Why property prices have bottomed

Property prices

CoreLogic data indicates that property prices in the 5 largest capital cities have fallen by 7.1% since May, when the RBA started hiking interest rates. Sydney has seen the largest price fall – down by around 10%, and Melbourne has fallen by 6.7%.

But it’s not all bad news. House prices in Brisbane, Adelaide, and Perth are still materially higher than they were a year ago.

I wrote a blog in March in response to fund manager, Christopher Joye’s prediction that property prices would fall 15% to 25% within 2 years if the RBA hiked rates by at least 1%. At the time, it was my view that prices would fall 5% to 7%. This has happened now, and I don’t think we’ll see any more (material) falls in investment-grade locations for the reasons set out below.

Supply and demand are more balanced

One of the reasons that prices have fallen this year is that it’s no longer necessary to overpay to buy a property. Last year, I wrote that the only way to successfully buy a property in 2021 was to overpay. That’s because potential buyers outnumbered potential sellers.

Buyer demand has fallen (probably due to higher rates, share market volatility and talk of a possible recession) but so has supply i.e., the number of new listings – they are 18% below the 5 year average. As such, the market is relatively balanced (between buyers and sellers) which means there is no need to overpay anymore. Good quality, investment-grade property is still attracting strong buyer demand and is typically selling for fair value.

Of course, some geographic markets might experience different conditions, such as regional towns and beachside locations. It is possible that some locations may experience larger declines in demand and as such, prices may continue to fall.

Most borrowers have factored in higher rates

Most borrowers realised that interest rates would not stay at 2% p.a. forever. Of course, if they were listening to (and believing) the RBA governor last year, they wouldn’t have expected rates to rise this year (the governor was saying they’d rise in 2024). But whether it was 2024 or 2022, most borrowers have been prepared for higher interest rates.

It is true that the historically low rates in 2020 and 2021 did encourage people to borrow more. But not because they thought rates would never rise. Most borrowers realised that interest rates tend to range between 5% and 7% over the long run, so they viewed borrowing in 2020 or 2021 as a bit of a free kick (cheap money for a few years), especially if they fixed, which many borrowers did.

Many existing borrowers took the opportunity to fix the interest rates on their mortgages during 2020 and 2021. These fixed rates will start expiring from next year and as such, repayments will increase substantially – more than double in some cases. This will have an impact on discretionary spending, which hasn’t yet declined.

Also, variable interest rate borrowers haven’t yet felt the full effect of the rate hikes, as there’s a two-to-three-month lag.

The upshot is that most borrowers are prepared for higher loan repayments. There’s a lot of fat in discretionary spending at the moment, particularly in hospitality, travel and retail that will need to be redirected towards servicing mortgages. Given the low unemployment rate, unusually high amount of savings that Australians accumulated during Covid and the ability for people to curtail spending, I do not expect any material levels of financial stress. Of course, there will always be some people that have not planned for higher repayments, but these will be the minority.

Top of the rate cycle is close

Perhaps the biggest factor that will help the market look beyond the recent rate hiking cycle is knowing what the terminal cash rate will be i.e., how high will rates get. Many commentators anticipate that the RBA may hike rates two more times (0.25% p.a. each) bringing the peak cash rate to 3.35%. Once the terminal cash rate becomes clear, markets are more likely to look beyond this hiking cycle.   

The interest rate story may change next year… start talking about cuts

It is considered likely that higher interest rates in the US will push its economy into recession. That will cool global growth and could have an impact on our domestic economy. If that occurs, it is possible that central banks may need to start cutting interest rates in the second half of 2023.

However, higher inflation might be more persistent than most expect, as suggested in this article by Research Affiliates. The authors suggest that historical data indicates that when inflation exceeds 8%, it usually takes between 6 to 20 years to revert to 3% (with the mean period being 10 years). If history repeats itself, we could be in for a period of stagflation, which is when low economic growth and high inflation occur at the same time.

Investment property rental yields are increasing

Nationally, dwelling rents have increase by 10% over the year to September 2022, according to CoreLogic. In October, the national vacancy rate was a mere 0.80% with Adelaide, Perth and Hobart having the tightest rental markets. It is clearly a very tight rental market. Rising rents will eventually attract more property investors into the market, thereby raising the demand for property and therefore underpinning prices.

Population is growing

Overseas migration will once again stimulate the economy and demand for property. The Albanese government will increase the permanent immigration intake from 160k to 195k people this financial year. Temporary visa holders are quickly bouncing back to pre-Covid levels too (see here) and have increased by 500k over the past year.

Pete Wargent writes that Australia’s population is likely to increase by 3 million people by 2030.

Student visa holders have only just begun their recovery so there’s plenty of growth left. This will add further demand pressures to the rental market.

Of course, an unexpected event could occur  

Assuming no major catastrophes occur, for the reasons situated above, I think we have seen the lion share of the property value reductions in investment-grade locations. Prices will stabilise from here. For prices to continue to fall, there needs to be an imbalance of supply and demand. Demand is already relatively low, and I can’t see supply increasing dramatically. As I said above, borrowers have plenty of financial fire power to deal with higher loan repayments, albeit at the cost of discretionary expenditure.  

However, if life has taught us anything, especially over the past decade, we should expect the unexpected. So, if an unexpected risk arises, it could alter these expectations.

Property will always be a long-term investment and we know that over long periods of time, prices have always trended higher, so intermittent price volatility is meaningless.