It is Christmas 2009 and Julie and Josh are out to buy their first home. They are able to buy a house in Parramatta for $455,000. It is within their budget, decently spaced and a reasonable walk from the station. They are one step closer to the “Australian Dream”. Fast forward to April 2017 and the medium house price in Parramatta has soared to $1.1 million.
It is no secret that you are inevitably more likely to get struck by lightning twice than buy an affordable first home 40 minutes from Sydney City. Investors like Joe have greatly benefited from growth in property prices across the Sydney and Melbourne markets, although new investors and owner occupiers must contend with property prices that are a higher multiple of average incomes. While booms are a regular occurrence, we have not seen such substantial growth since 1980, causing some people to speculate about the formation of a property price bubble. Average property prices rose 7% over the past 6-7 years, buoyed by aggressive interest rate cuts, high population, lacklustre supply growth and booming investor interest backed by interest only loans.
One of the major factors that buyers must consider when purchasing a property is the amount of interest they have to pay on their mortgage. The Reserve Bank of Australia is the regulatory body in charge of setting the target Cash Rate, a benchmark interest rate banks pay to borrow funds from other banks in the overnight money market. The Cash Rate has a direct effect on the interest rates banks provide to consumers and investors; as such, when the cash rate falls, interest rates also tend to fall.
Sluggish global growth hindered by Europe and Asia along with low headline inflation forced the RBA to gradually lower the cash rate from 4.75% in October 2011 to the current historical low of 1.50% over the last 6 years, causing banks to in-turn lower interest rates.
Whereas Julie and Josh would pay about 7.24% interest on their home loans with CBA in 2011, current investors and consumers only pay about 4.5% interest. This lower cost of borrowing and higher availability of credit has increased demand for housing and also resulted in individuals often overpaying for prices as the low interest environment allows them to finance higher debts. Hence, falling interest rates have resulted in higher property prices, as they have increased the servicing capacity of buyers.
A big issue in Australian politics surrounding housing is that of negative gearing and the capital gains tax discounts.
Introduced in 1985 to provide incentive for investors and developers to contribute to the creation of more houses through investment in negatively geared properties, the negative gearing policy and capital gains tax discounts have been big issues in Australian politics. The capital gains tax discounts is a 50% discount on the net taxable gain for investors like Joe when they sell investment properties held for more than 12 months. The negative gearing taxation policy applies when the loan costs are greater than the rental income on an investment property. The loss can be offset against an individual’s personal income. In 2013, the average loss on an investment property was $10,000 – meaning if Joe held an investment property his taxable income would go from $85,000 to $75,000 – pushing him into a lower tax bracket.
The capital gains tax discounts is a 50% discount on the net taxable gain for investors like Joe when they sell investment properties held for more than 12 months.
In a high capital growth and low yield property market like Sydney, rising prices provided incentives for many investors like Joe to purchase properties, offset losses against their taxable income and benefit from higher capital gains. Furthermore, the interaction between the two policies directly results in high investment activity then what would otherwise occur. Both these policies wouldn’t be a problem if individuals were investing in new housing which would increase supply and provide a counter to the rise in demand – however the majority of investors use these policies to bid for houses demanded by owner – occupiers and first home buyers.
There has also been a high level of interest and demand from foreign investors, especially from China, to purchase property in Australia. These purchases are concentrated in the high growth Sydney and Melbourne markets. Chinese investors purchase new housing at a rate of $8 billion a year – approximately one in five new homes across NSW and Victoria. Although the government has implemented certain policies which act as hurdles to Chinese investment, the relative value of Sydney homes result in high demand for Australian property. As seen in fig X, although prices are all time historic highs in Sydney, Melbourne and Brisbane –they remain cheap in comparison to major Chinese cities. Furthermore, rental yields in Australian cities are more than double those in Shanghai and Beijing. This strong demand for property has resulted in accelerated prices and contributed to the unaffordability of property.
Upon receiving a mortgage, individuals can either choose to either pay a portion of the loan principal with interest every month or else choose only to make interest payments – mortgages where they merely pay the monthly interest bill. Part of the Australian dream has always consisted of owning a house and paying it down as quickly as possible. However, recently individuals like Josh and Joe have shifted to interest only mortgages. The value of interest only loans has almost doubled between 2012 and 2015, as shown below in Figure 2 and big 4 banks hold about 40% of loans in interest only – that is 40% of loans which are held by people who have no intentions of paying them down. Shifting the loan to interest-only allows both consumers and investors to temporarily fund a higher level of debt as their expenses are lower. This encourages individuals to buy properties which may be outside their budget, should there were a change in economic circumstances. This shift not only increased prices, it has also increased indebtedness and illustrating the banks mentality of writing loans for people who could not afford them.
The shortfall housing supply, especially in Sydney and Melbourne, has contributed to the unbalanced demand and supply ratio and has resulted in higher prices. With high population growth and strong demand for Australian housing, there has been a cumulative shortfall of property since 2005. This is especially true between 2011 and 2015, where a rise in underlying demand was unable to be met by housing completion and the shortfall of supply resulted in higher prices.
A variety of factors have inevitably created an environment of heightened risks and soaring prices. While it may seem that investors like Joe have benefitted at the expense of buyers, the high risk environment has resulted in a tightening of lending to domestic investors detrimentally affecting both parties. Unfortunately, counter cyclical measures to headwind property growth are far too little and far too late. Many young Australians have given up on the dream of a home to call their own and the others toss up the prospect of saddling themselves with a lifetime of debt. Christmas 2009 has long gone and with it goes the idea of the “Australian dream”.
Cover Photo: AFR