Vocal market commentor and fund manager, Chris Joye wrote in the AFR in November last year that Australian house prices could fall by 15% to 25% after the RBA starts increasing interest rates (here’s a copy of that article).
Of course, there are many property doomsayers that perpetually (and often inaccurately) predict property market crashes. However, Chris is not one of these people. In fact, Chris’ predictions are usually quite accurate. However, on this occasion, I disagree with his prediction, and I share the reasons why below.
However, more importantly, I wanted to discuss what impact rising interest rates might have on the property market.
It’s interesting that almost everyone disagrees with the RBA
The RBA has persistently reminded us that it will not raise the cash rate until inflation is sustainably within its 2% to 3% band. And for that to be the case, the wage inflation rate must be sustainably in the 3% to 4% range, according to the RBA. Price inflation can’t remain sustainably high unless it’s supported by rising wages. Last week, wage inflation printed at 2.3% p.a., so we are some way off the RBA’s target.
Despite the RBA’s clear indication, the market stubbornly predicts that interest rates will rise quickly over the course of this year. In fact, this chart shows the money market is currently pricing in 7 to 8 rate hikes (of 0.25% each) over the next 16 months. This seems over ambitious.
So, why would the market ignore the RBA’s commentary and price in more rate hikes? The RBA’s in full control of the cash rate, so shouldn’t we listen to it? It’s like your child telling all her friends that she thinks she’s coming to the party when she’s grounded. I suspect the answer is that markets are imperfect, especially in the short run.
It is worth noting that Australia is in a much different position to the US. In the US, inflation is very high (at 7.5% p.a.) which is underpinned by historically high wage inflation (at 4.5% p.a. which is a 40-year high). One of the main problems is that the US participation rate hasn’t bounced back like it has in Australia and other countries, which results in a tighter labour market. The high Covid death rate per capita in the USA might be responsible for this.
It is therefore very likely that the US (Fed Reserve) will hike rates by 1% or more during 2022, but the RBA is likely to do very little until wage inflation increases.
Higher rates do impact asset values
Theatrically, increasing the cash rate should result in lower asset values. There are a few fundamental reasons for this.
Firstly, as it becomes more expensive to borrow money, people become more careful with how they invest these borrowings i.e. they are more careful to not overpay for a property. Also, demand for new borrowings falls. Less capital flowing into the market results in lower demand and all things remaining equal, it will lead to lower prices.
Secondly, as interest rates rise, lower-risk investment options such as term deposits become more attractive, compared to higher risk options such as shares or property. Many investors prefer lower risk options but have been forced to invest elsewhere (in higher risk investments), whilst interest rates are close to zero.
Therefore, theoretically, higher rates should lead to lower asset prices.
Firstly, owner-occupiers don’t care about financial theory
As the ABS’ chart below illustrates, owner-occupiers have been responsible for driving property demand since May 2020 (dark blue line) – contributing an additional $10 billion per month of lending compared to pre-pandemic levels. Whilst investor lending has increased too (orange line), it was coming off a lower base and has only recently increase by circa $5 billion per month from mid-2021. Investors were a bit late to the party as property prices had already risen substantially by mid-2021. Therefore, I conclude that owner-occupiers have driven prices higher during the pandemic, not investors.
Owner-occupiers are influenced by financial theory to a much lesser extent. People buy (upgrade) homes primarily for lifestyle reasons, not financial. Decisions tend to be relatively long dated i.e. a 10+ year time frame. Home buyers tend to think very carefully about affordability and factor in higher interest rates – it’s more a question of affordability than asset valuation. Finally, and perhaps most importantly, a home is not a discretionary asset (unlike a pure investment such as stocks). It’s a necessity and people know that the same home will probably cost a lot more in 5 to 10 years from now, irrespective of what happens to interest rates. Therefore, they buy when they can afford to do so.
