It is almost impossible to go to a dinner party in Sydney without the discussion eventually turning to residential property prices. The animated enthusiasm of those already in the market is tempered by the uncomfortable silence and sometimes palpable anguish of those who are not.
Yet despite the copious amount of media attention allocated to the subject, it is equally clear that there is a fundamental misunderstanding of the main drivers of house prices. Like any asset, house prices are driven by a function of demand and supply. When demand for housing exceeds supply, then it is likely that prices will rise. Equally, as we saw in the United States and parts of Europe during the Global Financial Crisis, when rampant development led to oversupply and accessing finance became difficult, prices crashed.
Indeed, these demand/supply imbalances often become magnified during a recession when banks restrict lending, some developers fall into insolvency and the pipeline of new developments typically shrinks. In Australia, the immigration policy often means markets don’t stay stagnant for too long. Before COVID, it was estimated that there needed to be around 180,000 new dwellings built per year just to keep up with population growth. Historically, this has helped limit price declines during an economic downturn.
When supply and demand are in equilibrium, there are still factors that impact property prices including:
- scarcity of land
- income growth
- population growth
- interest rates and inflation
Land scarcity increases the probability that demand will exceed supply over the long run, putting upward pressure on land prices (and therefore house prices). This helps explain why house prices, on average, appreciate more than apartments. Although apartment price growth in established areas, where new developments are restricted, often mirrors gains in detached housing.
Income growth allows the average household to borrow more for a property, while population growth increases demand. All other things being equal, both factors will put upward pressure on prices.
The major price driver over the last 25 years, however, has been interest rates. Ever since the late 80’s/early 90’s when interest rates hit 17%, the property market has enjoyed the tailwinds of falling interest rates enabled by the deregulation of the banking sector and of course a slowdown in inflation. This has translated into a large increase in the amount households can borrow that, in turn, has helped drive tremendous growth in property prices.
With cash rates at record lows, and inflation finally rising around the world after decades of being contained, the tailwinds that have been enjoyed for so long are now turning into headwinds as interest rates start to rise.
Example 1: A dual income household with after tax income of $150,000 and disposable income of $78,000 could borrow 25% more in 2021 than they could at the start of 2015.
| 2015 | 2021 | ||
| Combined after tax income: | $150,000 | $150,000 | |
| Living expenses (ex-repayments): | $72,000 | $72,000 | |
| Surplus funds for mortgage: | $78,000 | $78,000 | |
| Pre-APRA change | % | ||
| Home loan term: | 25 years | 25 years | |
| Basic mortgage interest rate: | 4.90% | 2.50% | |
| APRA serviceability buffer: | 2.50% | 2.50% | |
| New loan assessment rate: | 7.40% | 5.00% | |
| Maximum Loan permissible: | $887,370 | $1,111,000 | +25% |
| Total repayments (P&I): | $78,000 | $77,938 |
In recent months, APRA has changed their serviceability buffer of 2.50% above a bank’s home loan rate to 3.00%. This has effectively reduced the amount the average household can borrow by about 5%.
Example 2: The same household mentioned in the first example could now borrow 5% less under the new APRA rules.
| Pre-APRA change | Post-APRA change | % | |
| Home loan term: | 25 years | 25 years | |
| Mortgage interest rate (p.a.): | 2.50% | 2.50% | |
| APRA serviceability buffer: | 2.50% | 3.00% | |
| New loan assessment rate: | 5.00% | 5.50% | |
| Maximum Loan permissible: | 1,111,000 | 1,057,650 | -5% |
| Total repayments: | 77,938 | 77,938 |
With interest rate expectations rising, we have already seen fixed rates rise substantially as banks’ funding costs have risen after the RBA abandoned its yield curve control policy (where it was targeting to keep the three-year bond yield at 0.10%). With money markets factoring in a rise in the cash rate of at least 1% in 2022, the likelihood of mortgage rates being at least 1% higher over that time is relatively high. Such an outcome would reduce the average household’s borrowing capacity by around 13%.
Example 3: Assuming mortgage rates rise by 1%, the same household could borrow 13% less than they could at the start of 2021.
| Pre-APRA change | Post-APRA change | ||
| + 1% rate increase | % | ||
| Home loan term: | 25 years | 25 years | |
| Mortgage interest rate (p.a.): | 2.50% | 3.50% | |
| APRA serviceability buffer: | 2.50% | 3.00% | |
| New loan assessment rate: | 5.00% | 6.50% | |
| Maximum Loan permissible: | 1,111,000 | 961,900 | -13% |
| Total repayments: | 77,938 | 77,938 |
To protect falling margins, banks may well start to pass on their higher borrowing costs by either reducing deposit rates and/or introducing out-of-cycle rate hikes. Given the combination of margin and inflationary pressures, it is not inconceivable that variable rates could rise by 2% over the next 24 months, which would reduce the average household’s borrowing capacity by around 21%.
