Jonathan Wilson

Written by Jonathan Wilson, Analyst, StocksInValue

Original article first published in StocksInValue


 
With property being the single largest asset for around two thirds of Australian households the housing market is central to the health of our economy. Due to wealth effects, home prices are highly interrelated with key economic drivers such as consumer spending, jobs and household income. After two decades of unnatural growth with house prices rising faster than incomes, the debate is intensifying around whether the property market is a bubble about to burst.
As APRA Chairman Wayne Byer recently stated, the term ‘bubble’ is unhelpful. Rather than try to forecast the timing and extent of a possible correction, which would ultimately require an acute understanding of mortgage lending standards, for now we look at what has driven house prices to this point and where and how risks are accumulating.
Below is a figure from a study of long run trends in housing price growth by RBA economists Marion Kohler and Michelle van der Mewe. It shows the above-CPI growth of housing prices and value of new dwellings (removes the effect of quality improvements) since the late 80’s.
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Figure 1. House prices and inflation
Source: RBA, ABS, APM, CoreLogic RP data
House prices are determined by the relationship between supply of dwellings and demand from the number of homebuyers, their income and their willingness and ability to take on debt. With wages and CPI being closely linked, the authors separated the drivers of the unusually high housing price growth between increasing household leverage and the the supply gap (supply of new dwellings and underlying demand from household formation). These drivers appear to correlate with housing price growth to varying degrees over the 25 year period since 1990.
The combination of a more competitive lending environment due to financial regulation in the 1980’s, as well as declining interest rates from 1990, increased Australians’ access to cheaper credit and made housing much more affordable. The resulting rapid increase in household debt as a percentage of disposable income reflects the increased leverage in the housing sector.
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Figure 2. Household finances
Source: RBA, ABS
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Figure 3. Debt and Price-to-income ratios
Source: RBA, ABS, CoreLogic RP data
Dwelling completions mostly kept up with underlying demand but from the mid 2000’s a jump in population growth combined with below-trend housing activity resulted in excess demand putting upwards pressure on prices.
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Figure 4. Australia population growth
Source: World Bank
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Figure 5. Housing construction activity
Source: Deutsche Bank, ABS
Splitting leverage and the supply-demand effects Kohler and van der Meuw showed that between 1990 and 2005 actual price growth correlated with predicted price growth from the expansion of household leverage, and between 2005 and 2015 actual price growth correlated more with predicted price growth from the housing shortage.
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Figure 6. Housing price growth, actual and predicted values
Source: RBA
In coming years, the supply gap is expected to close due to slowing population growth and a recent acceleration of housing activity.
A key point is financial deregulation was a one-off event and the RBA cash rate is at a record low of 2.00% and can’t fall much further. Interest rates will no longer improve affordability so credit-driven house price growth will depend much more on lending standards. However, lending behaviour is difficult to track and usually a drop in standards is only known after the fact.
Regulators are increasingly wary of a deterioration of standards as lenders with a growth mandate seek to stimulate loan volumes in an environment of high household debt, low interest rates and subdued income growth. APRA is particularly worried about the recent strong growth in investor lending, and directed the banks to reduce growth to below 10% in December last year.
Keeping a lid on investor lending is crucial because speculative buying in the housing market is the air that blows a potential bubble. A belief that prices always go up coupled with accommodative lending and refinancing options are ingredients for a disastrous upward spiral as occurred in the US prior to the GFC.
Positively, since APRA’s December instructions the volume of investor housing loan approvals has fallen due to rate hikes on investor loans. However there are serious questions over the quality of data after widespread loan reclassification was revealed on closer scrutiny by the RBA.
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Figure 7. Housing loan approvals
Source: RBA
The full extent of reclassification is still unknown although Deputy Governor Philip Lowe presented the RBA’s latest findings in a speech to the FINSIA regulators panel in November. As shown in the next figure the RBA revised its estimates of the value of investor housing credit balances by $50 billion or 10% between May and September
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Figure 8. Investor housing credit
Source: APRA, RBA
After the data revisions the change in investor lending growth (solid line) appears to be much less than first thought (dotted-line).
 
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Figure 9.Housing credit growth
Source: RBA, APRA, ABS
The poor data quality is a serious concern as it misrepresents a key metric for identifying risk and reduces regulators’ capacity to introduce safety measures when needed. Following the recent revelations the RBA and APRA have vowed to intensify supervision of lenders.
Whilst the above refers the Australian housing market as a whole demand and supply pressures are mostly city-specific. In recent years Sydney and Melbourne have experienced strong home price appreciation while growth has actually been subdued across the other capital cities and regional areas.
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Figure 10. Housing prices
Source: RBA, CoreLogic RP data
Risks are therefore risks accumulating fastest in Sydney and Melbourne, which have higher ratios of median dwelling prices to average earnings.
 
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Figure 11. Estimated ratio of mean dwelling price to average earnings
Source: HIA, ABS, CoreLogic RP data
Foreign buyers, particularly from China, have contributed to in the increase in underlying demand recently, especially in Sydney and Melbourne, as shown in the next table with the proportion of foreign buyers in the investor market more than tripling for new dwellings and doubling for established dwellings since 2011. This trend will likely slow after the Chinese Government stated intentions to crack down on underground banking channels to limit capital outflows.
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Figure 12. Estimated proportion of foreign buyers in investor housing segment
Source: NAB, Citi Research
In sum, the key drivers of recent home price appreciation appear to be waning, which could see to a cooling of the property market, especially in Sydney and Melbourne. However, lending practices are still not under control so conditions could potentially worsen.