Predicting the end of the housing boom is one of the most popular games in town. Everyone has a theory – and the ‘tipping point’ is one of the better ones.
Housing prices, particularly in Sydney and Melbourne, have rocketed and the list of what may be to blame is long – from immigration, very low interest rates and record household debt to negative gearing and concessional capital gains tax. Yet none of these explanations stands up to any real scrutiny.
First, Australia has always needed population growth and immigration levels have been high since World War II. Despite this, housing prices were still considered affordable 30 to 40 years ago.
House prices increased at an even greater pace than today in the late 1980s when mortgage rates were in the double digits, so low mortgage rates do not explain much either.
Housing prices and household debt
While household debt is a concern, it is not a good predictor of a house price correction. Household debt to income levels have been at record highs every year for the past 30 years.
Finally, negative gearing has been around for more than 40 years – and capital gains tax didn’t appear until September 1985, yet prices were still considered affordable in the 1980s.
In fact, negative gearing now provides the lowest benefit for investors versus owner-occupiers relative to history. Owner-occupiers, however, have a significant capital gains tax advantage over investors.
Supply is the key
Once again, a better approach is to look for answers in supply. Research by Quay Global Investors adds the concept of ‘replacement cost’ to the supply equation to help explain house price fluctuations.
Quay says there is a profit incentive attached to adding new stock when prices are above the cost of replacing or replicating the housing. Conversely, when prices are below cost, supply remains constrained until prices recover.
At present, supply is responding to prices being above replacement cost but that will change as housing completions have increased sharply since 2015. An estimated 220,000 more dwelling completions are expected in 2017, Australian Bureau of Statistics data shows.
But there is an added complication. Assuming an average settlement price of $800,000 per dwelling and allowing for deposits and some all-cash settlements, the final credit requirement to fulfil these purchases may be as much as $150 billion.
Outstanding housing loans
Quay says that given at least 50% of the settlements are likely to involve investors and/or foreign buyers, the banking system will need to exceed the regulator’s 10% limit on investment lending. In effect, this will unravel most of the effort to contain investor credit growth since 2015.
The danger is that some banks may baulk at financing the settlements, either by choice or due to regulatory pressure. This would put downward pressure on home values, force some developers into fire sales and increase default rates – hurting banks and slowing the economy.
Of course, the banks may ignore the regulators, or non-bank lenders may be able to fill the void. But Quay says this will just delay the inevitable if prices remain above replacement cost.
If there is a housing correction, construction will collapse, economic growth will grind down, unemployment will rise, the dollar will suffer and official interest rates will have to be cut again. That’s not a good scenario.
Quay believes the risks are building, and the limits being imposed on new investor borrowing at a time of record new housing deliveries may turn out to be the tipping point.
Like others before it, Quay may also be wrong and housing prices will stage a measured decline, but its reasoning on the issue seems sound.