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Thursday, August 25, 2011

House prices will be flat in income-adjusted terms for nxt 10 years (charts)

Where will house prices be in 10 years time? It’s a question that confronts almost every buyer. Framed differently, what are reasonable expectations for the return I will make on my biggest life-time investment?

We recently tried to tackle this subject through some independent analysis. In particular, we surveyed 21 leading market economists—including all the big bulls and bears—for their expectations of nominal house price growth over the next 10 years. To the best of our knowledge, a survey of this kind has never been conducted before. And the (anonymised) results, which I will come to shortly, are fascinating.

Prior to commencing this test, our own projection was that, all else being equal, nominal house price appreciation would average around 4.5 per cent per annum on the basis that this was a fair benchmark for disposable income growth over the ensuing decade.

By way of historical context, disposable income on a per household basis has averaged a healthy 5.8 per cent per annum over the last 10 years, and 4.9 per cent per annum over the past 18 years.

Yet for a range of reasons that I have explained many times before—including the once-off, 40 per cent plus reduction in nominal interest rates over the 1980 to 2011 period—historical house price appreciation has consistently outperformed disposable income growth.

For example, we estimate that between 1982 and 2011 median Australian house prices rose at a 7.7 per cent compound annual growth rate.

Taking an alternative, and demonstrably more robust, approach, we examined every individual purchase and sale transaction in Australia since 1990 to work out what the median ‘buy-and-hold’ return was. As the first chart below shows, this landed at a strikingly similar 7.8 per cent per annum pace (before transaction/holding costs).

Interestingly, the best and worst performing cities were Perth and Sydney, respectively. Since 1990 the median Perth home owner has realised an impressive 10.3 per cent per annum capital return before including rents. Sydneysiders, on the other hand, have typically fared one-third worse.

Folks sometimes forget that in addition to (potential) capital growth, all housing assets generate income, one way or another. In the case of investment property, this is known as the rental yield. In respect of home-owners, it is called the ‘imputed’ rent, or, in effect, the rent you save.

If we take historical gross rents and cut them in half to control for residential transaction/holding costs, the ‘total return’ yielded by Aussie housing over the last 20-30 years creeps up into double digit territory (see this article for our analysis).

Yet these guides strike us as being far too ambitious when thinking about the future. Sure, if Westpac’s Chief Economist, Bill Evans, is right, and the RBA slashes interest rates four times, we could see the housing market storm back with near double-digit gains much like it did in 2009.

And it is certainly true that housing is probably your best ‘hedge’ (as the economy’s most interest rate-sensitive sector) in the event that the resources boom genuinely blows up, and our central bank is compelled to change course.

While the current leverage in the household system cannot realistically increase much further, it is sustainable. As the next chart illustrates, Australia’s household debt-to-disposable income ratio has, in fact, flat-lined since a number of years prior to the GFC. This tells us that the ‘new normal’ for credit growth is income growth, which is why the two lines have moved sideways.

When we think about future household income growth, we want to control for the effects of reductions in marginal tax rates, the rise of multi-income households, and the secular decline in the unemployment rate during the 1990s and 2000s.

We also assume that the productivity malaise of the last 10 years is not blindly repeated. This suggests to us that a reasonable, non-inflationary disposable income growth rate for households is going to be in the 4.0 to 5.0 per cent per annum ball-park, which, depending on your specific assumptions, is a 10 to 30 per cent discount to the historical precedents provided above.

Another way of thinking about this is to presume that disposable household incomes will not outperform wages (which they have done in the past). Average Australian weekly wages have risen at a 4.4 per cent per annum pace since 1990, which is in the middle of our credible range.

With the above background in mind, we undertook a survey of Australia’s top 21 market economists. The results of this (anonymised) analysis are revealed for the first time in the chart below.

In short, the ‘average’ and ‘median’ expectations for nominal house price growth over the next 10 years were 4.4 per cent per annum and 5.0 per cent per annum, respectively (as represented by the blue and black lines in the chart).

This is an important finding: the ‘market’ is telling us that future house price appreciation is going to be around 40 per cent lower than its historical rate. That seems like a fair assumption to us.

While all the ‘market’ bears were included in our survey (with the exception of the academic Steve Keen, who does not meet our ‘market’ definition), the lowest forecast was a still believable 0 per cent per annum. This implies a one quarter decline in Australian home values in real, or inflation-adjusted, terms over the next decade (and much more if we deflate by incomes). The highest prediction was 7.0 per cent per annum, which is still a nontrivial 10 per cent discount to the 20 year growth rate.

The key take-away from this analysis is that in ‘income-adjusted’ terms Australian house prices are not going anywhere over the next decade. Naturally if we look at house prices in ‘absolute’ terms, this work suggests that they will likely be 55 per cent higher in 10 years’ time.

Including net rents, that will provide a reasonable total return that is around 4-5 per cent per annum higher than inflation. Once you account for the effects of leverage (ie, the fact that most people buy a property with an 80 per cent home loan), the actual return on your ‘equity’ is substantially higher again, assuming, of course, that the historical (inflation-targeting) level of interest rates remains roughly the same.

Having said that, please pay particular heed to my repeated warnings about individual property level risk.