House Prices: Where to from here?
The value of a home is determined by the simplest market forces. Self interested buyers and sellers negotiate to a point where they both feel they’re getting a good deal. The perception of value from either side is driven by a range underlying forces such as their confidence in the market, their ability to access a loan, how many other houses are for sale, and how many other buyers are competing for a home.
Social and economic shocks like COVID-19, the GFC, or climate change reverberate through our communities in ways that we often don’t understand. That being said, house prices generally reflect changing sentiment and economic conditions as housing is a social phenomena just as much as it’s an economic one. This article delves into the present drivers of home values and helps forecast what house prices may do in 12–36 months.
In a simplistic and ideal world there’d be a home for everyone that needed one. Let’s use this idea as the base scenario for thinking about how home prices might work. If a home was built for every household, and a new house were instantly available for every new household then theoretically we would never pay more than the cost to build the house, plus labour and any utility premium. The utility premium is an economic way of saying the extra price we’d pay to live by the beach, or have a short commute, or any other feature that we believe enriches our lives.
Price = Materials + Labour + Utility Premium
In this world house prices would only be affected by changes in the price of the inputs that go into building a house. The price of the builders time, of the concrete and timber. The utility premium would change with those attributes like “location, location, location” and how much we value them. The additional value of a waterfront residence would be determined by the risk of a flood against the pleasure of a sunny afternoon by the water and the competition to pay for that additional utility.
In the real world, our world, house prices do work like this but naturally with a few changes. In dot point — house prices are also affected by:
- Access to credit (ability to get a loan)
- The price of credit (interest rates)
- Immigration and migration (the number of people)
- Housing supply (land availability, building approvals etc.)
- Sentiment (confidence and emotions at the time)
- Income, savings and tax (ability to afford the expense)
Each of these factors are significant in driving house prices. The difficulty is that the weight of each category isn’t fixed, their influence is variable and ever changing. For example, in light of COVID-19; sentiment and income have dropped while both the ability to access a loan and the price of loan have become more favourable — yet it is sentiment that is driving property down, and is little affected by the other variables.
Another example would be if you had 100,000 households but only 50,000 homes. Sentiment would be of minimal impact and prices would be driven by the huge mismatch of supply and demand. The housing supply shortage would cause prices to skyrocket irrespective of the other factors.
Although the real world is incredibly complex I thought that we could still apply theory to macro home valuation and forecasting. The theory I devised is still a simplified version of the real world but it brings into context the macro variables, micro decisions and the raw costs of inputs.
The theory I’ve devised is surprisingly intuitive. House prices are determined by the inverse of the number of housholds with access to credit and the current interest rate, divided by the housing supply plus the utility and sentiment premium. In plain english; house prices are determined by the individual choices and values of the people that qualify to purchase a home, the prevailing interest rate and the cost of the materials that go into the home.
Let’s unpack the mysteries of the housing market highlighted by house price theory through some simple categories. Mortgages and loans to explore how your ability to walk down to the bank and take out a loan affects the market, Sentiment to delve into how our emotions and perception drive our decisions to buy or sell, Supply and demand to expand on how housing supply is generated, and finally Income, savings and tax to see how cash flow determines not just our ability to afford housing but how it also links to sentiment, mortgages and demand. Don’t worry though, there won’t be any more maths, just some graphs.
Mortgages and Loans
For most of us, a major hurdle to buying a house is going to the bank and getting a loan. That approval for a loan is usually the result of years of hard work and saving, and is reliant on demonstrating a consistent income. Contrary to popular economic thought, the ability to get a loan is even more important than the price of a loan.
The evidence for access to credit rather than the price of credit is overwhelming. We can see it in the simple decisions of millions of people as they go to lower tier lenders like non-bank lenders that charge higher interest just so that they can get a loan. During the 1991 recession people still went and took out mortgages to buy homes despite interest rates of 18%. On the otherside of the ledger is lending discrimination and the overwhelming history of refusing to lend based on traits like ethnicity, and employment type. The most recent impact of reducing access to credit is the Australian Royal Commission into Banking which resulted in the banks tightening their lending criteria and as people’s ability to access a loan reduced house prices fell alongside them.
