What drives house price growth in the long-term? Does it reflect rising household debt or inadequate housing supply? A new research paper by Mario Kohler and Michelle van der Merwe from the Reserve Bank explores this issue in some detail.
The fundamental driver has shifted over time, with the sharp rise in dwelling prices during the 1990s and early 2000s reflecting a significant increase in the debt-to-income ratio of Australian households. More recently, strong population growth has effectively propped up the property sector, particularly in Sydney and Melbourne.
Nominal dwelling prices have grown on average by 7.25 per cent per year over the past three decades. During the 1990s this growth mainly reflected inflation, which can be seen on the graph below, while gains during the 1990s and early 2000s were significantly higher after adjusting for inflation.
The past decade has been characterised by growth that has been broadly in line with household income growth. This relationship has broken down recently, with the house price-to-income ratio surging to a record high after the RBA cut rates to its lowest level in history.
In determining the drivers of long-run house prices, the authors have had to delve into the murky world of house price modelling. Their purpose is to examine “the extent to which changes or trends in such fundamental drivers correlate with observed changes in longer-run housing price growth.”
This isn’t an assessment of whether housing is priced appropriately or whether housing is affordable. That is a separate question and beyond the scope of this paper.
According to economic theory, the price of any asset is a product of the demand and supply for that asset. Both dynamics are relatively complex in the property market.
In the short run, “the demand for housing can change more quickly than the supply of housing”. The supply response usually takes more time, reflecting the lag between when investment decisions are made and when construction is complete, which often results in prices overshooting in both directions.
In the long term, supply can adjust to a shift in conditions but that doesn’t necessarily mean that the supply response will be adequate. That is particularly pertinent to a country such as Australia where supply is artificially reduced by state government policy.
The large divergence between the price of housing and the cost of building a new dwelling indicate the market is at least partly determined by factors external to housing supply, such as financial deregulation.
The deregulation of the financial sector during the 1980s, combined with the shift towards lower inflation and interest rates, increased the access to finance for many Australian households. The ability of households to service their new or existing mortgage improved significantly during this period prompting households to borrow increasing amounts as the housing market spiralled upwards. This whole process was supercharged in 1999 when the Howard Government introduced the capital gains tax discount.
This process was structural in nature and boosted price growth over a 15-year period. This adjustment appears to have run its course, with the household debt-to-income ratio relatively stable over the past decade.
Beyond financial deregulation, the most likely source of house price appreciation is a failure of housing supply to keep up with underlying demand. According to the authors, underlying demand is effectively “the longer-run level of demand, abstracting from shorter-term influences on housing demand related to the business cycle”.
Underlying demand, which consists of “demand from newly formed households; demand for new dwellings to replace demolished ones; and demand for second or vacant homes”, is largely unobservable. We can try to estimate it, but there is no way to tell for sure whether those estimates are correct. This is a problem that many property analysts have had to deal with over the years.
Underlying demand was relatively modest throughout the 1990s due to a combination of subdued population growth. This offset the ongoing decline in average household size. Underlying demand ramped up over the past decade as Australia’s population growth rose to be among the highest in the OECD.
Realistically we can expect underlying demand to moderate somewhat over the next few years as population growth returns towards a level that is considered more normal.
Putting the pieces together, it appears the number of dwelling completions was near the lower band of estimates for underlying demand. The recent construction boom should see between 180,000 and 190,000 new private dwellings added to the housing stock during the 2014-15 financial year.
The figures can differ significantly by state. It probably won’t surprise readers to know the gap between underlying demand and supply in New South Wales has been quite large for much of the past decade. That gap is slowly beginning to close but the demand/supply dynamics will likely provide some support to prices in the near term.
The authors take their analysis one step further by attributing growth in each financial year to its fundamental driver: rising debt or the demand and supply gap. This modelling clearly shows that financial deregulation was the main driver during the 1990s and early 2000s, while inadequate supply has helped to support price growth over the past decade.
These figures may point towards some downside risk to the housing market over the next decade. The household debt channel is largely exhausted -- even the Reserve Bank believes that a further rise would be undesirable -- while estimates of population growth are unlikely to return towards their earlier peak.
Relatively weak income growth -- resulting from the decline in Australia’s terms of trade -- also suggest that future price growth won’t replicate the growth that we have become accustomed to over the past few decades.