The influence of mortgage rates on property prices.
The web of high inflation, cash rate, and mortgage rates.
Inflation measures the rate of change in prices of goods and services that a typical household buys. Annual inflation is currently at 7.8%, well outside the RBA’s (Reserve Bank of Australia) 2-3% preference band. Therefore, consumers have been facing the fastest deterioration in purchasing power since the early 1990s. High inflation levels can cause various socio-economic problems that disproportionately impact lower-income households, including a reduction in the quality of life.
Governments rely on various monetary or fiscal policy tools to address inflation, depending on the underlying cause. The RBA believes that excess demand is the driver, partly because unemployment is very low, at 3.7% in January 2023 (seasonally adjusted). This is because when people have excess financial resources (proxied by very low levels of unemployment or under utilization rates or, at times, high wage growth), demand for goods and services outstrips supply and pushes prices upwards.
A straightforward solution for demand-led inflation.
Monetary policy has a straightforward solution for demand-led inflation: tighten the cash flow in the economy, forcing demand to fall. This is typically achieved through cash rate rises – which are passed on by banks to consumers through a mortgage or interest rate increases, which deter borrowing-led spending (individuals will spend less on credit cards). Higher interest rates also increase debt servicing costs for mortgage holders, meaning households have to tighten everyday budgets to bear larger mortgage repayments. The resulting reduced spending power dissipates demand-induced inflationary pressures. March 2023 marked the 10th consecutive increase in the cash rate by RBA to 3.60%, the highest in just over a decade.
How do mortgage rates affect the property market?
If mortgage rates rise, it becomes more costly to gain entry into or retain property ownership, which has the inadvertent effect of slowing down housing demand. Higher mortgage rates also have a negative impact on borrowing capacity. Anything restricting the amount or number of prospective buyers can influence price cycles and reduce property prices. Like most economic concepts, this explanation assumes that all other things remain constant. However, when buying a house, the buyer will not look at the mortgage cost in isolation; they will compare it to, among other things, long-term capital gains (rising house prices represent financial security and independence) or their current rent costs.
Rents represent an opportunity cost for potential home buyers and have been growing in Australia at alarming rates. If home loan repayments are on par with rental costs, borrowers can own a home at the end of the mortgage term without making major financial sacrifices. Even if the mortgage repayment is higher than rent, the increased cost of living is offset by rising house prices or the appeal of becoming a homeowner (a prospect that becomes increasingly appealing as you get closer to retirement and living on a fixed income). Similarly, investors compare mortgage costs to what they can earn in rent or from future capital gains – not mortgage repayments this month versus last month – which is why the higher the expected rental income or capital gains, the greater the demand (price) for housing.
Therefore, it seems unlikely that mortgage rate increases alone could tank the property market. However, the recent decline in property prices is being attributed to the rapid rate increases
What is the relationship between house prices and mortgage rates?
We analysed 30 years of data to explain the long-term relationship between house prices and mortgage rates. This helps us to understand whether there is any lagged impact of mortgage rates on house prices and purchasing decisions. We also conducted the same analysis to explain the relationship between population and house prices.
On average, a 1% percentage point increase in mortgage rates will result in a fall in Australian house prices by 1.34%. This effect is significantly more visible in higher-value property markets, such as NSW and QLD. As property tends to be more expensive in capital cities, the effect of mortgage rate increases has been felt more acutely in capital cities than in regional areas. Furthermore, we find that changes in population are more impactful to property market movements than mortgage rates.
Our analysis shows that house prices react to changes in mortgage rates within the same quarter, whereas population has a cumulative longer-term effect.
The largest decline in house prices because of increasing mortgage rates was seen in Brisbane and Sydney, where a 1 percentage point increase in mortgage rates resulted in house prices dropping by 2.45% and 1.96%, respectively. The effect is likely greater in both cities because the Sydney and Brisbane property markets are relatively higher-value, meaning that a small change in the mortgage rates results in large changes to repayments and, therefore, affordability.
Melbourne was the anomaly. Despite being a high-value housing market, the effect of changing mortgage rates was almost half that of Sydney. The underlying cause may be because Melbourne has experienced the most rapid population growth rate historically and is set to become Australia’s largest city (population-wise) by 2031-32.
The rapid population growth has continued to drive an increase in housing demand despite increases in mortgage rates. Even with the negative demographic shifts during the pandemic, Melbourne has made a quick population recovery.
