Welcome to Finance and Fury. In this episode we look at the most important factor that moves property prices. In other words, what one thing affects property prices more than anything both positively or negatively.

This doesn’t mean that it is the only thing that affects property prices – as price movements at large are influenced by every factor of supply and demand working in tandem

  1. On the demand side – you can have things like population growth, increasing wages, proximity to the CBD, desirability of the suburb due to access to shops, schools, transport, parks and the like
  2. On the supply side – you can have the number of released developments – including units and houses as well as land availability and releases –
  3. But out of all of these factors I believe that one stands above all – and that is credit growth – with all else being equal – credit growth has had the largest impact on prices over the past 30 years – so in this episode we will look at this in further detail
    1. Again – many things affect prices for property – the term all else being equal means exactly that – in other words, if you keep every supply and demand factor the same and change just one metric – how are prices affected
      1. As an example – if the population grows and the supply doesn’t increase, wages stay the same, etc. – then prices are expected to increase – if employment and wages shrink, and everything else stays the same, then prices are expected to decline
    2. Comparing all other factors – these have natural limits and often don’t see large changes in either direction
      1. There is only so much population can grow by, be it immigration or natural replacement rates – there is a limit on wage growth – even supply is limited and slow as it takes many many months for property to go from the planning to completed stage –
      2. This is where credit growth is one thing that can be increased or decreased rapidly above all of these other factors
      3. This is why I think it is the one that has the greatest influence on prices both in the short and long term

To explain this – First – lets look at why credit growth matters – well – because credit growth translates into increased borrowings by households – which leads directly into property price growth

  1. Now there are a few conditions for this to be true – firstly as an individual, or couple, you have access to borrow credit from a bank in the form of a home loan – the more you can borrow then the more prices can increase by, secondly – it requires that property be in a competitive market – in other words you are competing with others over a property
    1. Lets break this down – lets say that the average asking price of a property is $400,000 and there are 10 couples competing for this property
      1. This asking price will be potentially limited by the state of the market and peoples borrowing capacities – lets start with the assumption that we each have a 20% deposit for $80k – and we are going to fund the rest by borrowing – if we are each limited by how much we can borrow – say the remaining $320k because we cannot borrow any more money – and we have no other savings – then it will be a tight bidding process – each individual might be able to scrape together a few more thousand from family or friends to pay them back over time – then the bidding will be very tight and the property likely sells close to the $400k mark
      2. Now – let’s say that all of a sudden each of our borrowing capacitates increases by $50k – well, now starts more of a bidding war on who wants the property more – the property may well sell for $450k now based around the competition – and this has set a new precedence – pushing the price of this one property up
  • But over time – this same dynamic plays out across thousands of properties – if borrowing capacitates continue to increase – the property prices will continue to rise due to people being able to bid increased amounts for properties
  1. This is because over time – the neighbours in the suburb see this increase – so the new listing prices for properties are set at an increase margin – therefore, property prices rise –
    1. Say the next round of 10 buyers are competing at an initial price of $500k – again, assuming that each bidder has a 20% deposit, of $100k, a $400k loan would be required. But if everyone has a borrowing capacity of $500k – then the bidding war commences and prices for this property can climb to anywhere to $600k
    2. This isn’t a perfect example, as each individual has their cut off points on where the pass in – but there will be one person left standing at the limits of where they can borrow
  2. Due to property being an illiquid asset – this process takes months if not years to materialise – property prices are a slow-moving beast compared to other highly liquid assets like share, or especially cryptoassets
  1. In regards to credit growth – There are two underlying conditions which either increase or decrease the amount people can borrow – this comes from both fiscal and monetary policy in the form of APRA and the RBA – these two entities have the greatest control the housing markets due to having direct control over how much people can borrow –
    1. APRA regulates the banks directly on their lending practices and then the RBA controls the cost of money – at which now banks assess the individual borrower based around a margin above the interbank cash rate – meaning that the lower the rate is, the more people can borrow
    2. Between interest rate movements and lending requirements – these have the greatest impact on borrowing capacity and therefore demand from private individuals and investors on the property market – all of whom are competing for properties – helping to bid prices up