Secondly, demand has been driven mainly by higher income earners
It has been well documented that Covid lockdowns and restrictions over the past two years have adversely impacted the lowest 40% of households by income (here and here, for example). Conversely, the highest 40% of households by income are typically in a stronger financial position compared to the start of Covid. The main reasons for this are that lower income occupations typically are not able to work from home. In addition, higher income earners have saved an unusually high amount over the past two years (lower spending due to lockdowns). In fact, nab economics estimate that Australian’s have saved $240 billion during the pandemic. Most of these savings would have been accumulated by higher income earners since the “average” Australian tends to have relatively low savings.
In short, I posit that higher income earners have been disproportionately responsible for driving higher property prices (through higher demand), which is what I expected back in October 2020.
If we agree that Covid restrictions are less likely from hereon in, consumer spending patterns should normalise, including spending on international travel. That may reduce higher-income earners savings rates, but it’s likely they are well prepared for higher interest rates.
It is also worth noting that lending rules have tightened significantly in recent years which includes testing affordability at much higher interest rates. If you have obtained a new mortgage over the past 5 years, its likely higher interest rates won’t cause too much stress.
At best, there’s a weak relationship between growth and interest rates
The chart below (click to enlarge) illustrates the annualised median house price growth since 1980 in Sydney, Melbourne and Brisbane. I have inserted the average standard variable mortgage interest rates in the grey rectangle below each growth period. You will note that there’s not a very strong relationship between interest rates and property prices. I suspect that’s because home buyers make an ‘affordability’ assessment rather than a ‘valuation’ assessment. If home buyers conclude they can service the required mortgage, they will proceed with the purchase because they know in the long run, property prices almost always trend higher.
Covid distorted demand and that will probably normalise this year
The property market has benefited from an unusually high level of demand over the past 18+ months and this demand is likely to normalise.
Firstly, FOMO drove many people to buy property. Commentators predicted that interest rates would remain low for a long period of time and that would lead to higher property prices, so people rushed into the market before prices become more unaffordable.
The work-from-home wave created substantially higher demand for regional properties, particularly in coastal locations.
Finally, since many people were spending less money on travelling and going out during lockdowns, they redirected these financial resources towards the property market.
Things are changing with the reopening of international boarders (and therefore overseas travel), the prospect of Covid restrictions is unlikely, talk of higher interest rates, and higher property stock levels. These factors should result in a more balanced property market.
But the value proposition hasn’t really changed all that much
Low interest rates stimulated demand for housing during 2020 and 2021. Even if rates increase by 1% over the next 1 to 2 years, they are still low relative to the past few decades. And due to much higher household and government indebtedness, interest rates won’t have to rise by much to cool inflationary pressures. It is conceivable that the neutral mortgage interest rate could be circa 5% p.a.
Therefore, from an owner-occupier’s perspective, the value proposition hasn’t changed that much i.e. housing is still relatively attractive due to interest rates being relative low compared to the past few decades.
Property prices will be closer to intrinsic values, which means losses for some recent buyers
The chart below was produced by Coolabah Capital and shows the change in property prices since 1850. It puts into perspective the magnitude of the price growth that occurred last year.
We can argue that the market value of a property is what someone is willing to pay for it. However, it is obvious to me (and lots of other people) that some purchasers were clearly overpaying for property throughout 2020 and 2021. That is, they paid more than its intrinsic value. It is unlikely that level of exuberance (over-paying) will extend into 2022. A more balanced market should result in more reasonable prices.
That means people that did overpay over the past 1 to 2 years might find themselves in a situation where comparable properties are selling for less than what they paid.
Medium term outlook will be driven by a healthy economy
I would not be surprised to see one or two quarters of small (immaterial) negative property price growth eventually i.e. after the RBA starts raising interest rates. However, I would be most surprised to see prices retreat by 15% to 25%, as predicted by Chris.
In my view, the property market will be driven by very sound fundamentals over the medium term:
- Interest rates remaining below the average rate over the past 20 to 30 years.
- A low unemployment rate.
- Population growth due to the return of overseas immigration (skilled migrants and students).
As such, quality property assets will continue to perform well.
