Real Estate Price Information and AffordabilityThe standard measures of housing affordability essentially try to measure housing loan repayments relative to household income. There are various measures in existence. One measures the proportion of average household disposable income needed to cover repayments on a median-priced house (assuming a 20 per cent deposit and a 25-year loan). The broad picture is that this ratio is now much higher than it was in the mid 1990s, and only a little below what it was in the late 1980s. There are three factors that drive changes in this measure: real estate prices; household incomes; and interest rates. the chart below shows how these factors have changed in recent years. In the mid 1990s, real estate prices were around 3 times average annual income; by the end of the housing boom in late 2003, this ratio had risen to about 6. It then declined for a couple of years, as real estate prices stabilised while incomes grew, but more recently real estate prices have been rising at least as fast as incomes. Mortgage interest rates have shown a couple of cycles over the period, rising in the late 1990s and again in recent years, but these cycles have taken place around a flat trend. Mortgage interest rates today are much the same as they were around 1996-1997. We are therefore left with the conclusion that the decline in measures of housing affordability since the mid 1990s is almost entirely due to the rise in real estate prices relative to incomes. Real estate price information and real estate price historyIt often seems that you can't pick up a paper without reading about the latest real estate price survey and wild predictions of either boom or doom. But let's step back and look at the long-term picture to get some perspective. Real estate prices have increased by an average of around 9% a year since it started monitoring them in 1973. By way of comparison, the average rate of inflation over that time period has been about 7% a year. Since then, it shows real estate prices have increased by around 8% a year as opposed to inflation of 4.5%. It's important to take such figures with a major pinch of salt if you want to use them to assess what sort of returns you can expect from housing. For example, real estate price indices only include houses that have been sold in the period concerned, which will represent only a small fraction of the nation's total housing stock. To complicate matters further, individual surveys measure their data in different ways which is why it's common for different surveys to come up with different price movements each month. And if you drill down into regional or local data, the small sample sizes can make the figures even more unreliable when comparing movements from one period to the next. In practice, we reckon even monthly movements on a national level are fairly inconsequential. Indeed, quarterly movements are also relatively unimportant. The housing market does not tend to shift direction overnight. In addition, if you concentrate purely on real estate prices, you're ignoring two other key components that affect the overall return you can generate from a property. Firstly, any rental income you could receive is ignored. By occupying your own home, you are saving yourself the rent you would have to pay if you lived elsewhere. Secondly, real estate price indices do not reflect the cost of maintaining and running a property. These two components do offset each other to some extent so it's fair to say that real estate price indices give a rough approximation of overall returns. Both the main real estate price indices show the same story and that is that real estate prices have beaten inflation by a small amount over the long term. So there is a reasonable case for saying that housing is a decent investment, even if the actual returns tend to be less than most people think. Housing returns are a lot steadier than those from the stock market however, which is one of the reasons property appeals to so many as an investment. Despite this, over short time periods real estate prices have fallen in the past, although it is rare for them to do so. Where next for real estate prices?Unfortunately it's impossible to say what will happen to real estate prices in the future with any degree of accuracy. However, one reasonable indicator in the past has been affordability in relation to average salaries. The most widely used yardstick is that housing is fairly valued if average real estate prices are three times average salaries. At the moment this ratio is around six times, indicating that housing is very expensive. This has led some people to predict real estate prices may be due for a fall. Interest rates are low at the moment though and this means people can get a bigger mortgage than they could several years ago but for the same monthly payment. So other commentators, who believe housing is not overvalued, argue that the proportion of our earnings spent on mortgages is still comparable with historic levels, being in the region of 30%. However, an important flip side of this argument is that inflation doesn't make the monthly amount you pay increasingly more affordable as the years go by. People who bought their properties in the 1970s and 1980s saw their monthly payments reduce significantly in real terms as they got near the end of their mortgage term. So what can we conclude from all this? Given that real estate prices are high when compared to many traditional measures, the likelihood of large gains in the near future would seem to be remote. Likewise, with a relatively healthy economy, a sustained period of falls also looks pretty unlikely. We think it's best to see your home as a place to live in first and foremost and secondly as a long-term investment. Prices can fall in the short term so when real estate prices appear high on some measures, as they do at the moment, it's especially important not to overstretch yourself and to make sure there is some slack in your budget to cope with the unexpected. |