If we think of the mortgage as being allocated a percentage of our income, say 40% . Then we can frame it in a way that we can borrow whatever amount has repayments up to that portion of our income. So if you earn $5,000 a month then you’d be happy to have mortgage repayments up to $2,000 a month. Now let’s assume that you’ve saved the deposit and meet the banks standards so you qualify for a loan. The next factor is how interest rates will impact the amount you’re able to borrow.
Interest rates are the cost of borrowing money and they really determine how much you can borrow on your wage. The lower the interest rate the smaller the cost to borrow is and the lower the repayments would be. Therefore to borrow up to your 40% limit you can actually borrow a larger amount. Lower interest rates mean more purchasing power and higher interest rates naturally mean lower purchasing power. As interest rates move, property prices will move in the opposite direction, so that if interest rates go up then property prices will go down and vice versa. All things being equal then the movement of interest rates and property prices will be proportionate so that in real terms you pay the same price for that house whether interest rates are 0.50% or 5.00%.
It’s important to understand that interest rates don’t stop people from borrowing or buying houses, they merely change how much they can borrow. It’s this question of how much can I borrow that pushes the market in either direction.
Changes in social norms such as female participation in the workforce, under-employment and second jobs have impacted our borrowing capacity. Most households now have two full time wage earners to service a mortgage repayment and therefore can afford to borrow more. Changes in regulation to relax requirements for deposits, hurdle servicing limits or verification of income also impact borrowing capacity.
Falling interest rates have combined with changing social norms to enable an explosion of household debt. As those interest rates went down we were able to borrow more and this in turn continued to push the prices up. However, this is debt binge is unsustainable. At some point the artificial creation of money will have to end and prices will come down.
Sentiment is the most difficult thing to predict as it’s completely intangible. It’s about our emotions; how we think and feel about the world around us. It’s swayed by those reality TV shows about property, news articles, debate at the dinner table and our own personal circumstances. COVID-19 has made us fearful, limited our ability to physically to go property inspections and for some of us it has tragically meant lost incomes.
The idea of sentiment in home prices even creeps into things about how we feel inside a house or a neighbourhood. Do we feel safe, do we love the view, is the design breathtaking and can we imagine ourselves living there. After a restful summer by the beach we might dream of a waterfront property but after floods then we couldn’t think of anything riskier. Sentiment can be totally irrational but fundamental in our decisions.
It is probably no surprise that consumer sentiment and house prices are highly correlated. This correlation causes significant concern for the coming 12 months as COVID-19 has seen a 17% drop in consumer sentiment. This is the largest drop on record and the lowest consumer sentiment has been since the 1991 recession. According to some commentators then a 17% drop in housing is entirely possible, if not highly probable.
Sentiment also drives the types of homes we live in. The NIMBY (not in my backyard) movement has limited building approvals and higher density living in cities. Housing density is a huge issue for countries like the United States and Australia as cities have been built on the idea of the car and driving from point A to point B. Cities consquently sprawl for miles and miles, with housing devouring precious farm land that’s needed to feed the population. The desire for a house and backyard rather than a large apartment or townhouse clearly impacts the housing supply.
Supply and Demand
Supply and demand of housing are two very simple aspects but they become incredibly complicated due to excessive government influence. Both the supply and demand sides of the equation are subject to politicisation, vote grabbing and media sentiment. Things like building regulation, immigration, and and sentiment can change quickly but have lasting impacts. A decision to build a home made in conditions of today must stand for the next 30+ years.
The supply of housing is dictated by government regulation and land availability. Council zoning of land for commercial, residential or farming purposes are easy examples of how the government dictates housing supply. Approvals to build or deveop and the regulations that go along with it further tie into the availabilty of housing stock. For example a city council may re-zone commercial property into mixed use, so a developer puts apartments on top of restaurants and shopping. There may be constraints on light, air flow and size of the apartments as well. When considering cost it’s good to remember there’s an infinite amount of space in the sky but only a finite amount of land.
As housing supply is so heavily dictated by government approvals it is logical that the indicators for supply are building approvals. The indicators for demand are changes in the population. The largest changes in the population come from changes in the governmental regulation of immigration.
As immigration goes up, the number of households able to access a loan goes up, and therefore the demand for housing increases. For immigration to have no effect on housing then new housing construction would need to increase at the same rate as immigration. The housing supply needs to be able to absorb the number of people needing homes or else prices will go up. As housing goes up then certain buyers are squeezed out of the market and you end up getting 30 year olds living at home with mum and dad or going to the bank of mum and dad for assistance with a deposit.
