Interest rates in Australia may be on hold for the time being, but that may not make those with a hefty home loan sleep any easier, thanks to talk of a bubble in the Australian housing market. One estimate is that residential property may be overvalued by as much as 50%, a figure which has made home owners, prospective buyers and investors understandably nervous. And there are signs that some of the drivers of housing demand may be hitting reverse. Among them are changes in the rules preventing some foreign investors from investing in residential property. Julian Lorkin of Knowledge@Australian School of Business asks Glenn Otto, a professor of Economics at the Australian School of Business for his analysis.
An edited version of the interview follows.
Knowledge@Australian School of Business: Australia's house prices have been rising between 10% and 20% annually, depending on the state, prompting some forecasters to warn that the country has an unsustainable housing bubble. And a recent calculation indicated that house prices are more than 50% above their fair value. How realistic is that?
Glenn Otto: Giving a figure on the degree of overvaluation of the housing market is a very difficult thing. What you have to look at is the underlying nature of fundamentals, and you have to think about why Australian house prices may be high - and there are some good reasons. On the demand side, there hasn't been a large effect on the Australian economy from the global financial crisis. There's been strong population growth recently. Interest rates have been cut quite substantially - although they have been rising again recently. But there was a period of about 12 months where interest rates were cut. The issue is on the supply side. It would appear that the supply response - supply elasticity - in the Australian housing market is relatively low. Essentially, that means when there is an increase in demand, there is a large rise in the price of housing, rather than a kick on in supply.
Knowledge@Australian School of Business: The figure of being 50% overvalued comes from the US investment bank GMO. Are there any lessons we could learn from the US sub-prime crisis?
Glenn Otto: The issue with the sub-prime crisis was banks and lenders took a particular view about the way US house prices would go in the future. They loaned money to people who were really not able to afford to repay it. They made loans at lower interest rates, with the contingent effect that interest rates would rise over time. Of course, these people (the mortgagees) were never going to be able to pay higher interest rates in the future. But the assumption was that house prices would be higher, and that people who weren't able to pay those loans would simply be able to extract the capital gain by selling the house. What was wrong was their forecast about future housing prices.
The Australian case, due to the nature of loans made by banks and mortgage originators, was somewhat different to the US. In Australia, there is no scope for what's called a non-recourse mortgage - with those (a mortgagee) can simply hand over the keys to the house if the value of the house falls below the mortgage. Australian banks were more cautious in their approach to lending.
In the US, there were social and political dimensions to the sort of lending that was going on there. Several governments had determinedly pursued a social policy to get low-income people into housing. We didn't have the same sort of policy in the Australian context.
Knowledge@Australian School of Business: However, the trigger for the housing market collapse in the US seemed to start with rising interest rates. And, as we've seen in Australia, first homebuyers, in particular, are seeing their budgets squeezed when affordability is an issue. The Reserve Bank of Australia (the central bank) must be aware of this issue. Is there a certain level over which interest rates will go that will cause real problems for the housing market?
Glenn Otto: The evidence suggests that changes in interest rates have an effect on the growth of house prices. There's an affordability issue because rising interest rates mean that the cost of repaying your mortgage tends to increase. And most people in Australia are on either very short-term fixed mortgages or floating mortgages. One issue that should be kept in mind though, is that prior to the global financial crisis, people with mortgages were paying interest rates of somewhere between 8% and 10%. At the moment, they're probably paying around 6%. When interest rates fall - even with a floating mortgage - a lender has to make a deliberate decision to go to the bank and ask them to lower the amount of the mortgage repayment. People probably took advantage of the fall in interest rates. If they didn't cut the amount of their repayment, basically they were making a larger payment on their principal of the mortgage, and so reducing it.
Most people's interest rates fell around 4% from pre-financial crisis levels. Although the rates have picked up by 1% or 1.5% now, there's still some way to go before they are back to the levels of mortgage interest rates and mortgage repayments prior to the crisis. If people are making the same repayment now as they were before the crisis, it will be some time before the banks will be asking them to repay at a higher rate.
Knowledge@Australian School of Business: Interest rates don't just affect those people who live in the houses, investors are also a key part of the housing market. In the UK, when interest rates rose to a certain level, a lot of buy-to-let investors who were renting out properties decided it was just too expensive. They weren't making any money and bailed out of investment properties. In recent weeks in Australia, foreign investors have, in effect, been ruled out of a large sector of that market. Is that going to affect the market in the future?
Glenn Otto: Having certain people taken out the market will have a downward effect on the growth of prices, that's true. Again, there is a difference between the US and Australia. In the US, there was a huge supply response, particularly in certain areas including California in what's called flat land US, where it's very easy and relatively cheap to provide housing. Now there are estimates of a large excess supply of housing in the US. You don't get those same estimates in Australia. Everyone says there's a shortage of housing in Australia, but I think that's a debatable issue. Simple calculations suggest that perhaps there is a shortage of housing, and there isn't a sharp supply response when house prices rise. That's the difference.
From the investors' perspective, there's no doubt that an increase in interest rates will tend to slow the growth rate of housing supply over time.
Knowledge@Australian School of Business: It's surprising that house prices in Australia have continued rising quite dramatically by around 10% or 20% over the past two or three years, through the middle of the global financial crisis. To a large part that's because Australia seems to have avoided the crisis, due to China's demand for its iron ore, coal and liquefied natural gas. What if China's demand for Australian resources was to collapse? How would that affect the Australian economy and the housing market?
Glenn Otto: One of the drivers of housing prices and housing demand is growth and income, along with population. A collapse in China - or even a slow down in China - will have an impact on Australian income growth, and that would certainly feed into house prices. The impact of unemployment is also crucially important for house prices. In the financial crisis, Australian unemployment rose somewhat, but not to the same extent as it did in, say, the UK or the US. If there was a shock that led to a large rise in unemployment in Australia, that would be likely to have important consequences for the house prices.
Knowledge@Australian School of Business: In terms of the housing market, it seems Australia may not be out of the woods then. Or, is it that we haven't even entered the woods yet?
Glenn Otto: Certainly, the growth rate of house prices fell during the financial crisis, but they have picked up again. The sort of growth rates that we're observing now are not out of alignment with the growth rates in house prices prior to the global financial crisis - and there are some differences across Australia's capital cities. From about 2004, Sydney had a fairly long period of relatively flat house prices that didn't occur in Melbourne. But overall, growth in house prices of about 1% per month is broadly consistent with what we've observed historically.