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Residential Property - too hot to handle?

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One of life’s earliest lessons is to avoid things that are too “hot”. The need to re-enforce this lesson appears to have been one the motivations behind the unprecedented television interview provided by the Reserve Bank Governor, Glenn Stevens, last month. During the interview the Governor made the following warning about the temptation to borrow and invest in residential property:

“I think it is a mistake to assume that a riskless, easy, guaranteed way to prosperity is just to be leveraged up into property. You know, it isn't going to be that easy.”

This statement follows a period of particularly strong price growth in residential property. Prices appear to be reacting to an imbalance in supply and demand. The number of new home buildings in recent years has not been able to meet demand, which has been boosted by our rising population.

The market will ultimately cool
The price adjustment that has taken place in residential property appears to be a perfectly rational response to the current market conditions. However, as the Governor highlighted, recent price growth rates (averaging 14% per annum across Australian capital cities) cannot be expected to continue indefinitely. Ultimately supply and demand will return to some form of balance.

However, even under market conditions of supply shortage, there is a limit to how high prices can go. With residential property markets dominated by owner occupier buyers, the upper limit of price is a function of the affordability of Australian households. Housing affordability is heavily influenced by the following factors:

  • household income levels
  • interest rates
  • loan supply and lending policies.

On all 3 fronts of affordability, there appears to be some medium-term constraints. Interest rates are increasing and household income growth has been restricted by moderate wage growth and falling working hours.

While movements in household income growth and interest rates are cyclical, there has been a change in housing loan availability post GFC that may have more permanency. The 2 decades that followed the deregulation of home lending in the mid 1980’s saw the supply of housing finance progressively increased. The increased availability of housing finance, combined with the lowering of average interest rates since the mid 1980’s, are 2 key contributors to the strong price growth in residential property over the past 2 decades.

However, as described in the following quote from the Assistant Governor of the Reserve Bank, Guy Debelle, there has already been some noticeable change in the approach to lending by financiers:

“There has been some tightening in lending standards, with several banks reducing their maximum LVRs (loan to valuation ratios) on loans for new borrowers from 95–97% to about 90% during 2009. Banks have also increased their ‘genuine savings’ requirements.”

Commercial property is an alternative
Whilst there may still be positive reasons to buy residential property for owner occupation, as an investment asset it appears to compare unfavourably with other types of property. For example, it could be argued that office property should be experiencing the same price pressures as residential property, given the current growth in population and employment. Additional land in business districts is hard to come by, and construction times mean there is a considerable lag in any supply response.

Unlike residential property, office property prices adjusted downwards significantly through the GFC period. This has created a rise rental yields with high quality office property now yielding in the range of 7% to 8%. This is in contrast to residential property where rents, net of expenses, are typically in the range of 3% to 4%.

Therefore, an investment in residential property needs to produce price increases of 4% per annum more than commercial property for it to be preferred. It would be reasonable to assume that commercial property prices would increase by at least the inflation rate over the longer-term. Hence for residential to breakeven relative to commercial property, price growth needs to be in the range of at least 4% per annum above the inflation rate.

Ongoing price increases of 4% per annum above inflation would rapidly put residential property beyond the purchasing ability of a significant proportion of owner occupiers. Hence any forecast that assumes this rate of increase is questionable. Without affordability there is unlikely to be demand. The scenario would require that home ownership rates fall and the wealthier portion of the population find cause to increasingly take on the role of landlord despite low rental yields.

Such a scenario, whilst not impossible, is likely to be resisted by policy makers on social grounds. The scenario is also likely to be resisted on economic grounds by policy makers, who would no doubt be looking to avoid an Australian version of a US styled housing price bubble. Glenn Stevens is one such policy maker.

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