The Kangaroo has landed

All signs in the Australian housing market are pointing downward for 2006.

The weighted average established homes price index for eight Australian capital cities rose by 2.26% in 2005, more than 2004’s 0.2% growth, but significantly lower than 2003’s 19.4% price increase.

But the national figure conceals tremendous variations. Sydney, which has the nation’s most expensive properties, saw its median house price fall in December 2005 to Au$485,000 (US$379,750), 4.8% lower than at the peak in June 2004 (Au$520,000). And with employment weak, Sydney’s residential property market seems likely to remain flat.

Melbourne, Australia’s second largest city, has the second most expensive house prices in Australia at Au$375,000 (US$293,625), while Canberra, the administrative capital, comes in at a close third at Au$368,000 (US$288,140).

In June 2004, the median house price in Canberra was Au$372,400 (US$291,600), higher than Melbourne’s Au$ 365,000 (US$285,800). Strong economic conditions in Melbourne underpin prices despite an oversupply of stock, especially of inner city apartments. Price growth has remained strong in resource rich cities Perth and Darwin.

The median house price in Darwin rose by 26.15% in 2005 after rising by 22.1% in 2004. Perth had 18% house price growth, on top of 17% growth in 2004. Booming economic conditions in Perth and Darwin, coupled with an increasing interstate migration inflow, strengthened the underlying demand.

RBA's fears

The slowdown in house price growth nationally owes much to the efforts of the Reserve Bank of Australia (RBA) to arrest speculation and prevent a crash. The RBA’s fears are not unfounded. The number of households in Australia owning a second house for rental or investment purposes is one of the highest in the world, at 12%. And they are still buying, despite very low yields.

Rental yields reached their peak of 9% (gross) in 1987. They have been dropping ever since. While prices have been growing in double digit rates, rents have only grown by an average of 2.8% p.a. from 1996 to 2004.

The share of households owning an investment property increased from around 8% in the early 1990s, to around 12% in 2002, according to the Australian Taxation Office (ATO). This is significantly higher than most other countries. In the US, data from the Internal Revenue Authority (IRA) indicates that only around 6.5% of individuals earn rental income. In Canada, the figure is about the same as the US. In the UK, less than two percent of households own rental property, though the trend is rising.

Negative gearing

One possible reason why households invest in residential properties is the way rental houses are treated for tax purposes. In general, Australian tax laws are favorable to buy-to-let investors. Negative gearing is allowed, i.e. losses on one economic activity, in this case rental investment, can be offset against a person’s principal source of income. This provision makes investments in rental houses relatively risk free compared to investments in other markets such as equities.

The strong economy and strong labor market have also contributed to house price growth, the economy, together with real wages, was expanding by an annual average of 3.8% from 1996 to 2003. The unemployment rate has been successfully reduced from 10.6% in 1993 to about 6.5% from 1999 to 2003.

Low interest rates have encouraged people to buy. The drop in interest rates over the past decade has led to increased availability of finance to both first time buyers and buy-to-let investors. Banks’ standard variable mortgage rates reached their lowest level in 2002, when they averaged 6.36%, extremely low compared to the 16 to 17% rates in 1990. Even in real terms, the trend of falling interest rates is evident; from 10% in 1989/1990 down to 2.5% in 2001-2002.

The low interest rates have been reinforced by the deregulation of financial sector, resulting in increased competition between mortgage lenders, leading to lower interest rates and better options for borrowers.

First home owner grant

The government has added to the upward price pressures. The First Home Owner Grant (FHOG) and the Commonwealth Additional Grant (CAG) were introduced in July 2000 and January to June 2002, respectively, giving first home buyers additional purchasing power. Under the FHOG, for instance, first-home buyers are paid Au$7,000 to offset the effects of the introduction of Goods and Services Tax (GST).

To arrest house prices, the (RBA) has been hiking interest rates. From 6.8% in November 2003, the standard variable mortgage rate rose to 7.05% in December 2003 where it remained for the rest of 2004. In was adjusted only in March 2005 when it was hiked once more to its present level of 7.3%.

While such interest rate changes may be deemed too small to have led to real effects, it is possible that they had a significant psychological effect, because of most loans are in variable terms. In addition, before the increase, the RBA repeatedly warned that interest rates would be hiked successively until the housing market cooled. In fact, the RBA only neededto adjust rates twice before it achieved its goal of cooling the market. The share of new loans intended for investment has already fallen to 37% in 2006, from 40% in 2004.

Yields up

The slowdown in price appreciation has led to an improvement in yields. Data for December 2005 from the Real Estate Institute of Australia shows that rents are outpacing prices. In Sydney, where real estate prices fell by around 5%, rents rose by around 3.5%. In Perth, where double digit house price growth rates of 17 to 18% were observed, rents rose by 21 to 29%.

Gross rental yields for apartments are now highest in Perth at around 5 to 9%. In Canberra, with 5.9% price growth and 7.4% rent growth, apartment yields are around 5 to 7%. For the rest of Australia, apartment yields are still low at around 2 to 5%.

Short-term interest rates are expected to remain at their 2005 level of around 5.7%, slowly cooling the housing market. It seems that the RBA is on top of the situation. They are avoiding drastic changes in key rates to avoid a housing market crash and have successfully guided the Kangaroo to a soft smooth landing. Investors should wait until yields return to healthy levels before injecting further capital into the market.