Wednesday, July 4, 2012

House prices won't collapse, but won't take off either

For years when people at dinner parties worried about houses becoming too expensive for the younger generation to afford, I used to tell them not to worry: it was logically impossible for prices to rise to a level no one could afford. Why do I remind you of this? Because it's starting to look like I was right.

When prices are rising, and have been for many years, it's easy to conclude they'll go on rising forever. Even easier to conclude - as every real estate agent encouraged us to - is that house prices can only ever go in one direction.

As we're discovering, it turns out not to be true. According to Saul Eslake, of Bank of America Merrill Lynch, Australian house prices rose by 142 per cent between 2000 and their peak in late 2010, but in the 18 months since then have fallen by a national average of about 7 per cent. (In Sydney the fall's been 5 per cent; in Perth, 9 per cent, Melbourne 11 per cent, Brisbane 12 per cent.)

There's no shortage of people, particularly foreigners, who're convinced this increase went way beyond what the "fundamentals" of supply and demand could justify - a bubble, in other words - and it won't be long before the bubble bursts and prices come crashing down, as they have in the US and various other countries.

They may prove right, but I'm with Eslake, who argues it's unlikely. He estimates the present level of house prices is fully justified by the change over several decades of the two main factors determining the affordability of housing: household income and the level of mortgage interest rates.

The Australian median house price rose from 2.8 times average annual household disposable income in 1993 to four times in 2001. Since then it's been relatively stable. What allowed that multiple to rise so greatly was a "structural decline" in mortgage interest rates that occurred in the 1990s with the return to low inflation and the shift to the official interest rate being set by an independent central bank rather than politicians.

We could have used that fall in interest rates to pay off our homes much faster, or to increase our spending on other things. Instead we decided to use it to borrow more and move to a better house.

Because so many of us made that choice at pretty much the same time, we weren't all able to move to "better" (bigger, better appointed or better located) homes. Rather, the main thing we achieved was to bid up the prices of homes generally.

In the jargon of economists, we took that essentially once-only fall in the average level of mortgage interest rates - which Eslake estimates to have been about 4.5 percentage points - and "capitalised" it into the value of our homes.

Eslake argues house prices aren't likely to come crashing down because we have the income and borrowing capacity to afford the price of housing at roughly its present level, because we haven't been building more homes than the growth in the population justifies (in fact, we've been building too few), and because we haven't been borrowing against our homes to finance other consumption.

Eslake does predict, however, that house prices will rise much more modestly over the coming decade or two than they did in recent decades. Whereas they rose at the rate of 9.5 per cent a year during the noughties, he predicts rises averaging 3 per cent or 4 per cent a year in future.

Why? Because there won't be another, one-off, structural fall in the level of interest rates that greatly increases our capacity to borrow without increasing our monthly repayments. (Don't confuse the Reserve Bank's ups and downs in interest rates as it manipulates rates to manage the economy through the downs and ups of the business cycle - which get so much attention from the media - with the underlying average level of rates over a longer period.)

Without a structural shift in interest rates, house prices can't rise much faster than household incomes are growing. The indirect flow-through to households of the ever-rising prices we were getting for our mineral exports caused household disposable income to grow at an average rate of about 7.5 per cent a year over the past decade or so.

That compares with 4.5 per cent a year during the 1990s. Now commodity prices have stopped rising and are easing back, a more modest rate of growth is likely in coming years.

Which brings me back to where I started. The value of your home is easily determined: it's worth what you can find someone willing to pay for it. The value of homes generally can be no higher than what people generally are willing to pay and able to pay.

While it's always possible for prices to be higher than particular individuals can afford, it's impossible for them to be higher than most people can afford.

But it's surprising how much flexibility - room for give and take - there is in the system.

Many parents understand that, from their own privileged position as home owners, they have to assist their children to make the expensive step up to a home of their own.

For as long as enough parents see it that way, house prices will stay roughly where they are.

Were too many parents to be unwilling to help their kids make the step up, however, house prices would have to fall. This generation sells its homes to the next generation.

I take the present small falls in house prices as a sign the limits to affordability have been reached, and won't be exceeded.