In April 2008, Reserve Bank of Australia governor Glenn Stevens was asked by Malcolm Turnbull why housing affordability was so bad.
“The big problem is not that interest rates are too high,” Stevens responded. “Prices are very high. We have very high prices in Australia relative to income. I think there are probably both demand and supply elements to that story.”
Turnbull knew what he was talking about, having chaired John Howard’s 2003 home ownership task force (which commissioned me to write a 380-page report on the subject).
A crucial finding was that improving the “elasticity” of otherwise sluggish housing supply – the construction of new homes – to changes in buyer demand would ameliorate affordability woes.
The RBA was not a subscriber to this supply-side thesis back then – publicly claiming it was all about interest rates and incomes.
But it has become a vocal advocate of the need to “elastify” supply to mitigate extreme price distortions.
The contemporary challenge is that since Stevens’s stark 2008 assessment that housing was expensive, median prices have surged 36 per cent.
In March 2008 the median capital-city home was worth $400,000, says RP Data-Rismark. By June 2014, this had rocketed to $545,000.
It is reasonable to think housing costs will track buyer incomes over time. Stevens was certainly right in 2008 when he said the ratio of prices to incomes was “very high”. RBA estimates put it at five times in April 2008, or about 20 per cent above the average ratio since the RBA started targeting inflation in 1993. The worry is Australia’s house price-to-income ratio is dearer again and rising. RBA data has it at 5.1 times in March 2014, a touch below the 5.2 records in 2007 and 2010. After both episodes, prices fell 6 per cent to 8 per cent. My analysis suggests the ratio has crept further since March as national prices continue to outstrip incomes. Lighter side of capital returns
With Australian home values in absolute terms and compared to incomes now at, or near, multi-decade peaks, there is a case that we have an emerging bubble. While Stevens has been reluctant to mention the “b-word”, the RBA’s latest research lends weight to the notion valuations are getting stretched.
In a new paper the RBA presents two main estimates of valuations: one based on house price growth rates since 1955 and another using capital gains over the last decade. Both are used as proxies for future gains.
The RBA’s 1955 number, equivalent to annual future price appreciation of about 5 per cent in nominal terms, appears to have been cherry-picked to engineer the politically palatable result that Australian home values were exactly fully priced in April 2014.
The RBA knows we don’t have reliable housing data before 1980 and has often argued the unusually strong gains over the last 30 years were boosted by the big one-off decline in interest rates after inflation stabilised in the mid-1990s. The average variable mortgage rate between 1980 and 1993 was 13.2 per cent, but has averaged 7.6 per cent since. The message is prospective capital returns are likely to be much skinnier than during the 1980s, 1990s and early 2000s.
So when the RBA deploys its alternative assumption – which is the more modest annual house price growth rate since 2004 of about 4 per cent in nominal terms – its model finds that Australian homes are 19 per cent overvalued. This just happens to be the same result you get if you compare the house price-to-income ratio to its average since 1993.
Other credible benchmarks on which to base future house price appreciation – including household income growth, the returns consumers think they will get and the rate at which rents rise – similarly imply that housing is overvalued by between 20 per cent and 30 per cent.
One of my preferred anchors for capital gains is household income growth per capita. Here the RBA paper echoes an observation I have posited before: that housing has historically been a “superior good”.
This means families have been prepared to spend a growing share of their earnings on buying properties even as prices climbed. But this process cannot continue indefinitely and may have run its course. Quarter-acre dream no longer
Housing is becoming more commoditised as cities inevitably densify and, as I argued in 2003, the “great Australian dream” of owning a quarter-acre block fades from the consciousness of younger buyers.
The home ownership aspiration is likely to be increasingly balanced against competing consumer priorities, like being close to work, social hubs and major amenities. When urban dwellers are living in apartments, or densely packed properties, it is harder to tell the difference between owners and renters. The convergence in the social cache imputed to owning and renting will work to accentuate the costs and benefits of investing in these assets.
In concert with record levels of leverage, more objectivity around the decision to buy or rent could elevate price volatility as values adjust more quickly to changing circumstances.
So what is a “bubble”? Simply put, it’s where prices materially exceed fair value. Speculative mania and/or rapid credit growth are only portents, not conditions, precedent to a bubble existing.
RBA officials claim they are not worried about a bubble because credit growth is low. This is muddle-headed for two reasons: first, housing credit growth is outpacing incomes, which is the key criterion; second, credit growth is only meaningful in respect of the light it sheds on changes in the level of household leverage and the probability of borrowers defaulting.
Low leverage combined with strong credit growth is a sign of dangerous conditions ahead. But RBA data shows that historically and internationally lofty leverage has already arrived: Australia’s 150 per cent household debt-to-income ratio is approaching its pre-financial crisis apogee. All we need now is an interest rate, income or unemployment rate shock to crush house prices and send leverage into uncharted territory.
And contrary to RBA rhetoric, house prices are hardly “cooling”. In the first seven months of 2014, prices have inflated at a 9.5 per cent annualised pace (triple wages growth).
With banks promoting the cheapest mortgage rates ever, I suspect Australia’s nascent housing bubble will get bigger.