The future risks of higher mortgage rates aren’t even
Home owners who bought when prices were at an all-time high will be more vulnerable to falling property prices and rising mortgage rates, as the peak house value will be locked into their mortgage for the next 30 or so years. Peak house prices will also result in larger mortgages with greater monthly repayments, meaning a larger portion of household income will be dedicated to making repayments. With the onset of the fixed rates cliff, we could see an increase in mortgage stress and a subsequent lift in distressed sellers. To date, distressed listings remain negligible and have fallen in recent months on Domain.
Furthermore, borrowers who were approved for home loans with the serviceability buffer and cash rates at 2.5% and 0.1%, respectively, may not be equipped to handle an increase in the cash rate by more than 3 percentage points. While the serviceability buffer will have prevented high default levels so far, it could merely be a delay. This situation is particularly exacerbated because average wages are increasing by around 4% (which barely offsets the rate rises). (5) In real terms, households who have borrowed at the peak of the market have seen their property values fall by as much as 6.1% across the combined capital cities (this is steeper in Sydney, down by 11.3%) and have suffered a fall in real income by at least 7%.
There is also evidence to suggest that high-wealth households are less affected by rate increases as they are buffered by a higher disposable income and are better able to meet higher mortgage repayments.
Furthermore, our analysis is based on past data, while we can reasonably assume that future house price fluctuations because of mortgage rate changes will be similar to our estimates above, the effects may vary, as there are other factors exerting stress on housing supply and demand:
Australian Prudential Regulation Authority (APRA) increased the serviceability buffer to 3%, meaning that the effective cash rate (for approval purposes) for potential borrowers is now closer to 7%, this change will reduce the property buying power of households and will see lower mortgage amounts being approved.
The increased cost of living (CPI) will mean that households will need longer periods of time to save up for the initial deposit, potentially delaying housing demand.
Supply chain delays have already slowed down housing supply, creating a backlog of new home completions and therefore pushing buyers to existing dwellings. It is unclear how this will affect house prices in the long run, it will, however, slow down new housing supply.
If there is no cost of living reprieve, the worsening household cash positions may lead to higher default levels, negatively impacting the housing market.
Housing is a long game
What does this mean for a home owner or buyer? Mortgage rates should play a role in determining the home loan amount you are willing to borrow, especially concerning serviceability buffers. However, mortgage rates are not as important for house prices in the long term. Multiple factors influence house-price fluctuations ranging from housing supply determinants, population and migration patterns, income growth, tax regimes and banking regulation to lifestyle preferences.
To estimate the causal relationship between house prices and mortgage rates, we use an ARDL (Auto Regressive Distributed Lag) model controlling for various other factors, including, among other things, population, income, housing finance levels, and structural breaks for economic shocks. Our data is sourced from ABS and Domain’s internal metrics. The econometric specification estimates the long-run causal relationship between mortgage rates and house prices. The analysis aims to explain the long-term relationship between two variables (30 years in this case), e.g. do the mortgage rates from 3 months ago affect my decision to buy today?
(1) RBA, The Financial Stability Review, https://www.rba.gov.au/publications/fsr/2022/oct/box-b-the-impact-of-rising-interest-rates-and-inflation-on-indebted-households-cash-flows.html
(2) Although there is a strong positive correlation between house prices and rents, the causality is unclear. It could either be that property prices are rising so home owners raise rents to recoup, or that prices are rising because rents are rising and the increased rental income makes owning multiple homes more feasible as the rent meets the mortgage obligation or that the higher rents promise better returns than other investment alternatives in the economy, resulting in a reallocation of investment resources.
(3) The ACT, NT, SA, and TAS were excluded from the analysis either because the data did not go as far back for that state meaning that the time series was not expansive enough to draw reliable conclusions, or because the results were statistically insignificant for the state or territory.
(4) Melbourne set to overtake Sydney as Australia’s largest city by 2031, The Age, Jan 2023, https://www.theage.com.au/national/victoria/melbourne-to-overtake-sydney-as-australias-largest-city-by-2031-20230104-p5cab6.html
(5) ABS, Wage Price Index, Australia; https://www.abs.gov.au/statistics/economy/price-indexes-and-inflation/wage-price-index-australia/latest-release
(6) Wage price index – (Consumer Price Index + rate rises)
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Domain editorial March 23