Australian house prices are now falling following a long boom powered by a massive expansion in debt, built on low interest rates and easy credit. There is now a growing realisation that the high debt costs associated with investing in these low-yielding property assets are going to be very burdensome to repay. This will likely lead to a long-term adjustment in house prices, as in the iconic fable, it becomes clear that the housing Emperor is rather scantily clad.
The repayment conundrum
Recent buyers of average-priced homes on average incomes, especially in Sydney or Melbourne, will find repaying a 25-year mortgage extremely onerous at current price levels. The illustration below shows how a fairly standard 80% mortgage of A$652,000 on the median Sydney home worth A$815,0001 will cost almost double this amount in repayments over the life of the loan – and that assumes a benign interest rate environment over this period.
This means that today’s average Sydney home buyer will need to earn approximately A$2,000,000 before tax simply to pay the mortgage. Feeding and clothing the family, paying for electricity and water and the odd trip to the supermarket will require overtime!
This brings into question the strongly-held Australian assumption of perpetual house price gains for all, with perhaps the odd short-term hiccup. The crowd are now starting to realise that the Emperor is actually wearing no clothes at all.
Income to mortgage disparity
The average full-time salary in NSW as at May 2018 is A$83,517 according to the most recent data available from the Australian Bureau of Statistics. This makes the medium average Sydney home price 9.8 times the average NSW salary.
Sydney salaries exceed the NSW average and mortgages are disproportionately secured by the relatively higher paid. Nonetheless, mortgages taken out on average homes are now typically in excess of six times average incomes.
This has two significant implications for would-be home buyers.
- A 20% deposit - of A$163,000 for the median Sydney property - is now typically required as lenders grow more fearful of their diminishing security and mindful of the increasing regulatory oversight that they face. This will likely take most average earners a long time to save. Even a 10% deposit will challenge those on average salaries in cities where rents are relatively high at a time of modest income growth and low interest rates. Existing owners looking to upsize relying on the equity from their rising home values will also now find this less easy.
- Once a deposit has been found, either through hard saving or good fortune and a mortgage on a typical home has been secured, the challenge of meeting the monthly payment remains. Assuming a 4% interest rate, the average salary earner would be spending a massive 65% of their post-tax income on mortgage payments. This proportion would obviously rise in the event that mortgage rates were to increase without being offset by wage growth.
Clearly the personal finance maths simply do not add up for the typical home buyer in Australia’s major capital cities at these price levels. Hence, in practice, two salaries are required to support a mortgage (and deposit) and/or it is necessary for average earners to settle for purchasing sub-average priced homes.
Therefore, greater scrutiny of the likely lifetime debt cost associated with purchasing a low-yielding asset with an expectation of zero real capital gains for some years to come is prudent.
Three risks facing homebuyers
There has been insufficient attention paid to three key risks facing prospective home buyers in this market:
- Economic risk – A rational home purchase at current price levels requires a high conviction in the continuation of the status quo. This includes the assumption that the current benign economic environment that delivers consistent growth, full employment, an increasing population and government support for property owner-friendly tax measures will endure indefinitely. The gross rental yield (which takes no account of costs and taxes) is currently just 3.2% in Sydney, according to CoreLogic - the lowest of all the major cities in Australia. It is assumed that wage growth will return to drive historically low rental yields back up to more normal levels through rising rents – despite the reality that rents actually fell by 2.4% in Sydney during the year to October 2018 – rather than through falling house prices.
- Interest rate risk – The above graph illustrates the long-term debt cost facing the prospective home purchaser. Accepting exposure to this risk implies a firm conviction that either the current ultra-low interest rate in Australia represents the ‘new normal’ or the borrower enjoys the prospect of material real income growth over the long-term.
- Cohort risk – An individual home purchaser may well be able to manage their long-term debt cost. However, they are nonetheless exposed to the fortunes of other home buyers in their street or neigbourhood who may be less cautious in their purchases or less lucky in their financial lives. Downturns in other global property markets have demonstrated how the inability of some home owners to manage mortgage repayments – either due to rising mortgage rates or income interruption – soon impacts other owners. This is because the emergence of forced sellers in a locality drives down valuations, leading to negative equity, which traps owners in high variable interest rate deals, which further increases mortgage stress.
It is the most recent wave of property buyers that face the greatest risk. Unlike previous cohorts buying into the rising market, they are less likely to benefit from the ‘greater fool’ entering in large numbers to deliver higher prices and the comfort cushion of increasing home equity.
Regulators and lenders are now recognising these risks and a significant change in lending behaviour is becoming apparent.
This is critical to the direction of Australian house prices as the normal rules of supply and demand are heavily influenced by the availability of credit, which is now retreating with home prices. The old cliché that wages drive rents, but credit availability drives house prices is becoming increasingly apt.
Therefore, the balance of risks appears to be leading the rational investor to conclude that buying residential property at current price levels in Australia’s major capital cities makes little sense at an individual level and even less so at an aggregate level.
Nonetheless, Australians’ inclination to remain irrational in the housing market should not be underestimated, even as the Emperor’s tailoring looks increasingly threadbare.
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