IMPACT OF INTEREST RATES ON DWELLING PRICES
Introduction
This report looks at long term drivers of residential property prices, including the impact of interest rates, on:This report looks at long term drivers of residential property prices, including the impact of interest rates, on:
• House prices (nominal house prices)
• House prices adjusted for inflation (real house prices), and
• The house price/income ratio
It also compares the trend in Australia’s house price/income ratio since 1976, with the trend for some other countries.
The conclusion is, unremarkably, that the solidly rising housing market we are seeing today is entirely consistent with history and the economic fundamentals, and that the upward house price cycle is likely to have a considerable way to yet run, even if interest rates rise further.
1. Nominal house prices
The house price chart below is from The Economist – we use this, because it is consistent with some other charts shown further below. All interest rate charts are from the RBA.
This chart shows that the price of a typical house is six times more expensive than it was 24 years ago, which is a doubling about every 6-12 years - i.e. the index (based at 100 in 1986) took 12 years to double from 100 to 200, then 6 years to double to 400, then another 6 years to grow 50% to 600. Within that period, there have been some occasions where dwelling prices dipped a little.
The boom periods were: 1986-89, when index prices rose 50% (from 100 to 150); and 2002-05, when index prices rose 60% (from 250-400).
If we look at standard variable home loan interest rates over the same period (see chart below), we see that a long term correlation between interest rates and house prices appears to exist: this is because, since 1986, interest rates have generally fallen and house prices have generally risen.
However, this apparent correlation is simply a result of the time frame chosen. If we take house price and interest rate charts back to earlier years we see that, in the long term, house prices have consistently risen at the about the same rate, regardless of what interest rates are doing.
The house price chart below is from ANZ and looks at data from 1965 to 2007. It shows the prices on the vertical axis using a different scale (called a log scale). With a log scale, the % rate of growth is indicated by slope of the line, so that an increase in the housing index from 2 to 4, shows the same rise on the chart as an increase in the index from 20 to 40, or 100 to 200.
These charts demonstrates that historically, over the long term, nominal housing prices have risen at a fairly consistent rate, across many housing interest rate environments, ranging from below 6% to over 16%. That is, there is no long term historical correlation between growth in nominal house prices and interest rates.
Yet we know that high interest rates obviously affect affordability, and hence must have some impact on house prices. Solving the puzzle requires some more detailed analysis.
2. Housing prices adjusted for inflation
The next chart adjusts for inflation and shows that the real (i.e. inflation adjusted) increase in housing prices is about 2.5 times over 24 years.
When we compare real house prices with interest rates, the evidence seems to be that real house prices and interest rates tend move in the same direction. That is, high growth in real house prices is associated with high and/or rising interest rates, and a flat housing market is associated with low or falling interest rates.
This might seem counter intuitive, but it is mostly consistent with the evidence:
• During the first boom, from 1986-89, real house prices rose about 30% (from 100 to 130), while interest rates were at their highest
• During the period until 2002, when interest rates were falling, real housing prices did not surge, but were generally flat
• During the 2002-08 boom, real house prices rose by almost 80% (from 140 to 250) interest rates were generally rising
• During the GFC, real house prices and interest rates both fell together
• Following the GFC, both real house prices and interest rates have risen together
The explanation for interest rates and real housing prices generally moving in the same direction, is that the strength of the economy drives both interest rates and housing prices in the same direction, and the impact on housing prices from the economy tends to overwhelm the impact of interest rates.
3. Housing prices against average income
The next chart shows house prices as a proportion of average income. (The Economist chart for this measure commences earlier, in 1976). This suggests that, over the longer term, house prices grow faster than average income. This makes intuitive sense, because as we become wealthier as a nation, it makes sense to apply more of this wealth to housing assets than other assets, because housing is the only asset that provides a combination of direct lifestyle enhancement, wealth creation, and low price volatility.
At this level of detail we find the correlation we would expect:
• during the period from 1976 to 1990, when interest rates were rising (from around 10% to 17%), the house price/income ratio fell (i.e. house prices rose, but they rose more slowly than income, because rising interest rates constrained affordability)
• during the decade of the 1990s, when interest rates generally fell (from around 17% to 6%), the house price/income ratio recovered (ie house prices continued to rise, but rose more quickly than income, as falling interest rates improved affordability)
• during the current decade of interest rates being fairly flat and low by historical standards (i.e between 6% &10%, the house price/income ratio has tended to flatten out, but at a level a little higher than when interest rates were higher
4. International comparisons
The chart from The Economist also allows us to compare Australia’s house price/income trend with that of other western countries such as the US, Britain & Canada. This is done in the chart below.
This indicates that Australia’s long term house price/income trend is not out of line with that of other countries and, in particular, is not (as some doomsayers say) especially high compared to its historical average.
5. Assessment
We believe that the Australian economy will continue to show solid growth. Unemployment is low, and there is strong demand from Asia for many of our exports.
If the past is any guide, this solid economic growth will continue to place upward pressure on dwelling prices. If anything, the upward pressure on prices could be higher than in previous growth phases, because the undersupply of dwellings is greater than in previous growth phases. Even if interest rates rise further in response to rising incomes and inflation pressure, history suggests that this will not prevent the rising incomes from spilling over into higher dwelling prices.
The pace of dwelling price increases is difficult to forecast (actually impossible, because not only is the relationship between key drivers such as economic growth and interest rates uncertain, but an accurate forecast of those drivers themselves is impossible).
Nevertheless, while precise forecasts are usually wrong, history and economic fundamentals do suggest some strong probabilities. This is that while the very strong growth of the last year is unlikely to be sustained, available evidence and history suggest that the upward cycle has a considerable way yet to run.
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