August 2022

In March, house prices rose by well over 1%. By June, house prices declined on average across Australia. As is so often the case, averages can deceive. Since the end of last year, house prices have declined in Melbourne and were essentially flat in Sydney. Growth remained strong in Brisbane and Adelaide. The other capital cities were in between.

The impact of the first cash rate rise in May appears clear. But price growth had already begun to moderate in Sydney and Melbourne, reflecting affordability concerns and the big rise in the supply of homes available for sale. Prices are starting to decline in the cities (Hobart and Canberra) that do not appear cheap (relative to their historical average price compared with Sydney). The cities that are still experiencing growth (Brisbane, Adelaide, Perth and Darwin) are the ones that are cheap (again relative to Sydney).

Previous episodes

This is not the only time that house prices have fallen over recent decades. Over the past forty years, house prices have fallen on six occasions (excluding the very brief decline that happened at the beginning of the pandemic). The peak-to-trough declines have been relatively modest (-3 to -11%). On the first four occasions, the declines lasted for just over one year, although on the past two occasions the falls have taken longer.

Historically, house price growth has not started to slow until well into the monetary policy tightening cycle. One reason is that the first few rate hikes have typically taken place when momentum in house price growth was strong and the economy was performing well. In earlier episodes, house prices and debt levels (relative to household incomes) were a lot lower so the initial rate hikes had less impact, although they eventually rose to a level that led to declining growth. The one exception was 2017-19 when the bigger issue was not so much the cost of finance (interest rates) but its reduced availability reflecting a tightening of credit standards.

Experience of past house price declines

With further cash rate rises to come, house prices are almost certain to decline further in coming months. The RBA recently suggested that historically a 2 percentage point rise in the mortgage rate had led to a 15% decline in real house prices over the following two years. With financial markets suggesting that the cash rate could rise by almost 3.5 percentage points from its low in this cycle if that relationship continues to hold, it would be consistent with real house prices falling by 25-30%. With inflation likely to be rising by close to 10% over the next 2 years, the RBA rule of thumb is suggestive of a decline in house prices by around 15-20% if current financial market pricing is correct.

There are mitigating factors. Rents can be thought of as the earnings generated from housing (similar to the way that profits drive equity prices). Movements in rents provide a snapshot of the demand-supply conditions in the housing market. Just as rising earnings don’t necessarily mean a rising stock market, rising rent doesn’t necessarily stop house prices from declining. But if rents continue to rise for a long enough period, they provide strong fundamental support to house prices. Asking rents have been rising strongly, particularly for houses in all cities.

Another factor that will start to support the housing market is a reduction in the number of houses available for sale. Just as high prices lured many sellers onto the market, declining prices will lead to less stock for sale. In the year to date, there has been a big reduction in the number of places sold in Sydney, Melbourne and Canberra, although that has largely reflected an increase in unsuccessful sales. Another plus is that immigration growth is again on the rise.

Offsetting a reduction of existing homes for sale is that there will be a large number of new homes that are due for completion over the next year. It is also possible that the large amount of alterations and additions work has led to some households renting a place, temporarily reducing the available supply for rent. That will unwind as the alterations are finished.

Different valuation metrics suggest that Sydney may suffer the biggest house price peak-to-trough decline (not surprising for the least affordable city). House prices in Melbourne might remain under pressure, at least until it is clear that immigration numbers are returning back to be closer to their pre-pandemic levels.