Adelaide real estate still undervalued despite the boom



The combination of low interest rates and high household savings helped trigger a “perfect storm” for the Adelaide real estate market. UniSA researchers Chris Leishman and Peter Rossini argue that the local real estate market has been undervalued since 2013 and is expected to continue to rise until we see several interest rate hikes from the RBA.

The debate over the future of Australian interest rates is now almost as hot as that of its property markets. For weeks now, financial markets have been increasingly nervous about US inflation and the possibility that interest rates will eventually rise slightly. The RBA, on the other hand, has been very consistent in its message that low interest rates are here to stay for several years to come.

Low interest rates on home loans play a major role in increasing the purchasing power of home buyers and investors. Most homeowners and investors are not cash buyers, but rather rely on borrowing to finance their purchases. A relatively small change in interest rates can have a huge impact on the cost of servicing a loan, and rates have been trending down for years (see figure below).

Considering the importance of interest rates to the length of service of home loans, it is instructive to ask how high house prices should be given the level of interest rates at any given time.

The following chart compares the median house price in Adelaide to a hypothetical measure that we describe as the purchasing power index of homebuyers.

This is derived by finding the maximum home loan that would be affordable for a two-earner household, with an average salary, spending 30 percent of their income on a home loan.

By comparing the HPP index to the median price, a measure of under or over valuation can be created.

We focus on the concept of double the median income, as this measure is a much more important price factor in the Adelaide housing market than elsewhere in Australia.

In Sydney and Melbourne, housing pressures are more strongly influenced by net migration overseas.

The trends in the data are quite striking and underscore the stability of the Adelaide housing market relative to other locations in Australia. House prices were overvalued both before and immediately after the GFC, but wage growth coupled with gradually falling interest rates caused home values ​​to become undervalued in early 2013.

They have remained undervalued ever since, but significant interest rate cuts from 2019 have widened the gap further.

Household savings have also played an important role in the recent and ongoing boom in the Australian housing market.

The pandemic has almost disrupted international travel, helping to divert funds to consumption and investment in housing.

In the following figure, we show the average annual household cash savings as a percentage of the median house price in Adelaide. There are several interesting trends.

For example, we can see that savings were on a downward trend for years after the GFC.

This was the main period in which house prices in Adelaide became undervalued relative to the purchasing power of home buyers (reflecting wages and interest rates). Household savings have been increasing gradually since around 2016, and this accelerated during the pandemic.

Figure 3 Household savings and over / under valuation.

When we put the different trends together, we can see why there is now a perfect storm in the Adelaide housing market.

While Adelaide’s housing market has been undervalued since around 2013, the HPP index remained fairly stable during that time – until just before the start of the pandemic.

In the second quarter of 2019, average household cash savings rose to around 20% of the median house price in Adelaide for five years, and it continued to rise sharply during the pandemic.

It is quite clear that the HBPPI started rising for two or three quarters before the rapid rise in house prices started, showing that this is a good leading indicator of market activity. But, the data also shows that mortgage service life alone is not enough to explain the surge in prices – excess household savings were also needed.

The question is: what future for the Adelaide real estate market? Although the RBA has remained firm in its publicly stated opinion that there will be no increase in the cash rate for the foreseeable future, it is difficult to see how Australia can chart a different course than the majority of the OECD bloc.

Many commentators see two rate hikes in 2022 in the United States, and potentially three in 2022.

In Australia, most banks routinely assume a 2.5% increase in their stress test calculations (of course, that doesn’t mean such an increase is likely in the near future).

APRA recently revised its guidelines and now requires banks to assume a 3% margin in their stress tests. In the following figure, we explore what a series of 0.25% rate hikes would mean in 2022 and 2023 for the HBPP Index.

The analysis suggests that three rate hikes would be needed to bring Adelaide home prices back in line with the HBPP index.

Assuming there is no further house price growth in the meantime, this suggests that there will be no price overvaluation until the end of 2023.

However, this point will clearly be reached much sooner if house price growth continues, and possibly by the end of 2022.

Meanwhile, the surge in house prices in Australia has finally triggered red flags in the banking sector with the RBA, CBA and ANZ in recent weeks signaling that restricting lending is now necessary in order avoid new threats to financial stability.

Professor Chris Leishman and Peter Rossini work at UniSA Business, where they deliver real estate and real estate programs.

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