Australia’s housing boom: reports of bubble are overblown

Low interest rates have pumped up Australian house prices, leading to concerns that not only is housing across the nation becoming less affordable, but the boom will meet its eventual bust. However, we believe the housing cycle over the next few years is likely to play out differently from this worst-case scenario.

The strong rise in housing prices is not a national phenomenon. Capital city house prices increased by 7.6 per cent over 2014. A large portion of this is attributable to Sydney and to a lesser extent Melbourne.

Sydney house prices rose 14.9 per cent over the year to March 2015, more than twice the next best performing capital Melbourne, where house prices rose 6.0 per cent. Outside of Sydney and Melbourne, capital city prices have been more contained, growing by less than three per cent – a rate of growth well in line with income growth and therefore not a cause for major concern.

This raises the natural question – Why Sydney?

It is not surprising that investors have bet on Sydney. A combination of recent trends has combined to drive a stronger economic outlook for New South Wales (NSW) relative to any other State.

In particular, a low-interest rate environment benefits industries in which NSW has a relatively greater reliance, such as finance, insurance and professional services.

The NSW economy also stands to benefit from a boost to competitiveness driven by the 25 per cent fall in the Australian dollar (AUD) since late 2014. This will provide some relief to NSW and Victoria’s larger manufacturing sector.

In NSW, the share of employment accounted for by tourism is also second only to Queensland among mainland states. Further, NSW punches above its weight in terms of international student numbers.

Outside the Hunter valley coal region, the NSW economy relies less on mining than mining States that are facing growing headwinds from falling commodity prices.

Finally, the NSW State Government has embarked on a significant infrastructure program, in contrast to several fiscally constrained jurisdictions where austerity is still a focus. 

These factors have combined to spur population growth in NSW – the primary driver of underlying housing demand – which has improved over the past three years; particularly when compared to the deceleration in population growth occurring in the mining States.

NSW’s share of net overseas migrants nationally has reached a 10-year high and net interstate outflows – a traditional drag on population growth – are at their lowest in more than three decades.

But is fast house price appreciation leading to a tipping point for investors and owner-occupiers in Sydney?

For owner-occupiers, housing affordability is a key. On this metric, Sydney and Melbourne are now looking stretched.

One measure of housing affordability reflects mortgage repayments as a percentage of average household disposable income (Figure 1). On this basis, over the latest housing upswing cycle since 2011, affordability in Sydney has deteriorated to such an extent that an average household would require more than 40 per cent of their income to service a mortgage on a median priced home.

In other capital cities, apart from Melbourne, housing affordability is more contained at less than 30 per cent.

For investors, rental yields and expected capital gains are pivotal.

A useful metric is the rental yield compared with the real mortgage rate (Figure 2). If rental yields fall below the real mortgage variable rate, then investors are increasingly betting on real capital gains (increases in real house prices) to make up the shortfall (including costs associated with buying a home in addition to mortgage payments) and earn a positive return.

The situation is more favourable for investors if the rental yield is higher than the real mortgage rate. On this basis, Melbourne and Sydney – with rental yields below mortgage rates – have become less attractive than Brisbane, Perth and Adelaide – where rental yields are above mortgage rates.

The relative attractiveness of the Sydney market therefore increasingly rests on higher expected capital gains – a dangerous scenario when a sudden shift in investor sentiment can cause a sharp price correction. So how worried should people be about prices collapsing in Sydney?

A sharp correction is unlikely given both cyclical and structural factors at play. With interest rates expected to be kept low for several years and the NSW economic outlook very positive, house valuations will remain supported. Structurally, limited land supply in inner city Sydney will also continue to put a floor under prices.

Rather than a sharp price correction, weaker affordability metrics and rental yields do mean owner occupiers and investors will increasingly shift to regions offering better potential returns.

The first stage of this transition has, and will continue, to occur within Sydney itself. Sydney is not homogenous from a residential property point of view.

Suburbs on the urban fringe have better fundamentals. For example, many suburbs in Sydney’s South West have rental yields of 4.5 per cent or higher, compared with less than three per cent in the inner city.

Given easier loan serviceability, investor activity in such regions is also less likely to be affected by increased scrutiny over lending standards by the Australian Prudential Regulatory Authority. Housing affordability metrics are also better in such areas (in some cases below 30 per cent).

Investors and owner-occupiers will be increasingly drawn to these urban fringes. For example, population growth in South West Sydney is currently running at 2.4 per cent, compared with 1.4 per cent in the rest of NSW.

The next stage of the housing upswing will be an eventual shift back into cities such as Brisbane given higher rental yields and much better affordability.

However, this sort of transition is only likely to occur once the impact from a fall in mining capex and more front-loaded fiscal austerity relative to other States passes. With large tourism and trade exposed sectors, states such as Queensland also stand to benefit from a lower currency and an eventual pick-up in global growth prospects. Stronger job prospects and better relative affordability will drive population flows back into such states.

In a low-interest rate environment, rather than a housing market collapse, the housing upswing is likely to continue to ripple across the nation as investors continue their search for yield, driving further house price gains in the process.

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