Locked Out: How the Great Australian Dream Hit Reality

The Great Australian Dream of home ownership features prominently in economic and social discussion. In the mid- ’90s, house prices were typically about 2.5 times greater than household disposable income for each of the capital cities, except in Sydney where the ratio of house prices to disposable income was approximately 3.2. In recent years house price growth has exceeded household income growth for all capital cities. By 2005, Perth house prices had risen faster than any other major capital, with Perth surpassing Sydney as the least affordable city. House prices are now about 4.8 times greater than gross household disposable income (GHDI), with Sydney’s house prices closer to six times GHDI (rendering it the least affordable capital city).

House price growth relative to household income:

Our empirical research found three key determinants of housing affordability – population growth, interest rates, and spillover effects. These factors dominate the effects of employment and expectations.

Population: Population growth contributed significantly to house price appreciation across each of the capital cities over the period 2002 to 2007, fell sharply around the GFC, rose then fell again. A quick look at the impact of population growth on housing demand across the capital cities shows that the impact was greatest for Perth and Brisbane, particularly the former. Overall, changes in population growth appear to have induced significant volatility in the Perth housing market, resulting in sharp shifts in housing demand (and housing affordability) since 2007. In contrast, the recent impact of population growth has been relatively small for the remaining capital cities.

Interest rates: Our empirical analysis shows that the relationship between house prices and interest rates is non-linear and that there is a critical threshold rate (about 6 per cent). When the standard variable mortgage rate rises above the threshold the effect is to discourage borrowing, dampen demand for housing and generally improve housing affordability. In contrast, when the mortgage rate falls below the threshold, investor activity increases dramatically, resulting in price feedbacks that statistically appear as explosive processes in the house price.

Spillover effects: We find that a rise in the house-price-to-income ratio for Sydney causes a rise in the relevant ratio for the remaining capital cities (with the exception of Adelaide, which appears to be less integrated than the others). The impact of a price shock in Melbourne is similar to that of Sydney, although the magnitude of the impact on Sydney and Brisbane is smaller. In particular, Brisbane is clearly more susceptible to a shock emanating from Sydney, while Adelaide does not appear to be particularly receptive to either shock.

Ratio of house prices to household income:

Currently, standard variable rates are close to record lows and have prompted sharp increases in house prices. Our research suggests that with interest rates below the threshold, sharp changes to house prices will increasingly be unrelated to fundamental factors such as demographic or employment conditions. However, spillover effects from price increases in Sydney and Melbourne to the other capital cities will also be smaller. In other words, the probability of a housing bubble is high, but may not be widespread. Low interest rates are therefore more likely to result in asymmetric (or two-speed) housing markets.

Locked out of the housing market

The relative pace of house-price appreciation to income growth has been particularly pronounced in the last two years. Falls in housing affordability are especially onerous for lower to moderate-income households. With falling affordability, households in this group have a reduced capacity to access affordable housing, and additional financial stress stemming from their increased debt-service requirements. This latter pressure, in particular, is likely to be observed when interest rates start to normalise. With increasing numbers of households being locked out of the housing market, the proportion of renter households has increased in the last two decades. Consequently, the rental market is also not immune to developments in house prices, and rent levels have risen substantially in recent years as investors seek returns from their increasingly expensive assets. People in the 25 to 34-year-old bracket, in particular, have shifted towards renting rather than owning but are likely to find it increasingly difficult to either purchase or rent.

Policy change now

Three policy areas require closer scrutiny in order to improve housing affordability. First, is the policy governing the supply of land for housing development adequate? Second, are there tax-related policies that induce speculative real-estate activity? Third, what policies can be implemented to support the rental market? Clearly, more in-depth study is needed to disentangle the ‘cause and effect’ relationships between the demand for and the supply of housing, but a focus on these three areas is a step in the right direction.