By David Bassanese

For those like myself thinking that the Australian east coast property boom was likely to end soon, this week’s official figures from the Australian Bureau of Statistics made for sober reading.

As I’ll show, relative to household income, Sydney property prices are now at record highs and well above the average of the past decade or so. By that measure, prices are clearly overvalued.

Yet given still very low mortgage interest rates, it might surprise some to know that Sydney “mortgage affordability” is still only a little above its long-run average. Incredibly, based on mortgage affordability (albeit crudely defined), Sydney property prices are still only at fair value.

Other cities, moreover, are still quite reasonable valued – especially given low interest rates, but also in outright terms compared to household income.

Let’s look at the facts.

According to the ABS, established house prices surged by 5% in the June quarter, to be up 10.6% over the year. Using a weighted average across capital cities (as used by the ABS), the unstratified national median price of properties transacted in the quarter rose to around $636,000.

The chart below details the national picture. By my estimates, the national median house price of $636,000 is now around 5.4 times the average after-tax household income of $117,000 (comprised of a fully employed male and female on average weekly earnings for each gender respectively). That’s above the average since March 2004 of 4.8 times income.



But here’s the effect that low interest rates can have on the market. Assuming a deposit or other home equity of 20% of the purchase price (which is clearly a stretch for first home buyers), the loan required to purchase the median priced home would be $508,000 – which also ignores stamp duty. With the average discounted bank variable mortgage interest rate at 4.6%, monthly loan repayments over 25 years would amount to around $2900 or $660 per week. That’s around 30% of after-tax average household income – which is still slightly below the average since March 2004.

Of course many will note that other costs need to be considered – such as stamp duty and onerous deposit requirements for first home buyers. But many of these costs have not changed in decades, so they should not dramatically affect our estimates of affordability over time. What’s more, the market has responded to first home buyer difficulties over time by lowering up-front deposit requirements and even pushing out loan maturities.

In this sense, low interest rates are having the same effect on the property market (at least in some cities) as they are having on the equity market – namely driving up prices relative to underlying income or earning capacity. In the share market this is evident from the above-average price-to-earnings (PE) ratios the market has enjoyed in recent months.

As seen in the chart below, house prices relative to income were above average in only three cities last quarter – Sydney, Melbourne and Darwin. They were below average in Brisbane, Perth and Hobart and close to average in Adelaide.
 


In terms of mortgage affordability, moreover, only Sydney had an above average repayment burden last quarter! 


 
Of course, the challenge going forward is what will happen to property prices once interest rates inevitably start to rise. If we assume a long-run mortgage rate of 6.5%, and household after-tax income growth of a modest 3% per annum, then over the next 10-years national property prices could only rise by 2% per year if mortgage repayments - by the end of the next decade - were held at no more than the long-run average of 31.5% of household after-tax income.

In Sydney and Melbourne, house prices could rise by 0.4% and 1.4% per year respectively over the next 10 years under these assumptions. By contrast, healthier house price gains – of around 3% to 4% per year - would still be possible in most other states.

My hunch is that we will see nominal (i.e. not real) house price declines of around 10% from previous peaks in at least Sydney during the next inevitable interest rate “normalisation” process.