What’s going to happen to housing affordability over the next few years?

There is always talk in the media about housing affordability and how a whole generation of Australians will no longer be able to realise the great Australian dream of owning their own home.

But now that we’ve moved into the next phase of the property cycle, one where house prices are falling in many locations around Australia what’s going to happen to housing affordability?

Recently QBE released its Australian Property Market Outlook — 2018–2021 and they looked at his question, and the results may not be what you expected.

Affordability in the Sydney and Melbourne property markets may not improve much at all

Here’s what the report suggested:

Housing affordability

While demand and supply are an important influence on prices and rents, there is an upper limit on how much of a household’s income can be spent on mortgage repayments.

As it becomes more difficult to service a mortgage, further property price growth becomes less possible unless incomes rise, spending habits change or interest rates reduce sufficiently to make purchasing more affordable.

In Sydney and Melbourne, the level of affordability (as measured by the ratio of mortgage repayments to average household disposable, or after tax, income) reached its worst point in 2016/17 at a similar level to 2008, when variable interest rates were much higher at 9.6%.

At this level any increase in mortgage repayments (i.e. higher interest rates, or conversion from interest only loans to principal and interest) is likely to leave some households in distress.

With prices declining in 2017/18, affordability levels have improved, but remain elevated.

Affordability outside of Sydney and Melbourne is much better.

Canberra has seen affordability levels deteriorate to a degree after witnessing strong price growth.

Brisbane, Adelaide and Hobart affordability levels have only deteriorated slightly in recent years, while large price reductions in Perth and Darwin have made purchasing a dwelling much more affordable and affordability is at levels last seen in the early 2000s.

Outlook

Affordability over the next three years is likely to be most influenced by price movements.

In Sydney and Melbourne, without major price declines or significant growth in income, affordability will not improve significantly and these markets will remain vulnerable to rises in interest rates, as the most recent purchasers may have stretched themselves to buy their dwelling.

The situation in the other capital cities, which currently have affordability ratios under 23% in 2017/18 (compared to 34–36% in Sydney and Melbourne) are expected to remain around current levels over the next three years.

The exception is Brisbane, where stronger forecast price growth by 2019/20 and 2020/21 will likely lead to deteriorating affordability levels, although affordability will remain attractive relative to previous periods in the mid-late 2000’s.

Interest rates

Housing interest rates are set with reference to the ‘overnight cash rate’ which is set by the RBA.

The cash rate has remained unchanged at 1.5% since August 2016 (the lowest on record), having been cut from a high of 4.75% in 2011.

The reduction in the cash rate has reflected the modest outlook for employment and income growth, and in turn the outlook for inflation.

The margin between the cash rate and the standard variable lending rate set by the banks has widened as the cost of funding for banks has increased since the Global Financial Crisis, and rises in funding costs in 2018 have seen banks raise the standard variable rate by a further 15 basis points.

Banks also differentiate between customers by offering a discounted variable rate for borrowers with lower risk.

The indicative standard variable rate used by the banks for owner occupier residential loans is now around 5.35%, although many banks offer discounted rates more than 100 basis points below the standard variable rate to approved borrowers.

Regulatory influences

In recent years, APRA sought to contain rising speculative investor demand and provide more stability to the financial system.

APRA did this by progressively increasing oversight, mandating the strengthening of bank balance sheets and tightening lending guidelines, with a focus on containing growth in investment lending.

In April 2017, APRA mandated that banks limit interest-only lending (which is favoured by investors) to 30% of new residential loans.

The result has been an increased differentiation in lending by the banks between owner occupiers and investors.

Investors pay an interest rate premium of about 60 basis points over the equivalent owner occupier principal and interest rate, while for investors with interest only loans, the premium is around 100 basis points.

Maximum loan-to-value ratios offered to investors are also lower than they were prior to the regulatory intervention.

The consequent reduction in investor demand has resulted in increased competition for more secure owner occupier borrowers.

Outlook

While employment growth nationally was strong in 2017, some slack remains in the labour market, and wage and inflationary pressures should remain benign for the next couple of years.

The cash rate is forecast to remain at 1.5% through to the end of 2019, with the RBA forecast to tighten interest rates in early 2020 with a 25 basis point increase in the cash rate, and a further 25 basis point rise in 2020/21.

Concerns are likely to emerge about inflationary pressures building up as the economy begins to pick up as investment strengthens, unemployment falls and the potential for stronger wages growth increases.

Equivalent increases are expected in other lending rates.

While not contained in the forecast, further rises to wholesale funding costs by lenders could result in additional out-of-cycle rises to borrowing rates independent of increases in the cash rate by the RBA.

Originally published at propertyupdate.com.au on November 13, 2018.