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ARE AUSTRALIAN HOUSE PRICES OVERVALUED?
Posted on 2010-05-27
ARE AUSTRALIAN HOUSE PRICES OVERVALUED? PART 2
(DEBUNKING HOUSE PRICE TO INCOME MEAN REVERSION)
International comparisons of house price to income ratios have been widely
used to suggest that Australian house prices are significantly overvalued.
These analyses are not only dangerously simplistic but explicitly ignore a key
component of the housing affordability equation – interest rates.
House price to income ratio: a flawed measure of affordability
Simple house price to income ratios have been widely used to suggest that
Australian house prices are significantly overvalued. These arguments centre
around the concept of ‘mean reversion’ i.e. elevated house price to income
ratios must revert to their long term historical average for ‘affordability’ to be
‘sustainable’.
However, as a measure of housing affordability, house price to income ratios
are very misleading as they completely ignore interest rates. Ultimately,
housing affordability comes down to debt servicing costs of which interest
rates are a key driver. This not only means that house price to income ratios
are fundamentally flawed as a measure of housing affordability but also
makes intertemporal and cross border comparisons of these ratios next to
meaningless.
In Australia, the house price1 to income ratio rose from an average of around
3 in the 1980s to an average around 5 since late 2003.
That is, the median house price in recent years represents 5 times the
average household’s annual disposable income compared to 3 times in the
1980s.…due largely to a reduction in mortgage interest rates
On average, mortgage rates have halved justifying a doubling of house price to income ratios
However, the major reason for this has been a structural (read permanent)
reduction in interest rates.
Mortgage interest rates in Australia in the 1980s averaged around 14%,
however, since 2000 the average has been close to 7%. This reduction in
mortgage interest rates has effectively been capitalised into house prices.
The halving of mortgage interest rates almost fully explains the measured rise
in the house price to income ratio leaving the house price to income ‘mean
reversion’ argument appearing myopic at best.
Housing affordability and the sustainability (or otherwise) of current house
price levels are extremely complex issues and drawing conclusions from
simplistic aggregate metrics such as house price to income ratios is very
unwise.
DISCLAIMER: Every care has been taken to verify the accuracy of the information contained herein, but no warranty is given or implied and prospective purchasers/ tenants are advised to carry out their own investigations. Details herein do not constitute any representation by the vendor. Lessor or the agent and are expressly excluded from any contract.