{"id":2079,"date":"2022-03-10T08:43:51","date_gmt":"2022-03-10T08:43:51","guid":{"rendered":"https:\/\/royabhishek.in\/urbanbuyer\/will-higher-interest-rates-cause-property-prices-to-fall\/"},"modified":"2022-03-10T08:43:51","modified_gmt":"2022-03-10T08:43:51","slug":"will-higher-interest-rates-cause-property-prices-to-fall","status":"publish","type":"post","link":"https:\/\/royabhishek.in\/urbanbuyer\/will-higher-interest-rates-cause-property-prices-to-fall\/","title":{"rendered":"Will higher interest rates cause property prices to fall?"},"content":{"rendered":"

[ad_1]
\n<\/p>\n

\n
\n

Please use the menu below to navigate to any article section:<\/p>\n<\/div>\n

Vocal market commentator and fund manager, Chris Joye wrote in the AFR in November last year that Australian house prices could fall by 15% \u00a0to 25% after the RBA starts increasing interest rates (here\u2019s a copy of that article<\/a>).<\/strong><\/p>\n

\"MarketOf course, there are many property doomsayers that perpetually (and often inaccurately) predict property market crashes.<\/p>\n

However, Chris is not one of these people. In fact, Chris\u2019 predictions are usually quite accurate.<\/p>\n

However, on this occasion, I disagree with his prediction, and I share the reasons why below.<\/p>\n

However, more importantly, I wanted to discuss what impact rising interest rates might have on the property market.<\/p>\n

It\u2019s interesting that almost everyone disagrees with the RBA<\/span><\/h2>\n

The RBA has persistently reminded us that it will not raise the cash rate until inflation is sustainably within its 2% to 3% band.<\/p>\n

And for that to be the case, the wage inflation rate must be sustainably in the 3% to 4% range, according to the RBA. P<\/p>\n


\n<\/p>\n

rice inflation can\u2019t remain sustainably high unless it\u2019s supported by rising wages. Last week, wage inflation printed at 2.3% p.a., so we are some way off the RBA\u2019s target.<\/p>\n

Despite the RBA\u2019s clear indication, the market stubbornly predicts that interest rates will rise quickly over the course of this year.<\/p>\n

In fact,\u00a0this chart<\/a>\u00a0shows the money market is currently pricing in 7 to 8 rate hikes (of 0.25% each) over the next 16 months.<\/p>\n

This seems over-ambitious.<\/p>\n

So, why would the market ignore the RBA\u2019s commentary and price in more rate hikes?<\/p>\n

The RBA\u2019s in full control of the cash rate, so shouldn\u2019t we listen to it?<\/p>\n

It\u2019s like your child telling all her friends that she thinks she\u2019s coming to the party when she\u2019s grounded.<\/p>\n

\"Rba\"I suspect the answer is that markets are imperfect, especially in the short run.<\/p>\n

It is worth noting that Australia is in a much different position to the US.<\/p>\n

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).<\/p>\n

One of the main problems is that the\u00a0US participation rate<\/a> hasn\u2019t bounced back as it has in Australia and other countries, which results in a tighter labour market.<\/p>\n

The high Covid death rate per capita in the USA might be responsible for this.<\/p>\n

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.<\/p>\n

\"001\"<\/a><\/p>\n

Owner-occupiers are influenced by financial theory to a much lesser extent.<\/p>\n

People buy (upgrade) homes primarily for lifestyle reasons, not financial.<\/p>\n

\"Interest\"Decisions tend to be relatively long-dated i.e. a 10+ year time frame.<\/p>\n

Homebuyers tend to think very carefully about affordability and factor in higher interest rates \u2013 it\u2019s more a question of affordability than asset valuation.<\/p>\n

Finally, and perhaps most importantly, a home is not a discretionary asset (unlike a pure investment such as stocks).<\/p>\n

It\u2019s 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.<\/p>\n

Therefore, they buy when they can afford to do so.<\/p>\n

Secondly, demand has been driven mainly by higher-income earners<\/span><\/h2>\n

\"Income\"<\/p>\n

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<\/a>\u00a0and\u00a0here<\/a>, for example).<\/p>\n

Conversely, the highest 40% of households by income are typically in a stronger financial position compared to the start of Covid.<\/p>\n

