Housing bubbles, rents and affordability in Sydney and Melbourne: A demographer's take

One of the most popular topics in the media at the moment is housing affordability. Specifically, are Sydney and Melbourne housing prices in a bubble? Take for example this recent article in the Fairfax media.

There is of course no clear answer to this – on one level, housing is worth whatever people will pay for it, like anything else, and if people are paying higher prices that’s what it’s worth at the moment. On the other hand, there is nothing to say house prices can’t go down over time as well. Just ask the people of Detroit. Often you don’t know you’re in a bubble until after it’s popped. And low interest rates certainly do seem to have fuelled big recent increases.

It has long been the “Great Australian Dream” to own one’s own home. It’s the “Great American Dream” as well, and many other countries. However some nations have very large populations renting and they get along just fine. There are some significant advantages to renting such as easy mobility and not having to pay for repairs.  When people talk about housing affordability, they are mostly talking about house prices rather than rents, and most of the discussion centers on whether or not first home buyers can afford a median house in the area. Basic analysis usually shows that first home buyers can’t afford most places without spending a very large chunk of their income on housing. Much of this is quite simplistic because:

• First home buyers usually aren’t buying a median-priced house. Traditionally they would buy an entry level house and trade up. However this is becoming more difficult to do, as stamp duty makes the transaction costs of trading up more onerous, so home owners are likely to move less often (stamp duty doesn’t get indexed to the rising cost of housing, and for higher prices, more and more of the cost goes into stamp duty). Nevertheless, we think that the first quartile housing price is more indicative of a first home buyer dwelling, and that’s why we show them on economy.id. See this example for the City of Darebin.
• Some areas simply don’t function as first-home buyer areas – they are unaffordable to first home buyers and have been for some time. Inner city areas and blue ribbon suburbs such as Brighton in Melbourne and Vaucluse in Sydney are like that. Comparing incomes to house prices in these areas is a bit meaningless because the home-owners there have been there for some time or have bought in with substantial equity from elsewhere.
• Where the first quartile and median are quite close together (eg. City of Campbelltown), this indicates that the area is attractive to first home buyers, and upgraders mainly leave the area to upgrade. In this case, using the median might be appropriate.
• Most first home buyers have to use two incomes to do so – this has been the case for decades now, so comparing a multiple of individual income is not a genuine measure of how people pay for housing.

So you really need to consider the role and function of an area before deciding whether it’s affordable or not. Who does it typically house, and can those people afford to buy there at present? The demographics in profile.id can help a lot with this. So how do you tell if houses are overpriced in an area? The best way is to look at the rents for similar properties in an area.

The rental yield is the percentage of the current value which you would pay per year to rent the dwelling. So a house worth $250,000 which rents for $12,500 per year would have a yield of 5%. This has historically been the average yield for Australian capital city properties, and you will still find it as “Net Annual Value” on many council rates notices. Typically regional areas are a bit higher than this, at about 6-7%. As interest rates have mostly been higher than 5% in the past (they’re around record lows now, and mostly close to 5%), this means that home owners have always paid a bit more to live in their properties than renters, at least in our capital cities. Add to this the fact that council rates, water charges (in many areas) and major property maintenance is all the responsibility of the home owner or landlord in Australia, and you get a considerable “home ownership premium”. There are good reasons for this:

• Home owners have more rights to modify and update their property, to “make it their own”.
• Home owners aren’t subject to periodic inspections and have more security of tenure.
• Areas with a high level of owner-occupancy are generally (but not always) considered more desirable places to live, and this pushes up prices relative to rents.
• Home owners get the benefit of any increase in the value of their property over time (it should be noted, however that they also wear the loss if prices decline), and are able to lock in today’s prices via a loan, which typically reduces their housing costs over time as the loan is paid off.

So some home owners premium is justified, and the fourth point is the reason that rental yields are typically lower in high socio-economic areas in our capital cities (more like 4% historically), because of the perceived higher capital growth in these areas. Increasingly, however, as interest rates have declined in recent years, speculation has pushed up house prices further. This is an additional premium which buyers (particularly investors who don’t want to live in a place long-term) will place on a property due to the belief that it can be on-sold relatively quickly at a profit. The Capital Gains Tax discount of 50% also encourages this sort of quick buying and selling, relative to the indexation method which it replaced, which encouraged longer term investment. Rents are not subject to these price distortions and represent a much better measure of the true value of housing at a given point in time – how much someone is actually prepared to pay just to live in the property, with no promise of a payoff in the future. So once a the rental yield dips much below the historical average of around 5% in capital cities (4% in more affluent parts, and 6-7% in regional), we can say that property is overpriced relative to rents.

In economy.id’s new section on housing costs, we now have first quartile, median and third quartile rents, as well as the median rental yield for the area. Note that currently we have 2014 figures on the site, and prices have increased since then, so yields may have gone down more recently in some of these areas, hence the cause for alarm). Here are some examples: City of Boroondara – very affluent inner eastern Melbourne, with low rental yield of 2.6% for houses (3.8% for units) City of Whittlesea – first home buyer area on Melbourne’s northern fringe, with average rental yield of 4.7% City of Campbelltown – relatively lower socio-economic area on Sydney’s SW fringe, high rental yield of 5.3% Tamworth Regional Council – regional city with high rental yield of 6.0% It is the more affluent inner city areas on which the housing affordability debate is currently focused, and these currently have very low rental yields. This means that it is far more affordable for renters than it is for home owners, and explains why many of these dwellings are still negatively geared, even in this low interest rate environment. Nevertheless, plenty of other places, particularly in regional Australia, show rental yields about normal for the area, and these areas are still quite affordable to buy.

So, is there a bubble? It certainly looks like in some areas, affordability is quite low. In Boroondara, for instance, you can rent a $1.1 million house for about $650 a week. When yields get to this level, would-be home owners are much better off to keep renting, if they want to remain in this area. If house prices have been pushed up by speculation, eventually credit runs out, or interest rates rise, and house prices stop increasing. A few things may naturally occur:

• Prices may stop rising for an extended period, allowing rents to slowly catch up (rents tend to increase more in line with inflation).
• There may be a combination of modest price falls combined with rent increases, bringing yields back to normal levels (remember that house prices may rise the most in affluent areas but they also fall the most).
• The bubble may pop, with precipitous declines in house prices, usually accompanied by more modest falls in rent. This is likely if there is another trigger, for instance a rapid increase in unemployment coupled with significant interest rate rises and an oversupply of housing relative to demand. The article above claims there is currently an oversupply in Victoria. However with our current very high rate of population growth, I think this is unlikely, except perhaps in a few high-rise areas of inner city Melbourne. Remember housing is all about location.

No-one knows what will happen to house prices. However the gap between prices and rents in some areas can’t continue indefinitely, and we may get some price declines. On the other hand, prices in regional areas and some outer parts of our cities are still well supported by rents and haven’t experienced the massive increases of inner Sydney and Melbourne. So as with all statistics, it all depends on your area. It seems this particular bubble is quite localised to a few places. You can now monitor house prices and rents using economy.id.