Sydney and Melbourne housing markets look to be 25-30% above their fair value, based on a historical comparison of house prices to earnings (HPE).
By the same measure, research from Capital Economics shows that prices in Hobart, Brisbane, Adelaide and Canberra appear to be 0-10% overvalued. Perth prices are around even while Darwin may even be undervalued.
Capital Economics chief economist Paul Dales said that from 1980-2016 Australian property had a HPE ratio of 3.6 times. It’s now around 5.8 times, which means house prices would have to decline by around 38% to return to their historical average.
“But comparing the current HPE ratio to the historical average doesn’t give any consideration to the structural changes in the economy over the past 40 years,” Dales said.
In particular, Dales cited the decline in interest rates in Australia over the same time period.
Lower interest rates mean that buyers are able to pay a higher price relative to their income, and can also accept a lower rate of return on the purchase.
Dales also noted the change in rental yields on Australian property, which have fallen from around 11% in the 1980’s to an average of 5.3% since 2004.
However, during that time rent to income ratios have remained relatively consistent. So on the basis of rental yields alone, it would suggest an increase in the HPE ratio from 2.2 to 4.6.
Therefore, comparing the current ratio of 5.8 to anything less than the historical average of 3.6 is too simplified, and would leave you with a figure that overvalues housing.
Given that it’s impossible to predict a true sustainable HPE ratio, Dales mapped out a scenario analysis based on different rental yields:
So, if you think that current rental yields of 4.2% are sustainable, then the numbers suggest that house prices are actually pretty close to fair value.
“For what it’s worth, we think it makes most sense to assume that the sustainable rental yield is in line with the average of 5.3% since 2004,” Dales said.
That results in a sustainable HPE of 4.6, which indicates house prices are still around 20% overvalued.
However, that doesn’t take into account the variations across different capital cities.
While noting that accurate personal income data for each city is hard to obtain, Dales calculated a proxy figure by using ABS data for employee income by state, combined with national trends in household income.
Based on the ratio of house prices to Dales’ income calculation, sustainable HPE ratios for each capital city look like this:
“This doesn’t mean that house prices will soon slump by 25% in Sydney and Melbourne and by 20% in all capital cities,” Dales said.
For one thing, Capital Economics don’t believe interest rates are going higher anytime soon. That puts them at odds with ANZ, who upped their forecasts to another two rate hikes next year.
“Our view is that prices in Sydney and Melbourne will broadly stagnate or fall modestly over the next two years and that prices won’t fall significantly until the RBA starts to raise interest rates, which might not happen until late in 2019,” Dales said.
“Thereafter, prices in both capital cities may fall by around 10%.”