The main reasons for this are that lower-income occupations typically are not able to work from home.<\/p>\n

In addition, higher-income earners have saved an unusually high amount over the past two years (lower spending due to lockdowns).<\/p>\n

In fact, nab economics estimates that Australians have saved $240 billion during the pandemic.<\/p>\n

Most of these savings would have been accumulated by higher-income earners since the \u201caverage\u201d Australian tends to have relatively low savings.<\/p>\n

\"Income2\"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<\/a>.<\/p>\n

If we agree that Covid restrictions are less likely from hereon in, consumer spending patterns should normalise, including spending on international travel.<\/p>\n

That may reduce higher-income earners\u2019 savings rates, but it\u2019s likely they are well prepared for higher interest rates.<\/p>\n

It is also worth noting that lending rules have tightened significantly in recent years which includes testing affordability at much higher interest rates.<\/p>\n

If you have obtained a new mortgage over the past 5 years, it\u2019s likely higher interest rates won\u2019t cause too much stress.<\/p>\n

At best, there\u2019s a weak relationship between growth and interest rates<\/span><\/h2>\n

\"PriceThe chart below (click to enlarge) illustrates the annualised median house price growth since 1980 in Sydney, Melbourne, and Brisbane.<\/p>\n

I have inserted the average standard variable mortgage interest rates in the grey rectangle below each growth period.<\/p>\n

You will note that there\u2019s not a very strong relationship between interest rates and property prices.<\/p>\n

I suspect that\u2019s because home buyers make an \u2018affordability\u2019 assessment rather than a \u2018valuation\u2019 assessment.<\/p>\n

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.<\/p>\n

\"002\"<\/a><\/p>\n

Covid distorted demand and that will probably normalise this year<\/span><\/h2>\n

The property market has benefited from an unusually high level of demand over the past 18+ months and this demand is likely to normalise.<\/p>\n

Firstly, FOMO drove many people to buy property.<\/p>\n

<\/p>\n

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.<\/p>\n

The work-from-home wave created a substantially higher demand for regional properties, particularly in coastal locations.<\/p>\n

Finally, since many people were spending less money on traveling and going out during lockdowns, they redirected these financial resources towards the property market.<\/p>\n

Things are changing with the reopening of international borders (and therefore overseas travel), the prospect of Covid restrictions is unlikely, talk of higher interest rates, and higher property stock levels.<\/p>\n

These factors should result in a more balanced property market.<\/p>\n

But the value proposition hasn\u2019t really changed all that much<\/span><\/h2>\n

\"LowLow interest rates stimulated demand for housing during 2020 and 2021.<\/p>\n

Even if rates increase by 1% over the next 1 to 2 years, they are still low relative to the past few decades.<\/p>\n

And due to much higher\u00a0household<\/a>\u00a0and government indebtedness, interest rates won\u2019t have to rise by much to cool inflationary pressures.<\/p>\n

It is conceivable that the\u00a0neutral<\/a>\u00a0mortgage interest rate could be circa 5% p.a.<\/p>\n

Therefore, from an owner-occupier\u2019s perspective, the value proposition hasn\u2019t changed that much i.e. housing is still relatively attractive due to interest rates being relatively low compared to the past few decades.<\/p>\n

Property prices will be closer to intrinsic values, which means losses for some recent buyers<\/span><\/h2>\n

The chart below was produced by Coolabah Capital and shows the change in property prices since 1850.<\/p>\n

It puts into perspective the magnitude of the price growth that occurred last year.<\/p>\n

\"003\"<\/a><\/p>\n

We can argue that the market value of a property is what someone is willing to pay for it.<\/p>\n

\"PriceHowever, it is obvious to me (and lots of other people) that some purchasers were clearly overpaying for property throughout 2020 and 2021.<\/p>\n

That is, they paid more than its intrinsic value.<\/p>\n

It is unlikely that level of exuberance (over-paying) will extend into 2022.<\/p>\n

A more balanced market should result in more reasonable prices.<\/p>\n

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.<\/p>\n

The medium-term outlook will be driven by a healthy economy<\/span><\/h2>\n

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.<\/p>\n

\"HotHowever, I would be most surprised to see prices retreat by 15% to 25%, as predicted by Chris.<\/p>\n

In my view, the property market will be driven by very sound fundamentals over the medium term:<\/p>\n