HOUSING: by Colin TeeseNews Weekly
Soaring house prices give illusion of wealth
, May 26, 2007
Why, despite the fact that we're working longer and harder and earning more, is housing apparently less affordable than ever? Colin Teese finds some surprising answers.Some economists, especially the ideologically committed, have allowed themselves certain liberties when considering what the boom in house prices means for consumers. One such, Alan Mitchell of the Australian Financial Review, is on record as suggesting that the housing boom is making house-owners wealthy.
He should know better, if only for the simple reason that, for those owner-occupiers of residential property - whether owned outright or under mortgage - the relativities don't change.
The property may be worth more than one paid for it, but if one needs to sell and move to another residence, then the enter price for the new property will reflect the capital gain on the property being sold. A capital gain on a house price can only be regarded as a source of new genuine wealth, if it confers on the recipient a source of benefit which can be used for purposes additional to that of replacing an existing residence.Illusory capital gains
In any other situation, capital gains on houses are illusory; in ordinary circumstances for an owner/occupier they are unrealisable.
Such capital gains could be considered otherwise if a householder sold a property for a capital gain and, in the period between that sale and purchase of another property, house prices collapsed. In that event, such a householder could be said to have made a real capital gain.
But that gain would have been made in special circumstances and at the expense of another property owner: those not selling into the same favourable circumstances would be denied any gain.
Attempts to consider house prices singularly in terms of economic considerations and economic theory tend to fall short of reality.
A recent paper by Dr Garrick Small of the University of Technology, Sydney, goes at least some way to helping us understand why this is so. In particular, he warns about the hazards of making simple forecasts using past trends as a guiding light.
In doing so, Small has noted the work of another academic, Peter Saunders. Saunders has concluded, based on a study of the Sydney housing market, that the patterns of movement in house price changes differ fundamentally from what had been experienced previously. He explains why and suggests, convincingly, why the present trend is probably unsustainable.
Saunders notes that, previously, while house price rises routinely exceeded the rate of inflation, they usually moved in line with wages. Thus older house-owners could pick up a capital gain above inflation, but new-entrant buyers were not precluded from entering the housing market, since prices moved more or less in line with wages.
However, the situation is now different and it calls into question the future affordability of housing for ordinary households. Such an outcome, if it happens, would undermine the expectation of the right to home ownership which runs deep in the Australian community psyche.
Some economists attribute rising house prices to an artificial land shortage created by governments. Their proposed solution is for governments to release more land.
It is true that it is the land not the house that escalates in price. Indeed, the cost of building houses is falling due to better building techniques, and houses are in fact a deteriorating asset.
As to the land, it is a fact that the mere release of it in a particular area creates its own shortage in that particular area and forces up land prices. There is much anecdotal evidence to support this view, and it was recognised more than two centuries ago by Adam Smith when he characterised land as a natural monopoly.
The rents charged for rented houses support this view of land. The rent charged more properly is related to the house price and the cost of providing it. The investor relies on capital gain for his return on land and, since it is a non-deteriorating asset in a shortage situation, that gain is indestructible.
Whatever may be currently observed in the housing market, it cannot yet be said that houses are unaffordable - since buyers and sellers are still transacting business. That is not to say, however, that the present situation is tolerable or acceptable - but rather to say that whatever fault exists cannot be attributable to imperfect market operation.
House prices in some measure are market-derived - on the basis of household income, inflation, interest rates and supply. In other words, the market moves as might be expected according to economic theory … well, up to a point. But there are other non-market factors at work which cannot be ignored.
Peter Saunders has provided some helpful research. He shows that, 20 years ago, average weekly earnings (AWE), the consumer price index (CPI) and house prices all rose at the same pace. The first big divergence came when, between 1988 and 1990, house price rises began to outpace the other two indicators. By 2004, rising house prices had gone well past the other two indicators.
Dr Small believes that interest rates - the major financial variable - are among the key influences on house affordability. Since interest rates have been falling steadily over the last 15 years, affordability has strengthened accordingly. Small believes that this rising affordability has “facilitated rising prices”, though this does not seem necessarily to follow.
What has happened is that, while house prices continued to climb ahead of earnings and inflation, affordability was not affected. This, Dr Small has contended, rightly, needs explaining, and nothing in economic theory seems to help.
Dr Small turned to the Australian Bureau of Statistics. He discovered that, over the last 30 years, household incomes have been rising at about twice the rate of adult wage growth. And house prices have tracked the growth in household income.
He also discovered that, while house price growth is now in excess of household income growth, the reverse was true until about 1986.
These were puzzling revelations. Why did household incomes grow faster than individual incomes? And why, ultimately, was house price growth able to exceed household income growth? In his search for answers, Dr Small had to look beyond economics.
He found his answer in a consideration of workforce participation. There was a simple answer to the question of why household incomes growth far outstripped the growth in individual incomes after 1960 - it lies in the greater influx of women into the paid workforce.
As this began to occur, escalating house prices remained affordable only to families enjoying two full-time incomes. Conversely, escalating house prices became less affordable to single-income families as house prices outstripped individual wages.
Dr Small concludes - probably accurately - that more and more women entered the paid workforce to enable the family to buy a house. And, as a matter of observation, he discerns that family size began to contract at the same time and in line with these developments.
He then moves to consider why house prices have continued to rise even faster than inflation towards the end of the 20th century. He attributes this change to the fact that interest rates have fallen noticeably.
In this situation, banks no longer seek to limit household borrowing for house purchase (whereas they once limited borrowing to the borrower's estimated capacity to pay).
In these changed circumstances, households - faced with escalating house prices - simply borrow more to cover the higher initial outlay. They rely on continuing low interest rates to make their larger loans affordable.
The banks are unconcerned about this because, in the new “free for all” environment, they require borrowers to take insurance cover against the possibility that they cannot meet repayment obligations.
Of course, borrowers probably don't see it this way, but the insurance premiums actually should be added to the interest rate to calculate the real cost of repayments.
That all of these factors have impacted on households' disposable income is revealed by figures from Dr Small. Household debt as a percentage of disposable income has gone from under 50 per cent in 1981 to 150 per cent in 2005. Over the same period, interest paid, as a percentage of disposable income of households, has increased from 6 per cent to 10 per cent.
At first glance, it might seem that all this bodes well for the future of the housing market. Dr Small believes otherwise, and with good reason.
First, housing affordability has been maintained in the face of rising prices by ever increasing numbers entering the paid workforce. Those numbers are no longer rising as a percentage because all women capable of working are now employed. In other words, that source of extra household income has now dried up.
Second, fertility rates, which began falling in line with female employment in the paid workforce, have now stabilised at low levels. This change shows up clearly in the household occupancy rates which now average about 2.5 persons per household.
Third, household debt and interest payments have grown enormously over the last 20 years, and most of this growth is absorbed by house purchase.
Taken together, these three considerations are very serious. Household income cannot really increase without big increases in wage levels. And such are the levels of household indebtedness that further household outlays - out of existing incomes - on house purchases seem improbable.
On these grounds alone, further increases in house prices seem unsustainable.Pressures on interest rates
But there is another factor - interest rates. These are at historically low levels, and it would seem that, if the boom prices for minerals recede, then international pressures will begin to affect interest rates.
Two questions then arise. How much will households, with their current high levels of housing debt, be able to cope with greater house payments? And how much will the impact of this feed, in an adverse way, into the wider economy? It is hard to say.
But, whichever way you look at this picture, one thing seems certain - only the bravest of gamblers would bet on a continuing rise in house prices. A fall seems much more likely.- Colin Teese is a former deputy secretary of the Department of Trade.