Pessimistic market outlook likely to put a lid on price growth: August state of the market analysis

Market Outlook: unchanged - neutral with negative bias

• Attractiveness of renting as a preferred accommodation option has further increased (as at June 2014).
• Purchase affordability is still very high, although slowly declining - this provides strong support for prices at the current level (as at June 2014).
• Confidence in the economy continues to deteriorate with no signs of improvement (as at August 2014).
• Housing Credit Impulse continues to grow, indicating there is still plenty of demand for residential real estate (as at June 2014).
• Actual prices are above what could be expected based on changes in housing credit - although the margin is reasonable it makes prices very sensitive to adverse changes in economic conditions (as at June 2014). 

National Real Estate Price Forecast

With purchase affordability at a decade high, the underlying demand for residential real estate in Australia remains strong and property prices continue on the upward trajectory, albeit at a slowing pace.

The current price level remains slightly elevated in relation to the underlying mortgage credit flowing into the market, indicating that prices are vulnerable and may suffer an unexpected stall or even reversal at this level (slowing price growth is a manifestation of this vulnerability).

Since buyers are now at disadvantage to renters due to faster rising costs of buying, return to wide spread optimism about the economy is a prerequisite for the continuation of strong price growth.

However, pessimism about the state of the economy is not improving, and hence, it poses a serious threat of derailing what is otherwise quite a robust market.

A sudden return of optimism could reinvigorate buyers and lead to a very substantial jump in prices in the coming months (since buying costs compared to average incomes are still at historical lows).

However, the more likely scenarios at present are either no improvement in perceptions about the state of economy, or a further rise in pessimism. Although this will not crash the market in the short-term, nevertheless, it can potentially put the lid on further price growth in September and December quarters.

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Detailed Analysis

• optimal accommodation choice: attraction of renting is increasing

The Buy-Rent Indicator (BRI) identifies how cost of buying is changing in relation to cost of renting.

BRI bottomed in June 2012 (indicating the lowest point in the current cycle) and it has been rising consistently since then. The indicator crossed the equilibrium line in March 2014 and continues on an upward trajectory.

This indicator is constructed based on the simple concept that renting and buying are substitute accommodation options, hence the optimal choice depends on which accommodation cost is rising in relation to the other. The practical use of this indicator is for identifying market cycles and for timing purchase and sale decisions.

The crossing of the indicator from buy to rent zone gives a signal that buying costs are starting to rise faster than rental costs.

In a market where property prices are rising, this marks the point in time when opportunities to purchase a property at attractive prices are limited.

For those intending to sell in the current cycle, it marks a time to start preparing for the sale - the optimal point for selling the property will be when the indicator peaks, which should coincide with an interim peak in property prices.

We are already two years into the current cycle and the next peak should be anticipated sooner rather than later.

Trough-to-peak of two years in duration was not uncommon in the last 30 years but there were also a few cycles with an uptrend as short a 16 months and the longest recorded was just over 3.5 years in duration. 

Further strong increases in property prices and/or a rise in interest rates will increase the cost of buying relative to the cost of renting, making purchasing a much harder option to choose than it is at present. Therefore, fast moving prices can lead to a quite dramatic reduction in the demand for properties and, in effect, shorten the overall cycle.

Stagnating or slowly growing prices can potentially limit the negative impact on demand as growth in buying costs will be offset to a large degree by rising rental costs. This can delay the peak and extend the duration of the overall cycle.

Indicators show that this cycle is a slow moving one and therefore the next peak may be still some way off (i.e. up to two years based on historical evidence). However, it all depends how fast prices and/or interest rates move up from here onwards.

• purchase affordability: at a historically high level and falling, but only just

The Purchase Affordability Indicator (PAI) compares changes in the annual cost of buying to changes in average full time adult income, therefore it identifies how purchase affordability has changed over time.

PAI is at historically high level and the revised June 2014 value has recorded only a small fall in relation to the previous month reading.

This indicator explains that, relative to incomes of Australians working full time, property prices are still very affordable.

In fact, the cost of buying a median priced property relative to average income is now 27.4% lower than it was in 1986. So, given the expectations of long term low interest rates, there is still a lot of room for prices to move before Australian property can be considered overvalued.

Since purchase affordability is declining very slowly at the moment, the support for current prices appears to be strong. It means that the property market should be very resilient if Australia were to experience a case a mild economic turbulence in the near future.

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• perceptions about economy: negative and deteriorating

The Economic Wellbeing Index (EWI) is designed to reflect general perceptions of Australians about the current economic conditions.

The EWI is falling since June 2013. August 2014 estimate is in the negative territory and continues to fall. A more volatile raw measure is also down and the signs of recovery highlighted last month were short lived.

The key premise behind this indicator is that people are generally less inclined to make big purchases when they are worried about the state of the economy.

Actual prices cannot be expected to advance strongly for much longer if there is no substantial change in perceptions about the economy.

If such a change comes soon, we should experience a very vibrant spring selling season, where prices continue to rise strongly.

However, if pessimism prevails, which as this stage seems to be the more likely scenario, it will most likely put a dampener on the pace of further price growth due to reduction in demand for properties.

Nevertheless, there is no reason to panic just yet as the likelihood of prices falling is still very minimal. However, a flat-lining market is not totally out of the question. 

• demand: still strong and trend is not yet changing

The Private Housing Credit Impulse (PHCI) provides an indication of the level of buyer activity in the residential property market in Australia, hence it reflects underlying demand for properties.

The June 2014 PHCI estimate is positive and the value of the indicator is at its highest since December 2011.

The June value of PHCI is subject to final revision but it is very unlikely the indicator will change from its current direction.

The practical use of this indicator is to provide early warning about impending changes in housing credit uptake, and hence, changes in the underlying demand for residential property.

A positive and rising value of the indicator reflects continued strong demand for residential property. When the indicator turns down, it will signal a change in the underlying demand.

Investors stepping aside, as reported recently in the media, may prove to be the catalyst for change if they are not replaced by home-upgraders and first home buyers. However, so far, the demand holds quite strongly despite rising pessimism about the economy. 

• property price expectation: growth to slow or flatten

The Property Prices Gauge (PPG) is a proxy of a property price index. It becomes a leading indicator when combined with House Price Index (HPI).

PPG recorded a small jump in June 2014. However, actual prices (June 2014 House Price Index) also increased by a similar margin and remain above what could be expected based on housing credit growth. 

The rebound in PPG provided evidence of a relatively strong support for the current prices.

However, the 12 month rate of growth in prices has now started to slow, reflecting softer market conditions in the last few months, as indicated by a flattening PPG.

Despite the rate of growth in prices moderating and PPG recording some gains in June, the gap between the two is not narrowing. It implies that property prices are vulnerable at this level and can unexpectedly stall or maybe even record a small fall.

If the rebound in PPG continues in coming months it will indicate a strong probability of further rises in property prices in the September quarter and beyond. However, any divergence from this uptrend will imply an underlying weakness in the market and hence greater uncertainty about the direction of property prices.

Arek Drozda is an independent property market analyst.

Caveat: The information is provided in good faith and does not constitute financial advice. Use with caution and at own risk.

For more extended description of individual measures and how to apply this information please refer to the first report in this series: State of the Property Market, April 2014.