PROPERTY INVESTMENT IN A RISING INTEREST RATE ENVIRONMENTMain drivers of dwelling prices & affordability
When interest rates are rising, the impact on property prices can be confusing. This is because the Reserve Bank tends to increase interest rates when income growth is strong, which creates two opposing forces on property prices:
• upward pressure from strong income growth
• downward pressure from higher interest rates
The long term relationship between income, interest rates, dwelling prices, and affordability, is discussed below.
It needs to be recognised that housing affordability is not simple to measure, and this has led to some back-of-the-envelope analyses, which have supported incorrect conclusions. The simplest (and unfortunately not uncommon) approach is to simply look at the ratio of:
• average income across Australia, to
• the average house price (as published by the Australian Bureau of Statistics - ABS)
While this might seem a good starting point, it is a deeply flawed approach unless a lot of work is done to ensure that the measures of “income” and “dwelling price” are meaningful – without this care and work, the measures are seriously flawed and inconsistent, and therefore do not give meaningful insight.
On the “income” side, the raw figure of average gross income is not the appropriate measure. The appropriate measure is the proportion of a household’s income that must be allocated pay off its mortgage. So adjustments should ideally be made for tax, interest rates, and the number of income earners in a household.
On the “property” side, the ABS data look only at capital city houses (i.e. they ignore regional areas and units). It makes no sense to take average income from the whole of Australia, and then compare it only with the portion of property represented by capital city houses (the most expensive dwellings). Adjustments need to be made to include all properties (eg units). Also, the analysis needs to be done region by region, because while capital city dwelling prices are more expensive, their incomes are also higher.
This more detailed work takes considerable resources. It has been done by a number of analysts including the RBA and Rismark, who conclude that while Australian property prices are not cheap, they are not unduly expensive or unaffordable, either by historical standards, or in global terms.
The most recent analysis has been done by Westpac in a very comprehensive report (26 pages & 48 charts). Some of the most interesting charts are shown below. Westpac assumes a mortgage equal to 75% of a property’s value. They then ask the question: “how much could a hypothetical household pay for a property if it allocated 25% of its income to repaying its mortgage?” The amount it can pay will change over time - it can afford a more expensive property as its income rises (from both inflation and “real” [i.e. after inflation] income growth), and if interest rates fall.
The chart below addresses this issue. The column on the left shows the situation for the 1980s. At the start of the 1980s, they take a hypothetical household that could afford a property worth about $50k (this is the dark bar at the bottom of the column at the left). By the end of the 1980s, if that household's income rose at the average rate due to inflation (the pink bar) plus real income growth (the grey bar), they could afford a property of about $150k with the same allocation of 25% of their income.
During the 1990s (the middle column), the combination of falling interest rates (the light bar) plus inflation & real income growth, meant that the property they could afford rose from about $150k to $250k.
During the most recent decade to 2010, the price of the dwelling that household can afford has risen to about $500k.
There is nothing magical about this. It is not a bubble. It is simply the fact that as incomes rise people can afford to pay more for their dwelling and they choose to do so. A $500k dwelling now, causes no more stress than a $50k dwelling did in 1980.
Another important factor (not included in the Chart above) is that an increasing number of households have dual incomes. Dual income households have incomes 75-80% higher than single income households; accordingly, they can afford more expensive homes. Dual income households have increased from 10% of total in 1994/95 to 18% in 2007/08. This allows (and causes) average dwelling prices to rise by considerably more than would be the case if there were only one income per household. Household vulnerability to interest rate rises
In an environment when strong economic growth has caused interest rates to rise, it is useful to look at the proportion of households that might be vulnerable to (not just inconvenienced by) rising interest rates.
This has been examined in detail over recent years by the RBA, who has obvious concern for financial system stability. The Westpac chart below reproduces an RBA chart that shows, up to 2008 (latest data available), the proportion of households that are considered potentiall vulnerable – defined as those with high repayments (>50% of income) and little equity (<10 or 20% of dwelling value). Only a very small proportion of households were in a "vulnerable" situation in 2008. We might expect less households to be in this situation now, because since 2008 interest rates have fallen, and property prices have increased.
The lack of vulnerable households is one reason that the mortgage arrears rate for Australia is very low compared with most other countries (see chart below). It has not much changed in recent years and only rose a little during the GFC.
The future
Australia is enjoying very strong growth prospects which will increase real income and support house prices. The latest RBA Board Minutes state that:
“GDP was expected to expand by 3½ per cent over 2010, with growth picking up to be in the 3¾–4 per cent range over 2011 and 2012. This positive outlook for the domestic economy was underpinned by the income surge flowing from the very high level of the terms of trade and the expected growth in investment in the resources sector.”
Nor is inflation a problem at present: latest RBA minutes state:
“In underlying terms, inflation was expected to remain around 2½ per cent until mid 2011, before gradually rising to 3 per cent by the end of 2012”.
So, the latest RBA Board Minutes suggest strong real growth of 3.5-4%pa, plus modest underlying inflation of 2.5-3%pa. This is nominal growth of 6-7%pa over the next few years, which we believe will drive medium-term property prices, in similar fashion to previous periods. Interest rates may continue to rise, but this will be in response to stronger real growth and/or inflation which will place further upward pressure on dwelling prices.
In terms of magnitude, there is no reason why dwelling prices should not continue to rise over the medium to long time with real income and inflation, as they have done in the past.
One factor that might slow the medium-term growth is that the impetus from the interest rate falls of the last two decades is unlikely to continue – this movement was probably a one-off event, as a result of a secular shift from higher to lower inflation (this contributed to a bit under $100k of the rise of the hypothetical household’s dwelling price increase from $50k to $500k).
On the other hand, there are factors that point to faster medium-term growth than in the past. These include Australia entering a resource-led growth phase that is likely to last for decades and, (as explained in previous reports) for several years dwelling construction has not kept pace with population, resulting in a very substantial undersupply of dwellings which shows no sign of abating soon. Investment Strategy if cash flow is an issue
For those investors for whom cash flow is a particular issue, it is helpful to look at properties that have healthy cash flow to offset higher interest rates. Attractive cash flow features can include:
• high yield (this might include furnished apartments)
• high depreciation (brand new properties have higher depreciation)
• low outgoings (house & land; or townhouses & apartments with low strata levies)
• deferred settlement, so repayments start when income is higher and (perhaps) interest rates are on the way down again (off-plan properties)
• low price point, so that interest repayments are lower
For example, a suitable property might be under $400k, with after tax cash flow well under $100 per week. If you are interested, we have sourced a number of properties across various regions of Australia that fit these criteria (assuming 100% of costs are borrowed, an above-market interest rate of 7.3%, and an investor in the second highest tax bracket), and have strong capital growth prospects.
Another strategy might be to look to benefit from what the RBA terms “the expected growth in investment in the resources sector”. We have undertaken considerable research on Gladstone, which has recently received government approvals for a number of multi-billion dollar plants to process Coal Seam Gas into Liquid Natural Gas. These projects will be underway shortly, will operate for decades, and will add tens of billions of dollars to the economy. Further research on Gladstone is available in the “Current Projects” section of our website. More information
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