Population growth may not be enough to prevent a downturn in Australia's housing market

Photo: Matt Cardy/ Getty Images.

Australian house price growth has slowed sharply in recent months, led by outright declines in Sydney, the nation’s largest and most expensive housing market.

According to data from CoreLogic, prices across Australia’s five mainland state capitals fell 0.1% last week in weighted terms, leaving the annual pace of growth at 5%, less than half the level seen in the first half of the year.

Naturally, after years of strong price growth, the question many are asking is whether the weakness in Sydney will act as a lead indicator for the rest of the country? And, beyond that, how long will any potential weakness last?

While no one knows that answer for sure, one of the underlying factors many commentators point to is Australia’s strong levels of population growth.

According to data released by the Australian Bureau of Statistics (ABS) in September, Australia’s population soared by 389,100, or 1.61%, to 24.512 million in the year to March, the fastest increase since 2014.

Most of that growth came via net overseas migration, increasing by 231,900, or 2.4%. Natural increase, a figure simply derived by subtracting deaths from births, accounted for the rest.

Australia’s population has increased by 40% since 1990, providing an underlying boost to housing demand.

Given the strength in population growth over this period, and the subsequent growth in house prices, it’s easy to see why so many regard the likelihood of a substantial pullback in the housing market as a remote possibility.

As the argument goes, more people means more demand for housing, helping to underpin prices despite headwinds created by affordability constraints, low household income growth and tighter macroprudential measures on interest-only lending from Australia’s banking regulator, APRA, which has curtailed investor activity in the market.

To Paul Dales, Chief Australia and New Zealand Economist at Capital Economics, it’s understandable why so many are pinning their hopes on population growth to offset those factors, pointing out that there’s some evidence that strong growth has contributed to faster increases in house prices both in Australia and abroad.

“The rapid rate of population growth offers some comfort as it means Australia can rely on a certain amount of demand for housing to be generated each year. And there is some evidence from home and overseas that faster rates of population growth tend to be associated with faster house price inflation,” he says, pointing to the chart below which examines the relationship between annual population growth and annual property price growth in a variety of advanced economies.

Source: Capital Economics

And, at a more granular level, there’s evidence that the same relationship exists in Australia’s property market.

Source: Capital Economics

However, even with Australia’s population growing at 1.6% per annum in 2016, and accelerating from the levels seen earlier this decade, Dales says the theory that strong population growth will lead to continued gains in house prices will likely be tested in the coming years.

In his opinion, prices are likely to be flat to lower, with the risks pointing to a potential national decline as large as 10%.

“There are two reasons why decent rates of population growth may not prevent house prices from moving broadly sideways over the next year or two and perhaps falling in 2020 and 2021,” he says.

“First, population growth only boosts house prices if the extra demand for housing is not met by additional construction.”

On that front, Dales says supply has not only kept up with demand in recent years but actually exceeded it, something that he says could potentially weigh on prices, especially in the apartment market.

“In recent years, the number of new homes built has far exceeded the number required by the growing populationm,” he says.

“This partly makes up for underbuilding in the mid-2000s and early 2010s. But since 2012, the number of new homes built per year has risen by 66% to a record high of 212,000, while our estimates suggest that the number of new homes required each year has fallen by 8% to 170,000.”

Source: Capital Economics

Dales says this overbuilding is much greater for apartments than houses in the current construction cycle..

Given his view that housing supply will outstrip demand for some some time yet given ongoing strength in Australian building approvals, Dales says this points to the likelihood that prices will stagnate in nominal terms over the next couple of years.

“We estimate that homebuilding will continue to outstrip underlying demand for the next four years,” he says. “Based on the past relationship, such an imbalance between underlying demand and supply is consistent with house prices stagnating for the next couple of years before rising modestly from 2020.”

So, if all other factors remain the same, prices are likely to go nowhere in the coming years from a national perspective, according to Dales.

However, Dales says there’s a second factor that, along with oversupply in some markets, could actually lead to period of prolonged price weakness: higher interest rates and the potential for ongoing macroprudential measures to cool the availability of housing credit.

“House price cycles are determined by changes in the cost of credit, the availability of credit and the health of the economy,” he says.

“Those factors are more likely to restrain rather than boost demand over the next few years.”

Dales says there’s already evidence that measures to limit investor activity in the housing market has contributed to the deceleration in price growth seen in the past year.

“The reduction in the availability of credit to investors and the rise in the cost of borrowing by investors, both triggered by the new lending rules implemented by the Australian Prudential Regulation Authority (APRA) in March, explain a good chunk of the softening in housing demand seen throughout this year,” he says.

“At the same time, banks have also cut the amount of credit available to overseas buyers.”

And, given the likelihood that the next move in official interest rates from the Reserve Bank of Australia (RBA) is likely to be higher rather than lower, fitting with recent commentary from RBA Governor Philip Lowe, Dales says it has the potential to weigh on prices even with an improvement in supply-demand imbalances.

“We don’t believe that mortgage rates for all borrowers will rise materially until the RBA starts raising interest rates, which may not happen until the second half of 2019. And with the labour market still improving and the wider economy in a fairly good shape, this may prevent demand from weakening by enough to trigger major price falls,” Dales says.

“But equally, interest rates may start to rise just at the time that the supply of housing starts to fall back in line with underlying demand. This extra restraint on demand will probably prevent house price inflation from rising in 2020 and 2021.”

Not only that, Dales says that it may lead to national price declines as high as 10%.

“We think even fairly modest interest rate rises in 2019 and 2020 will trigger a sustained period of house price declines, perhaps amounting to a peak to trough drop of around 10% spread over a year or two.”

While may regard such a call as alarmist, as seen in the chart below supplied by CoreLogic, prolonged and large price declines have been seen in Australia before, even with strong levels of population growth.

And after years of strong price growth, particularly in Sydney and Melbourne where prices have doubled since early 2009, some may deem a modest pullback as a healthy development compared to what may happen if the current trends are maintained.

Source: CoreLogic

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