A couple of weeks ago, our treasurer Joe Hockey stirred the pot by advising Australians wanting to buy their first home to “get a good job that pays good money”. Technically, he is right. It is increasingly harder today for average Australian households to buy their residential home than 30 years ago. So, What are the impacts? What may potentially be the driving forces in pushing the prices today? And finally, what are the implications?
The chart below show ratios between median house prices in Melbourne and median household incomes. Here, I assume that a household consists of a man and a woman, both receiving median incomes. Curiously, something dramatic occurred around 1997 that doubled the house prices in 15 years. We will get back to this later.
What does this mean?
If you and your partner wish to buy an average house in Melbourne today, they will need to fork out more than 5.75 times of their combined income (2013 figure). That might not sound that bad. But consider this. More and more households in Australia have only one person who generates income.
It gets increasingly dire even when there are two breadwinners in a household as well. Assuming that they pay a 20% deposit on their property and take out a 25-year mortgage at 4.6 percent per annum (assume fixed rate) for the rest, their monthly repayment will be 36.7 percent of their after-tax income. In comparison, our parents’ monthly repayment was around 16.2 percent of their monthly income. No wonder why they can pay off their mortgage so quickly.
What could be driving the prices?
I am not certain about cause and effect, but here is a thought. Many households are struggling to repay their mortgages, and note that interest rates have never been this low for a long time. Further, since interest rates fluctuate, this means that their financial circumstances are, what Nasim Taleb called, fragile. That is, small instability (ie, interest rates) can have a large consequence (unable to make repayment and refinance). So, in many buyers’ minds, buying property to live in is getting unattractive, because roughly they are expected to repay more than 68 percent of the principal in interest during the life of the loan.
It comes as no surprise that many buyers are increasingly looking at real estate as investment. In April, Australian Bureau of Statistics (ABS) released figures that show owner-occupiers accounted for just 48.4 percent of the money borrowed for home loans, the lowest on record. The other 51.6 percent are investors.
During the late 1990s, when the Howard government halved the headline rate of capital gains tax, investors were accounted for 34.8 percent of loans (Jan 1997). The reduction on capital gain tax means it is more profitable to buy and sell a house as an investment. This extra incentive pushed house prices up. When more investors see the rising prices, they pour even more money into the market, expecting the prices to continue to rise, and the cycle continues.
Would I call this a bubble? I don’t know until after the fact. What the ABS figures show is that investors are now buying houses with expectation that they will continue to rise indefinitely. The problem is, at some point, the music stops.
What can we do to protect ourselves?
If you already have a mortgage, given that the current interest rate is the lowest in a long time, it is worth considering refinancing and fix this low rate. Further, mortgage repayment calculation often assumes that you will never change your monthly repayment. However, as your income rises, it is worth repaying your mortgage earlier. Assuming that you will continue to repay at 36.7 percent of after-tax income, and an income growth of 3 percent per annum, you can pay off your mortgage 8 years earlier. This will save you 36 percent on interest.
If you don’t have a mortgage, think on the contrary. As there are more investment properties on the market, more rental properties become available in the market. Supply and demand theory would suggest that the rental prices should come down. Indeed, as the chart below has shown. It has dropped down since 2009 (GFC), but it is still a long way from the ratios we enjoyed in the 1980s.
In my personal opinion, it might pay to stay patient. Wise words from Bob Farrell: “excesses in one direction will lead to an opposite excess in the other direction.”