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The final word on Australian house prices

There is an enormous amount of time wasted debating whether Australian house prices are over- or under-valued.

The vast bulk of everything that is written on this subject is, unfortunately, both factually flawed and misleading.

So what are we meant to believe about the future of our property markets?

Today I want to objectively eviscerate the long-standing myth that the Australian housing market is in the throes of an unsustainable bubble using two very simple charts, which you are unlikely to have seen before.

By referencing this analysis alone one can conclude that current Australian house prices are comfortably explained by fundamental economic factors. That is, there is no evidence that domestic housing costs have overshot basic measures of fair value.

We will also see that the average Australian family’s disposable income after meeting all housing costs is actually higher than it has been at any time since our analysis begins in 1985.

What has influenced Australian property prices?

The first question we address is most powerful in its simplicity. Specifically, we want to work out how much of the growth in Australian house prices since 1985 can be explained by changes in disposable household incomes and mortgage rates.

Regular readers will recall that both the RBA and I have regularly argued that the increase in household debt-to-income ratios, which started during the early 1990s, and the coincident rise in Australia’s dwelling price-to-disposable income ratio, can be partly attributed to the circa 40% reduction in average mortgage rates between the 1980 and 1995, on the one hand, and 1995 and today, on the other.

These two periods book-end the introduction of the RBA’s “inflation-targeting” regime, which helped lock-in consumer price growth of 2% to 3% per annum, and thus much lower nominal interest rates.

More formally, mortgage rates averaged 12.6% between 1980 and 1995. Since that time, mortgage rates have averaged a little less than 7.5%.

In our first chart below Rismark’s research group has put this hypothesis to the test.

In particular, we take the median Australian dwelling price in June 1985 and “index” this by only two variables: (1) changes in incomes; and (2) changes in borrowing capacity enabled by variations in mortgage rates over time (assuming that the household’s loan-to-value ratio and mortgage repayments-to-disposable income ratio stay constant in 1985 terms).

The final income- and interest rate-adjusted 1985 median dwelling price is denoted by the blue line in the chart below. The red line represents actual median prices.

To get the best possible measure of the change in household earnings, we use the ABS’s disposable household income series, which is reported as part of the National Accounts.

We have not used the gross increase in disposable household income, since this is artificially inflated by population growth.

To control for the latter, we divide disposable household incomes by the number of households each quarter. This gives us disposable income on a per household basis, which expands at a lower rate than the headline disposable income series.

If we simply index the 1985 median dwelling price by this measure of incomes, we can account for 60.1% of the total increase in Australian housing costs over the last 26 years.

 

Australian house prices

As discussed, the second variable we use to adjust the 1985 median dwelling price is the change in household borrowing capacity over time. To properly quantify this, we keep the amount of money households spend on their mortgage repayments constant.

That is, we fix the 1985 mortgage repayments-to-disposable income ratio and apply this fixed ratio to the entire 1985 to 2011 time-series.

We do not, therefore, allow households to spend any more of their earnings on meeting housing costs over time. We also assume a constant mortgage loan-to-property value ratio.

Accordingly, the only variable that influences the household’s borrowing capacity is fluctuations in mortgage rates over time, which we source from the RBA.

Adding changes in borrowing capacity to the blue line in our chart above, we can explain a further 31.9% of the increase in Australian housing costs since 1985.

Collectively, incomes and interest rates account for 92% of the increase in median Australian dwelling prices over the period 1985 to 2011.

Note that since the average size of Australian homes has tended to rise, it is likely that there are some “compositional biases” affecting our median measure of housing costs (i.e., the red line in the chart above).

That is, it is conceivable that incomes and mortgage rates actually account for an even higher share of the time-series change in dwelling prices than our analysis suggests.

The housing affordability question

Our second chart takes a novel look at the question of housing affordability. This analysis actually borrows from an approach first developed by Dr Tony Richards at the RBA.

Specifically, it asks the question: how much real disposable do households have left over after buying the representative home and servicing all their mortgage costs?

In order to compare the welfare of different households over time, we take the disposable income measure used in the first chart above every quarter and assume the household buys the median-priced dwelling as recorded in that same quarter.

Given a fixed loan-to-value ratio, we then work out the principal and interest repayments owing on the household’s mortgage, which it meets out of its income. After adjusting for inflation we have a quarterly estimate of real disposable income per household netting out all housing costs (i.e., after buying a home and servicing the mortgage).

This is represented by the blue line in the chart below.

 

Australian house prices 2

It turns out that in 2011 Australian households actually have more income left over after purchasing the dwelling of their dreams and meeting their principal and interest repayments than any of their predecessors since our analysis begins in June 1985.

This was exactly the same result that Richards found when he first published his work in early 2008. On the basis of this benchmark, housing affordability in Australia has never been better.

In conclusion

In closing today’s column, I want to provide an update to our closely followed dwelling price-to-income ratio. We have recalculated this data to reflect the ABS’s September National Accounts.

The key conclusion is, as we have predicted for some time, that Australia’s dwelling price-to-income ratio continues to slowly decline to around four times, which also accords with what the RBA finds.

While one can quibble about exactly what the ABS includes in its measure of disposable incomes, we are more concerned about changes in the ratio over time (rather than the specific levels).

And when focusing on how the ratio has moved, we can clearly see that there is no evidence that Australian housing costs have grown more rapidly than disposable household incomes over the last seven to eight years.

In fact, when we use a much more precise measure of housing costs — namely, our hedonic indices – we find that per capita incomes in Australia have actually outpaced national dwelling prices by about 15% since the end of 2003.

