Why house prices will hold up

Property investors are understandably wary about the market’s resilience and future performance, now that the Reserve Bank has signalled more rate cuts are in store.

Property investors are understandably wary about the market’s resilience and future performance, now that the Reserve Bank has signalled more rate cuts are in store.

Looking ahead, it’s pertinent to consider whether this sequence of events is in any way unusual. For seasoned investors and analysts familiar with the property and investment cycle, the answer is that it’s not unusual at all.

Phil Anderson, managing director of Economic Indicator Services, is a long-time analyst of international property markets and has identified consistent landmark events in sophisticated markets like Australia’s. His review of United States land sales data from 1803 onwards shows a recurring pattern of peaks followed by downturns, and long periods of stable or rising prices in between.

In the first phase of the cycle, conditions for better market performance start with decreasing vacancy rates leading to improving rental returns. Higher rents attract investors into the market, increasing demand and inducing developers to bring more stock on to the market.

Next, construction of new dwellings starts to expand, influencing banks and other lenders to compete for new business and increasing the credit available to developers, investors and home owners. As the cycle continues, available land is absorbed and the competition for sites drives land prices up.

Real estate investors now start to see gains and more buyers enter the market keen to profit from rising prices. Sales volumes and prices rise rapidly towards the peak of the cycle, where competition between buyers becomes frenetic.

As the peak passes, confidence remains high, even as interest rates rise and activity starts to slow. Finally, when borrowing and purchase costs hit their highest point foreclosures start to rise and the market begins to slow.

In Australia, recessions in 1974, 1980-82 and the early 1990s all coincided with slowdowns in the residential property market, followed by longer periods of stable prices, strong growth and finally, boom conditions.

The only break from this pattern occurred with the quarantining of negative gearing and the introduction of the CGT by the federal government in 1985. With the financial equation for residential property changed, many investors abandoned the market, driving vacancy rates to new lows and rents to new highs. The resulting outcry forced the government to reinstate negative gearing.

So what lessons can today’s investors learn from both the generic and current property investment cycle?

The current record period of economic expansion, prosperity and strong gains in the property sector following the 1990s recession has only recently given way to instability in the sharemarket and a mild slowing in our property markets.

This time around, the US sub-prime crisis and international credit squeeze have been the catalysts, but the market’s progress in the future will broadly follow the same path as it has so many times before. Investors should not view the current or forward conditions as alarming or anomalous.

I believe the most recent cut in interest rates will have a positive psychological impact on the market, renewing some of the confidence lost over the past nine months or so. A cut of 25 basis points doesn’t substantially affect fundamentals such as cash flow for investors, but it does point to lower interest rates in the future. This will stimulate demand.

I think we are likely to see a further 25 basis point rate cut by the end of this year, probably in November and, as many market commentators are suggesting, further cuts in 2009.

The loosening of monetary policy is unlikely to be as aggressive as the cuts we have seen from the Reserve Bank in previous cycles; RBA Governor Glenn Stevens has hinted as much in recent comments. If interest rates are likely to fall gradually rather than rapidly, does this mean the Australian property market will follow the dramatic downturn occurring in the United States?

The evidence I’m seeing makes this scenario highly unlikely.

The American real estate boom of 2004-06 was characterised by aggressive lending of adjustable mortgage products to people who could not afford them, weaker labour markets and substantial increases both in new home construction and supply in the established market.

By contrast, Australia has seen an accumulating shortfall of new housing of about 30,000 units a year, strong employment and higher population growth over the past seven years. This means domestic demand remains consistently high and well in excess of supply.

These are the fundamentals that have driven our house prices up and, in my view, will provide significant downside protection for the property prices even as we enter a period of slower growth.

This article first appeared in Eureka Report


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