Wednesday, July 08, 2015

What bubble? Houses 30% undervalued, says Reserve official

Far from being overvaluedAustralian house prices are 30 per cent undervalued, the widest such gap in three decades, updated research conducted within the Reserve Bank has found.

The research finds current price expectations neither "unusual" nor "irrational". 

Delivering the preliminary results to a session on housing at the Australian Conference of Economists in Brisbane, and stressing that they should be attributed to him and not the bank, Reserve senior research manager Peter Tulip said that whereas a year ago home prices were "fairly valued", today they are about "30 per cent undervalued".

The change has been brought about by much lower mortgage rates and by changes in bond prices that imply mortgage rates will hug their present historic lows for a further decade.

In the past year, Sydney house prices have climbed 16.2 per cent, Melbourne prices 10.2 per cent and national capital average prices by 9.8 per cent.

But Dr Tulip and his co-author, Ryan Fox, argue that rising prices say nothing about whether home ownership is good value compared with the alternative, which is renting.

"We find that owning a house costs 30 per cent less than renting," Dr Tulip told the session. 

"That is, houses are 30 per cent undervalued.

"Another way of interpreting our results is to look at the expectations underpinning current house prices.

"Our results suggest that those expectations currently look fairly reasonable. They do not show unusual optimism, they do not show irrational exuberance.

"But this hasn't always been the case. Just one year ago when we last published results, we found that houses were fairly valued — that is, the cost of buying was about the same as the cost of renting.

"What has changed since then is that real long-term interest rates have fallen substantially. That fall made housing more attractive relative to renting, despite the increase in prices."

Dr Tulip and his co-researcher compared the cost of renting and buying identical properties, avoiding the common trap of comparing national average rents with national average prices. Because owned homes are typically "bigger and nicer" than rented homes, a lot of the apparent price difference reflects a quality difference.

They calculated the annual cost of a bought home from the purchase price, the transaction cost, the expected mortgage rate and the running and depreciation costs offset by expected capital gains.

The annual cost of owning a home bought in April was likely to be 2.7 per cent of its value. The annual cost of renting the same home was likely to be 3.9 per cent.

"So you can either pay 2.7 per cent of the value of the property to buy, or you can pay 3.9 per cent of the value to rent," Dr Tulip told the conference.

"The undervaluation is 30 per cent.

"It's unusually wide, the widest in at least 30 years. I can take you back further but the data quality deteriorates the further we go back.

"Under our assumptions, owning a home is now more attractive, relative to renting, than it has been at any time in the past 30 years."

The change in the past 12 months is partly the result of this year's two interest rate cuts, which have brought the typical discounted mortgage rate to about 4.6 per cent.

But Dr Tulip said that even more important was the change in bond yields, which meant the market was now expecting little change in interest rates for a decade. A year ago the market had been expecting interest rates to climb.

He has not prepared separate results for each Australian capital.

In The Age and Sydney Morning Herald