 

Australian house prices 3

In a recent report, the ratings agency Moody’s downgraded its outlook for Australia’s mortgage insurance sector almost exclusively on the basis of concerns about Australia’s housing market.

On the one hand, Moody’s argued that, “elevated house prices and mortgage debt levels are arguably at unsustainable levels and remain a key vulnerability for the LMI industry.”Yet in the same report they concede that “our view is that the data on the sustainability of Australian housing prices remain ambiguous.”

While these two statements are difficult to reconcile, we hope that the evidence presented above will help clarify Moody’s views.

This article was first published in Property Observer and is reproduced with their permission. It is not investment advice.

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About

Christopher is a leading financial economist and is a leading financial economist and a director of Yellow Brick Road Funds Management and Rismark. This article is not investment advice. Visit Christoper Joye's blog


'The final word on Australian house prices' have 6 comments

  1. Avatar for Property Update

    February 4, 2012 @ 11:42 am Jeff

    Something I would like to know is – do peoples own homes and investments get separated in these studies?
    The reason I ask this is a lot of “old school” ( for a lack of a better description) investors and even home owners to a lessor extent have/ had a phobia towards debt. Whereas newer thinking is a lot more comfortable with higher levels of debt. I have had first hand experience of this, as I have a very casual attitude toward debt, and my business partner is the opposite. I prefer to have investments 100% financed where possible and pay interest only whereas he wants them paid off as soon as possible. It would be interesting to know if this has an effect on the statistics on the affordability of houses. To me there seems to be so many variables e.g. Larger houses (as mentioned above) , more technically advanced houses (extras like alarms, air con, infloor heating,intercoms etc) and houses becoming greener (better insulated, solar, rainwater collection/ recycling etc) that are increasing the costs of new homes that it seems ridiculous that we even try to make comparisons . Each individual purchase needs to be judged on it’s criteria really. I see incredible opportunities everywhere I look. I just can’t make money fast enough to take advantage of them all.

    Reply

    • Avatar for Property Update

      February 4, 2012 @ 12:22 pm Michael Yardney

      Jeff
      You make some great points.
      When talking about affordability the studies relate to “home owners” – not investors

      Reply

  2. Avatar for Property Update

    February 5, 2012 @ 2:35 am Jeff

    Michael
    Thanks for your reply. I found this an interesting article along with the one about Steven Keen. I have trouble understanding the reasoning behind the negative predictions he and others are continually making. Christopher’s information has reinforced my confidence that their predictions are largely unfounded. My wife and I own properties in Sydney – 2 residential and one industrial. The residential properties have appreciated in value no more than 20% over the last 6 years that we’ve owned them, so in my mind I find it difficult to see the bubble that they can. I think it already floated away and a new one will start to form over the next few years. I just hope the things they say aren’t putting too many people off from entering the market until it’s too late.
    We own our industrial property in partnership with our business partners and rent it to our own company. When we purchased it (6 years ago also) we probably paid $150,000 too much for it because there are very few available the size we needed in the location we were already established in and several other business owners in the area were trying to outbid us for it because of this same reason. However 6 years later, after having spent $80,000 – $100,000 renovating it before we moved our business into it, it is valued approximately $400,000 – $500,000 more than we paid for it. We have absolutely no regrets about paying too much for this property. However, had we not bought it and waited to find another one at the “right” price, we may not have found one that was suitable and we certainly would have ended up paying even more when we did – would we have regretted this ? – absolutely !
    I honestly believe that even if people spend 10% too much for the “right” property for its intended purpose, be that investment or their own home, long term they won’t regret it. We haven’t.
    I also think buying a well chosen property at the wrong time will still outperform a badly chosen property bought at the “perfect” time in the long term.
    There is nothing worse than getting to the bus stop at the exact “right” time when the bus came early.
    I would like to thank you also for the inspiration and financial education from your books and newsletters. I have bought several copies of your books to give to friends and family interested in property investing. I’ ve read hundreds of books on business, marketing and investing and your books have quite honestly taught me more than any others – not just on property investing either. It’s funny how a lot of you what you teach crosses over into business too. Thank you.

    Reply

  3. Avatar for Property Update

    February 9, 2012 @ 8:55 pm Goeffrey

    This guy, Simon Buckingham, from resultsmentoring.com has been saying the same thing for ages now! Interesting that Christopher uses the same graph. I guess it’s good to see two people, (one an expert in economy, and the other an expert with property investing and educating people on it) independently research and come to th same sound conclusions.

    I’ve been follow Simon for years, and he’s a very impressive guy… but that’s not what this is about.

    Well done guys!

    Reply

  4. Avatar for Property Update

    February 11, 2012 @ 7:00 am Jim

    Always refreshing to read your articles Michael. Nobody out there can see the glass half full. Doom and gloom, people can’t get enough of it. The way I figure it, all we have to do is look at history on the property cycles over the last 100 years, property doubles in price every 7 to 12 years. Clockwork. Assuming humans continue to breed, housing will always eventually go up in price. This year I believe the market will completely stabilise, another 3-4% increase in people wages and suddenly things are beginning to look affordable again. Look for solid deals right now, there are plenty out there. Like all solid investments, give it time. My wife and I just bought another one this year, a complete mess but under valued by about 50 G. A little hard work and our capital gain is assured. Freedom 55!!!

    Cheers

    Reply

    • Avatar for Property Update

      February 11, 2012 @ 7:24 am Michael Yardney

      Thanks for the kind words Jim
      You’re speaking words of wisdom that come from experience. The problem is those who haven’t lived through a few cycles find this hard to understand

      Reply


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