Housing supply also needs to match the locations where people want to live. With huge urban migration, cities have exploded and housing supply has struggled to keep up. Meaning that huge price dislocations can occur between metro and regional property. This could be attributed to the utility premium as people see metropolitan homes having more utility than regional homes or it could simply be a factor of people moving to where there is an income.
The interesting question after COVID-19 is whether immigration will go up or down. This will be driven by the sentiment aroud whether countries like Australia are safe havens with access to world class healthcare or whether it is too dangerous to travel.
Income, Savings and Tax
Our ability to afford a home has to be the single most important factor in home prices. The simple yes or no question of can we afford to buy that house dictates whether we participate in the market or not. The government has a habit of distorting affordability through its use of tax breaks and rebates. Things like first home buyers grants, negative gearing and minimum wages all impact house prices.
For house prices to be going up then our net income has to be going up or we have to be taking on more debt. We simply can’t spend more than we have unless we use debt. So for house prices to rise we either need to earn more or borrow more. Recently, it’s been a lot of borrowing more rather than earning more. Wage growth has been dismal and low interest rates have sparked a borrowing frenzy.
Combine this with tax incentives in countries like Australia and there is a significant bias to accumulating property. First home buyers get rebates and property investors can use investment expenses to reduce their personal income tax. This government policy creates distortions in the competition for property and further pushes prices up as people buy additional homes for tax benefits. The tax regulation changes the composition of borrowers much like immigration policy does. The tax incentives for property investment mean that investors crowd out first home buyers and other entry level property buyers, or force them to borrow more as they compete to buy a home.
COVID-19 will do a few things to the income, savings and tax components of the house price equation. The loss of jobs, incomes and the businesses will be profound. Major employers have already flagged that they’re reducing wages by 20% over the next 12–24 months. A reduction in income will then be a reduction in the population eligible for a mortgage.
A drop in income means that less people will meet bank hurdle requirements for a loan. Savings in the short term will also diminish as people burn through their savings to survive the distaster period; further reducing the population with access to credit as fewer will have savings for a deposit.
The fear surrounding the virus and corresponding lack of spending will create a higher savings rate in the medium to long term as well. The worry of being able to live out the next crisis will mean people save more for a rainy day. History generally says that after a crisis 3–4% of people never return to the workforce and this could be attributable to a change in our spending behaviour. A change in sentiment causes the working population to defer more consumption today which subsequently reduces total income as their spending is no longer going into businesses and creating jobs, reducing the money cycling through the economy.
The huge stimulus packages of the government will need to be paid for. This will likely be in the years to come and will come in the form of higher taxes. We don’t know where taxes will be raised but we know that it will reduce national income. Therefore the only rational conclusion from the income, savings and tax component of house prices is that the downward pressure generated by COVID-19 will cause values to fall.
The question is, by how much?
If you’ve made it to this point in the article then it’s clear that you have the intellect to make your own forecast. You’ll probably have a feeling about where house prices might go and how the market will pan out. For me, the next 12–36 months property prices are headed down. New housing starts have fallen to levels not seen since the 1960’s, the reduction in incomes, and the deferred mortages will combine to push prices down.
Australia’s largest bank reflects the current mood with it’s recent downgrade of home price targets. It expects a deep economic hit from COVID-19 restrictions with residential property prices falling by 10% over the next 6 months.
The current sentiment is negative, repayments will need to made on existing mortgages and the income for those repayments may have reduced or disappeared. Circumstances will leave little option but for the number of houses for sale to increase. Simultaneously the number of buyers will fall as savings have diminished, incomes have reduced or sentiment has scared them away.
If the close correlation to consumer sentiment persists then house prices should fall by more than 15%. There is some slack in the market for first home buyers to pick up stock on the initial decline, but if immigration also reduces then it will be a buyers market for a few years.
However, after a point, the market should tick up. Unless the government changes policy regarding building, buyers grants, tax, immigration or anything else that so heavily impacts the property market, then the pause in building activity from COVID-19 should result in housing supply shortages in the future.
But what is the true value on having a roof over your head?
If you have any questions then please feel free to comment, and if there is anything you’d like to see analysis on or read about in the future then let me know.
Also, please note that this article does not represent financial advice or the views of any organization; it is only the opinion and analysis of the writer.
Thank you for reading.