HOUSE PRICES – AND WHY GLENN STEVENS IS RIGHT TO BE WORRIED

Glenn Stevens is the most influential banker in the country. As head of the Reserve Bank, when Stevens speaks markets listen. But do politicians?

Recently, Stevens made some telling comments about the shortage of housing stock and the prospect of rising house prices. Those comments have since fuelled a flurry of ‘housing bubble’ stories in the media, but typically the underlying problem of supply was glossed over.

For the record, here’s what Stevens had to say on the 28^th July to a Sydney business lunch in support of the Anika Foundation:

“A very real challenge in the near term is the following: how to ensure that the ready availability and low cost of housing finance is translated into more dwellings, not just higher prices. Given the circumstances – the economy moving to a position of less than full employment, with labour shortages lessening and reduced pressure on prices for raw material inputs – this ought to be the time when we can add to the dwelling stock without a major run‑up in prices. If we fail to do that – if all we end up with is higher prices and not many more dwellings – then it will be very disappointing, indeed quite disturbing. Not only would it confirm that there are serious supply-side impediments to producing one of the things that previous generations of Australians have taken for granted, namely affordable shelter, it would also pose elevated risks of problems of over‑leverage and asset price deflation down the track.”

Stevens was by no means first to identify the problems of undersupply. Industry groups and some informed economists have been pointing to the supply problem for some years. Almost two years ago, the ANZ Bank flagged a shortfall of 200,000 homes by 2010, in a warning issued in November 2007 (you can read it here).

The Federal Government’s National Housing Supply Council confirmed the shortage in its ‘State of Supply’ report in 2008, arriving at a ‘crude’ estimate of 85,000 dwellings in the then market of 2008. (The Exec Summary is here).

So the fact that there is a shortage is undisputed and the number is probably somewhere between 100,000 and 200,000 and getting worse. That’s a lot of rooves. But what got Stevens worried was that this shortage, combined with renewed activity in the market as a result of the increased First Home Buyer grant and the prospect of a ready supply of housing finance, would push house prices up without addressing the shortfall.

Evidence

The signs are already there. In Melbourne, a robust market is producing intense competition at auctions. New land releases are so eagerly anticipated that homebuyers are camping out to be first in line. As one agent described it “stock levels were so low buyers were being funneled into what is available and being forced to compete for it'' (full story here). Mortgage lenders have marginally tightened the amounts they will lend to first home buyers while typically leaving deposit ratios and LVRs untouched. (Story here). House prices generally have withstood the onslaught of the GFC, in some areas even rising marginally, leaving the IMF to suggest that Australian house prices remain 20% over valued – a sure sign that supply is insufficient for demand, and that even a global recession isn’t enough to cool people’s fundamental desire for shelter.

But public policy settings – the very things causing the chronic undersupply – remain unchanged. Queensland’s revised ‘South East Queensland Regional Plan’ will only exacerbate the shortage by setting hopelessly unrealistic targets for infill housing and limiting the areas capable of development for detached housing on the fringe. Councils are adding to the problem with unwieldy if not impossible approvals processes and usurious infrastructure levies.

The market reality now is that developers find themselves faced with a chronically undersupplied market – and are basically powerless to do anything about it. The first problem is obvious: a global credit squeeze and the retreat of lenders from the domestic market. Many developers can’t find the credit needed to proceed with projects while others have been hit with massive devaluations such that their existing debt ratios don’t exactly make the prospect of more debt something that would appeal to markets (or lenders).

A pricing floor?

But even if the credit squeeze was eased tomorrow, the raw price of land – a reflection of its scarcity – combined with the extortionate approach to upfront levies, has put a minimum cost on the price of new detached and attached housing. And that cost is currently above what many in the new homebuyer market can afford to pay.

I was quoted a figure this week of a minimum $500,000 per home unit for anything basic in Brisbane, given the land costs, infrastructure levies, planning compliance and build costs (which are higher for high rise developments than detached housing). A $500,000 home unit is roughly eight times average incomes, so the likelihood of finding a rush of buyers in that price range to ease the housing shortage isn’t good. (Assuming there are enough people wanting to live in units to begin with).

Detached house and land packages fare a little better although it would be difficult to bring any new supply onto the market for much under $400,000. Half of that, roughly, is the land cost alone. And that’s if you can find the land to begin with.

Conundrum

This creates the conundrum that has Stevens worried. New supply lead times are such that it would just about be easier to get a new coal mine happening than release a new housing estate. So supply is inelastic in response to the demand.

There is a price floor created by new regulatory weapons in the hands of public policy makers, which means that new supply is also very costly. Probably more costly than many people in the market can afford to pay. That being the case, developers will need to rely on second and third home buyers to make many projects stack up, or for the return of investors, provided rates of return remain attractive relative to alternatives (cash or equities).

So the chances of this nationwide undersupply being brought into balance by the rapid addition of new housing stock are looking pretty remote right now.

That being the case, you would imagine that the pressure of an undersupplied market will invariably find its way into the stock of existing homes. Evidence of that would be in the form of rising established house prices despite a climate of falling employment, or intensive competition for existing stock. Which is what we’re seeing now.

What happens next?

The shortage of housing is chronic but the willingness of public policy makers to do much about the problem is practically non existent. Given we can usually rely on policy makers to do the wrong thing (or nothing) when action is needed (other than perhaps hold an inquiry), the chances of radically changed policy settings freeing up land supply are remote, at best.

Economics 101 tells us that a shortage of supply relative to demand should equate to rising prices. And that’s quite possible in established markets, where competition for stock amongst those with secure incomes and the capacity to pay will translate into increasing prices.

But surely prices generally can’t increase by much – they are constrained by people’s incomes. If house prices rose much further, we would be facing housing costs on average at nine or even ten times average incomes, which on a global scale would make Australian housing the most expensive in the world (if it isn’t already). Incomes are unlikely to rise quickly for average workers and bank lending policies are unlikely to return the heady free for all of recent years. So that in effect puts a ceiling on price growth.

By the same token, prices are unlikely to fall, given the floor under the market created by public policy settings controlling the release of land (hence restricting supply) and the unrealistic approach to infrastructure levies.

The gap between that floor in prices and the ceiling is the space in which developers must operate to provide new supply. And it’s not a wide gap.

All of which means we are probably faced with a waiting game. Incomes need to rise faster than the increasing supply side costs created by policy settings, or those policy settings need to be relaxed so that relativity with incomes is restored.

In the meantime, Stevens has probably nailed what happens next. In his own words: “it will be very disappointing, indeed quite disturbing”.