Why home prices are falling and won’t rebound in a hurry

The Reserve’s inclination will be to talk tough, but err on the side of caution in raising rates much further now.

As a general rule of thumb, I reckon you can take the high point of your property’s valuation during COVID – when rates were at almost zero per cent – and assume that will represent something of a high watermark for a while to come.

In the short to medium term, of course, prices are receding from those levels, and will fall further.

Why? Because when you make it more expensive to borrow, people can’t borrow as much from a given income and less borrowed means less spent at auctions.

That’s pretty obvious. But another less obvious factor dampening borrowing capacity and home prices currently is the impact general inflation on people’s borrowing capacity.

When you go for a loan, your surplus cash flow is calculated as your income minus non-housing living expenses. The default assumption for living expenses – the so-called ‘Household Expenditure Measure’ – gets automatically indexed higher each quarter with inflation.

So, if your annual after-tax income is $100,000, and non-housing living expenses were $60,000, you’d have $40,000 surplus cash flow to afford your new mortgage.

But inflate those living expenses by the full latest inflation figure of 7.3 per cent, and that brings them to $64,380, leaving you only $35,620 surplus cash flow to service your loan – assuming no change to your income.

So, as you can see, even absent any interest rate hikes, borrowers have suffered a significant reduction in their ability to service loans thanks to the rising cost of living.

Add rate hikes, of course, and borrowing capacity has shrunk dramatically.

According to AMP chief economists Shane Oliver, rate hikes since last April have reduced the home buying power of an average full-time earner with a 20 per cent deposit by 27 per cent, from $600,000 to $440,000.

Viewed in that light, the 8 per cent fall in home values so far since their highs early last year looks relatively modest. Oliver predicts further price falls of about 9 per cent out to about September.

Much depends, of course, on where the Reserve Bank takes the cash rate from here.

Money markets are still betting the cash rate will hit 4 per cent, from 3.1 per cent currently. If that happens, Oliver predicts an even sharper total decline in prices of 30 per cent total.

Only time will tell, of course. I suspect the Reserve’s inclination will be to talk tough, but err on the side of caution in raising rates much further now, as opposed to jacking rates up only to have to cut them by years end. A major ‘x-factor’ remains how households on ultra-low, sub-2 per cent fixed rates respond as the bulk roll off onto rates closer to 6 per cent throughout this year.

Given the myriad forces in play, it’s hard to give firm predictions. A final force is that our prudential regulator has, at the urging of lenders, also shown a tendency to rush in to support home values with relaxed lending standards.

I suspect if rates rise much further from here, there will soon be great pressure applied to have the current 3 percentage point stress test applied to new borrowers relaxed (that’s the test to see if borrowers can afford their mortgage if interest rates were 3 percentage points higher than the current loan rate).

Some lenders are already pushing longer repayment terms, 40-year loans are available from some, which has the effect of reducing monthly minimum repayments and therefore boost total borrowing power.

So, do strap yourself in for more home price falls ahead. But don’t be surprised if outcomes depart from predictions. When it comes to home values, it’s anyone’s guess.