Mortgage repayments have risen by a staggering 40% since the start of the RBA’s belt tightening.
High rates have left us more indebted than any time in history and made a bad cost of living crisis worse. Yet house prices have risen for the second month in a row.
The computer says no.
This goes against every rule in the book on our monetary policy. But it raises an interesting question: are house prices predominantly driven by interest rates, or consumer confidence?
To better understand the interest rates argument, we can look to the RBA’s house price model.
It is about as close as we can get to a crystal ball for property predictions.
The RBA offers us two equations. The first determines a ‘base price’ to predict whether house prices will rise or fall. Let’s call that the fair value function. The second formula calculates dwelling prices as a function of mortgage rates, rents, and the user cost of owning a home. We can call this one the house price function.
In the fair value function, you divide annual rent by the user cost. Rent is self explanatory, but what is user cost? Put simple, it is the annual cost of owning a house as a share of the dwelling value.
When you compute the fair value function, you are left with a ‘base price,’ which is the long run target that house prices will gradually adjust to. This follows the logic that the cost of renting and owning a home are similar in the long run. If rents are more expensive than the user cost of owning a home, there is upward pressure on house prices in the long run, driving higher dwelling prices. If rents are cheaper then there is less incentive to own a home, so house prices will fall.
We are seeing this relation in effect now. While the user cost of houses has increased due to monetary tightening, the price of rents has increased more aggressively. Sydney-wide unit rents have climbed a record 20% since their pandemic lows, outpacing user costs in many cases. It is a similar story for our other capital cities.
This has led a run on house prices.
House prices in Sydney increased by 1.3% and increased by less than 1% in Melbourne, Perth, and Brisbane. Overall median house prices have increased by 3% in Sydney since January, as the state leads the housing market recovery.
Let’s turn to the house price function. It is a long and messy one, with lots of Greek letters and complicated maths, but it models the effect of different market variables on dwelling prices.
In the short run prices exhibit strong momentum and respond significantly to change. Interestingly, most of this change is driven by two variables. The RBA researchers found that from 1982 to 2019, interest rate changes caused 45% of house price movements and increasing rents caused 18%. The remaining 37% came from population growth, the liberalisation of credit markets, and income growth among other factors.
Their conclusions are a testament to the effectiveness of modern monetary policy.
However, with the world economy on a knife’s edge and money markets bloated with stimulus, monetary policy in 2023 is a different animal.
To get a good understanding of house prices, we need to look to the CPI: The Consumer Panic Index.
The consumer panic index, an inDebt creation, describes consumer sentiment and confidence in the financial system. When the index is high, consumers are panicked. They pull back their spending, spend less on housing, and are generally more conservative. This cools the economy and brings down house prices. On the other hand, a low index suggests boom times, with high spending and increasing asset prices.
The pandemic and a cooling global economy have made people more sensitive to panic. This turned the Australian property market into a house of cards.
In the past Australians were panic resilient. Our hunger to achieve the Great Australian Dream of home ownership led millions of households to confidently secure debt. They would bid just that little bit higher. Or offer just that little bit extra. Or do whatever it took to land their goal property.
The low panic of the past gave us a willingness to stretch to buy the right property, sending values sky high.
But the tide has shifted on panic. Throughout the pandemic we accumulated panic. The fear of the virus, the fear we’d miss out on toilet paper, the fear we’d miss out on property when prices started rising. We were primed for a panic shift.
We didn’t have to wait long for it either.
Rising interest rates and doomsday predictions of a housing market collapse made buyers and investors panic. They held back on taking out property loans and were highly negative about the fortunes of the property market. Their worries became a self fulfilling prophecies, driving a nationwide annual price decline of 8%. Panic won out over reason.
The current uptick in prices suggests that the panic has subsided somewhat.
Borrowers are less concerned that everything is going to crash and burn. There is a quiet optimism about the state of property in Australia. That’s reflected in rising values and less pessimistic news coverage on our screens.
This optimism is further accentuated by a change in the composition of borrowers in Australia.
Tightening lending criteria means that some borrowers are excluded. Not everyone who wants a loan can qualify for one. High interest rates mean that borrowers need excellent serviceability, well above the levels they were assessed on throughout the pandemic. At APRA’s mandated 3% serviceability buffer, a variable loan at 2.5% had a serviceability floor of 5.5%. That same loan might charge 6% now, so borrowers would have to prove they can afford a loan at 9%.
On a $1,000,000 facility that is a $35,000 difference per year. Its huge, and swinging the property market in favour of high-income, cash rich borrowers.
So while prices are rising on paper, it is actually an illusion. The volume of properties sold has fallen drastically as borrowers unfit for loans today exit the market. Without these borrowers, who are typically looking for lower value homes, the median house price increases. If you chop the bottom 15% off anything you get higher statistics.
This is exactly what’s happening now.
So as you can see, the recent developments in the property market aren’t so black and white.
The RBA’s economic model, our consumer panic index, and the changing nature of borrowers in the lending market highlights how change comes from all sides.
It isn’t just confidence or lending criteria that cause house prices to shift.
The dynamics are complicated and it is as much a financial game as it is a psychological one. But if there is one thing for sure, it is that emotions are powerful, and if we don’t read the room on panic correctly we could be in for a world of financial pain.