Example 4: Assuming mortgage rates rise by 2%, the same household could borrow 21% less than they could at the start of 2021.
| Pre-APRA change | Post-APRA change | ||
| + 2% rate increase | % | ||
| Home loan term: | 25 years | 25 years | |
| Mortgage interest rate (p.a.): | 2.50% | 4.50% | |
| APRA serviceability buffer: | 2.50% | 3.00% | |
| New loan assessment rate: | 5.00% | 7.50% | |
| Maximum Loan permissible: | 1,111,000 | 878,900 | -21% |
| Total repayments: | 77,938 | 77,940 |
This is likely to lead to significant downward pressure on the housing market. You would expect clearance rates to slow and prices to eventually start to retreat. Whether they fall by the full 21% is a difficult question given the other factors at play – but the point is falling rates contributed to the boom and so the opposite must equally be true.
Before those who have bought near the peak fall into despair, it is perhaps instructive to consider the longer-term impacts of rising wages and inflation. While inflation will increase the cost of living, typically wages follow at a similar rate. This means that in 5 years’ time disposable incomes should be higher, which should help support house prices.
Example 5: Assuming mortgage rates rise by 2%, in 5 years’ time with inflation and wages growing at 2.5% p.a., the same household could borrow 10% less than they could at the start of 2021.
| 2021 | 2026 | ||
| Combined after tax income: | $150,000 | $169,711 | |
| Living expenses (ex-repayments): | $72,000 | $81,451 | |
| Surplus funds for mortgage: | $78,000 | $88,250 | |
| 2021 | 2026 | % | |
| + 2% rate increase | |||
| Home loan term: | 25 years | 25 years | |
| Mortgage interest rate (p.a.): | 2.50% | 4.50% | |
| APRA serviceability buffer: | 2.50% | 3.00% | |
| New loan assessment rate: | 5.00% | 7.50% | |
| Maximum Loan permissible: | $1,111,000 | $995,160 | -10% |
| Total repayments (P&I): | $77,938 | $88,250 |
Even in a scenario where the standard variable rate is 2% higher than today, we would expect house prices to be no more than 10% lower in 5 years’ time and slightly above today’s values in 10 years.
Example 6: Assuming mortgage rates rise by 2%, in 10 years’ time with inflation and wages growing at 2.5% p.a., the same household could borrow 1% more than they could at the start of 2021.
| 2021 | 2031 | ||
| Combined after tax income: | $150,000 | $192,013 | |
| Living expenses (ex-repayments): | $72,000 | $92,166 | |
| Surplus funds for mortgage: | $78,000 | $99,847 | |
| 2021 | 2031 | % | |
| + 2% rate increase | |||
| Home loan term: | 25 years | 25 years | |
| Mortgage interest rate (p.a.): | 2.50% | 4.50% | |
| APRA serviceability buffer: | 2.50% | 3.00% | |
| New loan assessment rate: | 5.00% | 7.50% | |
| Maximum Loan permissible: | $1,111,000 | $1,125,940 | +1% |
| Total repayments (P&I): | $77,938 | $99,847 |
Conclusion
Historically, there is a reasonably significant negative correlation between changes in interest rates and residential property prices, but it is important to not overstate the significance either because it is not perfect. This is because when demand exceeds supply, an increase in interest rates won’t have anywhere near the same impact on prices as when supply and demand are in equilibrium. Given that supply had substantially improved in Australia before the onset of the pandemic due to rampant apartment construction activity, we would expect an increase in interest rates to take the momentum out of the market. Our modelling suggests that if mortgage rates rise by around 1% from current levels, borrowing power reduces by up to 13%. If mortgage rates rise by around 2%, borrowing power reduces by up to 21%. In theory, these changes could translate into a fall in property prices of up to that magnitude (with a lag of around 12-24 months), all other things being equal. In reality, falls are likely to be more modest (between 6%-10%), as the supply of properties available for sale tends to fall in a weaker market.
Liability limited by a scheme approved under Professional Standards Legislation. Any advice included in this article is general only and has been prepared without taking into account your objectives, financial situations or needs. Before acting on the advice you should consider whether it’s appropriate to you, in light of your objectives, financial situation or needs. You should also obtain a copy of and consider the Product Disclosure Statement for any financial product mentioned before making any decisions. Past performance is not a reliable indicator of future performance. Advisors at Pitcher Partners Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth Management Pty Ltd, AFS number 336950.
