House Prices - A Balanced View

You would be hard-pressed to find a more disliked public figure than Reserve Bank of Australia (RBA) Governor Philip Lowe. The RBA has hiked interest rates for eight consecutive months, taking the cash rate from 0.10 per cent to 3.10 per cent. This comes after Lowe assured borrowers as recently as November last year that the conditions for a rate rise weren’t expected until 2024. Compounding the pain, inflation is 6.9 per cent, eroding savings buffers and disposable incomes.

State of play

Coinciding with the first interest rate rise in April, national house prices have fallen 7.0 per cent from their peak. Put simply, an increase in interest rates acts as a handbrake on asset prices including property. Existing borrowers incur higher mortgage repayments, estimated to be $1,668 per month for a $1 million home loan. The borrowing capacity of new homebuyers also falls, limiting them to less expensive purchases.

However, what is rarely mentioned is the significant equity buffers most households have built. House prices across the country have increased by 28.6 per cent since the onset of the pandemic. All cities, except Melbourne and Sydney, could weather a further 15 per cent price fall from here and still be above April 2020 levels.

 RBA data suggests a fall of 20 per cent in house prices would only increase the share of balances in negative equity to 2.5 per cent. The major risk to the housing market is therefore not in terms of home values but the ability to service debt.

Cash flow stress

Households have so far proved resilient to increases in the cash rate, with overdue and non-performing loans anchored to historical lows. However, we know monetary policy acts with a lag, meaning the full impact of interest rate hikes won’t be felt for another 12-18 months. Furthermore, many households took the opportunity to fix mortgages at 2-3 per cent, which won’t roll off until the second half of 2023.

At the current cash rate, 50 per cent of variable-rate mortgages would incur a monthly repayment increase greater than 30 per cent. For fixed-rate loans, it’s estimated that 60 per cent will incur an increase greater than 40 per cent. It’s difficult to ascertain precisely how households will react, but it’s clear this will cut into disposable income. Assuming another two 25 basis point rate hikes, 15 per cent of borrowers will have negative cash flows. To maintain repayments, this cohort will need to dip into savings or risk defaulting.

While higher interest repayments undoubtedly place stress on owner-occupiers, it’s unlikely to cause a major problem for most. Selling is a last resort option, and as we highlighted earlier, most households have significant equity buffers. The owner-occupiers most at risk are first-home buyers, who typically borrow at the maximum borrowing capacity and buyers over the past year.

Where the impact will be harder felt is with investors. For the last decade, negatively geared homes have benefitted from tax benefits and capital appreciation. Now, cash outflows are rising and capital values are falling. This is reflected in new lending, which shows a marked drop off in investors compared to owner-occupiers.

Fundamentals remain solid

Notwithstanding the impact of higher interest rates, Australian property fundamentals remain strong and will underpin prices over the longer term. Unemployment is at a multi-decade low of 3.4 per cent, supporting the ability of households to service higher repayments. Employees are also benefiting from varying degrees of wage growth, with private sector wages increasing 11 per cent annually.

The rental market is extremely tight, with vacancy rates and weekly listings at decade-lows. There doesn’t appear to be a big supply response, with new dwelling approvals falling and builders struggling to cope with inflationary materials and labour input pressures. A return to normalised levels of migration will also underpin rental demand.

Finally, inflation looks to be easing and will likely peak in the early months of next year. Global commodity prices are off 35 per cent and shipping rates have fallen 70 per cent. This will soon allow the RBA to slow the rate of hikes and reserve the ability to reduce them should the economy require it.

How far will house prices fall?

Ultimately, in the short term, house prices will be dictated by how far the RBA needs to increase interest rates. We think the RBA is nearing the end of its hiking cycle and will eventually pause to evaluate its impacts.

It’s also worth pointing out that lenders historically stress test 250 basis points (recently increased to 300 basis points) above the borrowing rate. With 300 basis points already passed through, the RBA will be reluctant to keep raising because the impact on recent borrowers is now unknown.

The big four banks largely estimate a fall from the peak of 15-20 per cent. Betashares, using its mortgage repayment ratio, estimates at least a 10 per cent fall to get back to the long-run average. This range of forecasts is likely where house prices bottom, and depending on the city, above levels seen before the pandemic. Over a longer time horizon, Australian property remains well-placed. Immigration and an already tight rental market will drive demand in addition to the absence of new supply. Households are also entering the interest rate hiking cycle from a position of strength, which should mitigate against any serious downturn.

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