The unrefuted trend in all investment markets is mean reversion. It means that a period of below average returns is always followed by a period of above average returns. It is my thesis that investment-grade property in Melbourne looks attractive compared to other markets and that there are several economic tailwinds that may result in the median house prices doubling over the next decade.
The macro environment is positive for property
In short, property prices are driven by the law of supply and demand.
Demand for property is mainly dictated by interest rate settings, unemployment, and access to borrowings (mortgage lending).
Supply is mainly dictated by volume of new construction and consumer sentiment i.e., whether people are willing to buy and sell property. In times of higher uncertainty, most people stop transacting, as we’ve seen over the past 12 months.
Locking in higher discounts now will mean lower future interest rates
All the big 4 bank CEO’s have commented that the mortgage market has become the most competitive that it’s ever been in history. Banks are offering unusually high interest rate discounts and cash incentives to win and retain customers.
This chart (recently published in the AFR) suggests that banks are not generating a high enough return on new loans due to offering significant discounts. That means these discounts probably won’t last. I expect that banks will reduce discounting over the next 6 to 12 months once most of the low fixed rate loans have expired.
As such, there’s a window of opportunity for investors to obtain an interest rate discount of 3% (or more) off the standard variable rate. Your discount will remain in place for the life of the loan.
The chart below sets out interest-only investment interest rates after applying a 3% discount since 2003 (when the data set began) i.e., back testing to see what impact a 3% discount would have had. The average interest rate would have been 4.2% p.a. over the past 20 years (of course, this is theoretical because you would have never received a discount of that size). I think it’s realistic to expect your average interest rate to range between 4% and 5% over the long run. You should do your calculations assuming 6% p.a., just to be safe.
We need more investors to solve the rental crisis
On average, borrowing capacity has reduced by around 30% over the past year due to (1) the RBA rate hikes and (2) APRA increasing the interest rate buffer that lenders use when testing your ability to repay a loan. This is depicted in the chart published by CBA in its results briefing in February 2023.
The rental crisis has been driven by a reduction in the number of properties that are available for rent, as I discussed here. There are fewer investment properties for two main reasons being (1) a lot of investors cashed in and sold during 2020 and 2021 and (2) tightening of lending rules since 2017.
The only way to solve the rental crisis is to increase the supply of privately owned rental properties, which is what the government will eventually have to do. They could achieve that by removing the interest rate premium that applies to investment loans (compared to home loans) and reducing the 3% interest rate serviceability buffer.
If/when they do that, it will increase investor demand which will stimulate the market.
High population growth and low unemployment is good for property
Australia’s unemployment rate is only 3.5% which is a historic low. The 10-year average unemployment rate is 5.4%, so even if the unemployment rate rises, which it probably will, it’s not of a concern. A low level of unemployment means that most people have a job and can borrow and repay their mortgage. That is typically good news for property prices.
Australia’s population growth will benefit from a splurge in overseas immigration. Treasury forecasts that more than 650,000 people will immigrate to Australia in the 2022/23 and 2023/24 financial years. Normally, we’d only expect between 400,000 and 500,000 over a two-year period. These people will need somewhere to live.
A healthy economy and rising population are stimulatory for property prices.
New dwellings: shortage or satisfactory supply?
Over the past 20 years, I have read endless forecasts that suggest Australia will have a housing undersupply. I do not believe them.
We currently build about 180,000 new dwellings each year and that doesn’t seem to be much short of what we need. Of course, with a lot more construction companies going bust, it is conceivable that Australia will build fewer new dwellings over the next few years. But I don’t think the undersupply is chronic, at least not at a macro level.
The point I would like to make is that housing supply is either at equilibrium or perhaps undersupply, but it’s certainly not in oversupply. Nor does it look like the volume of new construction is likely to increase. Therefore, if supply is relatively fixed, but demand is growing, for the reasons discuss above, then that is likely to cause property prices to rise.
Recent growth below long-term average
I have shared the below chart previously in this blog, but I have updated it to include data until the end of calendar 2022.
As you can see, growth in Melbourne and Sydney has been below materially average over the 5 years ended December 2022. We know that periods of below average growth are always followed by period of above average growth, as demonstrated in the chart.
For the rest of this blog, I would like to focus my commentary on the Melbourne property market for two reasons.
Firstly, an investment-grade house in Melbourne is a lot more affordable than in Sydney. You can buy an investment-grade house for $1.2-$1.5 million in Melbourne whereas you must spend a lot more in Sydney.
Secondly, Melbourne is expected to benefit from much higher population growth over the next decade (projected increase of over 1.08 million people versus 760k in Sydney). Melbourne’s population will soon be larger than Sydney’s.
What will Melbourne’s median value be in 2033?
The chart below sets out the median house price in Melbourne since 1980 – green line. The solid blue line is the average growth rate since 1980 being 8.20% p.a. The dotted blue line is 7.5% p.a. average growth – noting that all eastern capital cities have exceeded this rate since 1980 – so I consider this to be the low end of the range.
This chart makes two points. Firstly, the green line has always reverted to the solid blue line i.e., reversion to the mean. Secondly, it appears that Melbourne property is approaching a growth cycle as the green line is well below the solid blue line.
The chart below extrapolates the median value over the next decade. It suggests that by the end of 2032, the median house price in Melbourne could be between $2.05 million (7.50% average growth) and $2.95 million (8.20% average growth). According to the REIA, the median house price was $974,500 in December 2022, so conceivably, property values could double over the next 10 years.
Of course, property prices may not double. There are no guarantees with property prices. Whilst this data is mean house price data, it is critical that people invest in high-quality, investment-grade property, for the reasons discussed here.
Using the principal of mean reversion isn’t rocket science. For example, I held an investment briefing in my office in November 2018 (see here). In this presentation, I presented a case, why I thought Brisbane was the most attractive property market at the time. I held this view mainly because its growth since 2011 had been well below average. We know now that the average growth since that presentation has been over 9.5% p.a. and many of my clients have made a lot of money by investing in Brisbane since 2019.
My point is that I don’t know when prices will start reverting to the mean. But it’s not a question of “if”. It is only a question of “when”. I think Melbourne is an attractive property market for the same reasons that I liked Brisbane back in 2018.
I should say that, in the long run, I think investment-grade property in Melbourne, Sydney and Brisbane will deliver good returns over the next two to three decades. It’s just that I think Melbourne is particularly attractive at the moment, for the reasons stated above.
