SHANE OLIVER: On most measures Australian housing is overvalued, but it's still unlikely to crash

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How did Australian house prices get so high over the past two decades?

It’s a debate that’s been growing in intensity over recent months, seemingly flaring whenever the latest batch of house price or finance data is released.

Some blame debt, others inadequate supply. Increased investor activity, and a prevalence of foreign buyers, are also regularly cited.

Source: AMP Capital

Who is right and who is wrong? Ask 10 people and you could get easily get 10 different answers.

Shane Oliver, chief economist at AMP Capital, is the latest brave soul to wade into the debate, suggesting that not just one factor, but many, have led to higher prices.

Out of the list above — debt, supply, investors and foreigners — Oliver reckons that it’s the first two that have been the major contributing factors.

“First, the shift from high to low interest rates has boosted borrowing and hence buying power. This has taken Australia’s household debt to income ratio from the low end of OECD countries 25 years ago to the top end,” says Oliver.

“Second, there has been an inadequate supply response to demand.”

He points to the following chart that shows underlying demand for housing, and the increase in supply, to reveal the cumulative shortfall in dwellings over the past 10 years.

Source: AMP Capital

Along with increased debt and under supply, Oliver says that investors — both domestic and abroad — are also playing a role in accentuating demand.

On the role being played by domestic housing investors, he says that the interaction between negative gearing and Australia’s capital gains tax discount may be resulting in higher investment activity than would otherwise be the case, enhancing the after tax return available to investors.

Oliver also says that foreign buying is contributing to around 10 to 15% of demand, albeit largely isolated to specific areas.

With those four factors all contributing to house price growth in Australia’s southeastern corner, particularly in Sydney and Melbourne, it’s left Australia’s housing market overvalued on most measures, says Oliver.

“On the basis of the ratio of house prices to rents adjusted for inflation relative to its long term average Australian houses are 39% overvalued and units 13% overvalued,” he says.

Others, such as the 2017 Demographia Housing Affordability Survey, put Australia’s median house price to household income ratio at 6.6 times, well above the 3.9 and 4.5 levels in the US and UK.

In Sydney that ratio soars to 12.2 times, and 9.5 times in Melbourne.

Giddying levels, but does that mean Australia’s housing market will crash?

No, says Oliver, although he believes that prices will see a pullback once the RBA starts to lift interest rates.

“Generalised price falls are unlikely until the RBA starts to raise interest rates again and this is unlikely until later in 2018, which after a few hikes will likely trigger a 5-10% pullback in property prices as was seen in the 2009 & 2011 cycles,” he says.

In particular, he believes that Sydney and Melbourne, having recorded the biggest increases in the current cycle, are at the most risk, particularly for units.

“Units are at much greater risk given surging supply and this could see unit prices in parts of Sydney and Melbourne fall by 15-20% as investor interest fades as rents falls,” he says.

However, in order for a more pronounced decline in prices — a “crash” — Oliver says that it will either take a recession, a sharp spike in interest rates or an even longer boom in residential construction than what anyone currently expects.

Though the first risk will undoubtedly be subject to debate, the latter certainly appear to be long-shots given the current set of circumstances.

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