by cutting the cash rate). We've also commented elsewhere that we felt the jump in inflation in 2007-08 was more likely to be a "level” effect due to a once-off recalibration in commodity prices and not a permanent "growth effect” whereby commodity prices continuously rise (the former means that the once-off spike should eventually pass through the inflation data like a "pig through a python”). And the spin that some economists have put on the RBA's decision to radically reduce rates in September 2008 – a few weeks before other major central banks – as being "ahead of the curve” is wide of the mark.

The fact is, while the RBA is an exceptionally capable economic institution and arguably one of the best central banks in the world, it was behind the eight ball in 2007-08 and has been forced to slash rates in an unprecedented fashion to bring its monetary policy settings back into line with reality. We all make mistakes.

What happened to house prices in 2008 after households had been slugged with a similar cost of capital increase to that which they bore in 1994-95? As the chart below shows, the outcome has been unerringly similar. House prices have again fallen by just over 2 per cent. But let's keep this decline in perspective – thus far it has been nothing more than a rounding error. Sure, within the national house price index there have been areas that have experienced much larger gains and losses. But the representative Australian capital city property, with a median value of around $450k, has registered only a tiny decline in value.

Now, this is not to say that prices will not continue to soften slowly. There are, of course, some material differences between 2008-09 and 1994-95 including, but not limited to, the following:

1) Households in 1994-95 had a much better debt-servicing ratio, and so borrowers today are more sensitive to interest rate movements (negative);

2) The RBA has reversed course much more quickly in 2008 than it did in 1994-95. It took the RBA until December 1998 to get the cash rate back to its July 1994 levels whereas in the last four months of 2008 it has cut the cash rate to levels not seen since December 2001 (positive);

3) The cash rate today is considerably lower than it was in 1994-95 and will likely fall to record lows of sub three per cent, based on the latest futures market pricing. Note that the lowest cash rate since 1990 is 4.25 per cent, which is where we are at currently (positive);

4) There is a much larger housing shortage today than there was in 1994-95. Westpac and ANZ estimate that the dwelling stock deficiency is currently around 140,000 homes. Based on Westpac's numbers, the housing shortage in the mid 1990s was less than 40,000 properties (positive);

5) Population growth (including both fertility and immigration) is currently much higher than it was in the mid 1990s, with fertility at its highest levels since 1981 (see my recent comments on this subject here) (positive);

6) Australian government net debt as a share of GDP peaked at nearly 20 per cent in the mid 1990s, whereas in 2007-08 the government's net debt was negative – although this is about to quickly change (positive);

7) Finally, the economic environment is vastly different today, with Australia almost certain to experience a non-trivial recession with higher levels of unemployment (negative).

I have previously addressed the issue of what happened to Australian house prices in the early 1990s when GDP contracted for two years running and unemployment rose from 5.6 per cent to 10.9 per cent.

It is not unreasonable to presume, therefore, that we could well see mild softening of prices during 2009, as households deal with the countervailing impact of dramatically lower interest rates, tax cuts, and huge fiscal stimuli juxtaposed against slowing wages growth and higher unemployment. It would not surprise me, though, if prices ended the year pretty flat.

For those who believe in the long-term demand and supply drivers of residential property, this will present highly attractive buying opportunities. The bears, on the other hand, will get an opportunity to short the housing market when the ASX launches its new residential property futures contracts across all capital cities and the national market using the RP Data-Rismark Indices.

Christopher Joye writes Business Spectator's property blog and is managing director of research group Rismark International which produces the RP Data-Rismark Hedonic House Price Indices. Rismark also operates a series of funds that invest in residential mortgages.