To help to prove this point – it helps to look at the history of property prices around changes both in the regulatory framework and interest rate changes – data from the St Louis Fed which provides an index tracking prices of property in Australia back to the 1970s

  1. From 1970 to 1980 – increase in prices was annualised at around 2% p.a. with a total increase of 21.5% over this decade
  2. Prices in 1988 were actually back to same index level as 1974 – where over a 14-year period there was an annualised growth in property prices of 0% over 14 years
    1. 1988 to 1989 was a boom year – prices rose but then stagnated again –
    2. So from 1970 to 1990 – the average price growth of property was still sitting at 2% p.a.
  3. Looking at this period of time – the flood gates were opened when it comes to banks ability to lend in 1988 in Australia with the removal of the fractional reserve banking system
    1. Look up “Why do banks seem to have the ability to lend never ending amounts of money?” – episode I did back in September of 2020 if you want to learn more about this – but in essence it unleashed the borrowing capacity a bank could do purely based around interest rates and legislation –
    2. Previously banks were limited based around how much you as a depositor were saving in a bank – as they could only lend 10 times your savings – so if peoples savings weren’t growing, then banks couldn’t lend more – now that they could issue capital through additional shares or hybrid notes – there was no limits to how much could be lend beyond the interest rates and APRA’s additional regulation – as after all, it was APRA that introduced the Capital Adequacy Requirements for banks under Basel 1 back in 1988
  4. Naturally you would think that from 1988 onwards property prices would boom – but they didn’t – But it was actually from the mid-1990s that property prices started popping off – this is because property prices declines for the first 5 to 6 years during this time period – so whilst banking regulations allowed additional credit growth, interest rates rose heavily – so the high interest rates were high limiting how much people could borrow – even though banks had the ability to lend – there was no demand due to the costs
  5. Interest rates rose heavily in the late 80s to early 90s – but from the mid 90s – rates started to fall heavily helping to boost borrowing capacities – and with it property prices
    1. From 1995 to 2005 – prices rose 75% over this 10-year period – or at an annualised rate of close to 6% – this was something that was unprecedented in Australia’s property history – prices increasing by such a massive amount in a 10 year window – but things would only continue to compound at a greater rate in line with APRA and interest rates
    2. Let’s look at the past 22 years of history from 2000 onwards – prices rose 160% over this period – or at an annualised rate of close to 10% per annum – this was a massive compounding boom in property prices – this has far outpaced any levels of inflation, population growth or wage growth
      1. In inflation adjusted dollars, house prices are at all-time highs – back in 1970, an average house in Sydney cost around 20% of what an average house costs today in inflation adjusted dollars – so in other words, the average sale price of Sydney house today is $1.1m – this would buy you roughly 5.2 houses back in 1970 in inflation adjusted dollars – this trend is similar in many of the major capital cities
      2. Looking at average annual income as a proportion of average house prices in 1970, this was sitting at 4.5 times average pre-tax income – so the individual’s average income was 4.5 times the price – now it is over 13 – an increase of around 3 times
    3. This is where population growth doesn’t seem to account for the increase as the sole explanation – surely it has had some effect – but for example, Sydney’s population has grown by 70% in the last 50 years and its average house price has increased by 520% after accounting for inflation – whereas Perth has seen a population growth of roughly 300%, but its house prices have only increased by 260% – this is again where Perth has additional supply capacity compared to Sydney which was already more developed –
    4. Wage growth has also been fairly consistent over this time period – so what has led to the boom-bust cycles in price growth over the past 30 years?
      1. Timing does correlate to interest rate changes and bank regulation changes – correlation is not causation – but the timing of each of the movements coincides to increases in borrowing capacities and property price movements
      2. From 1970 to 1980 – interest rates rose from 7.25% to 9.13% – this would explain the close to zero growth over this decade – people couldn’t borrow as much as growth was limited to population and wage growth versus supply – hence these two growing factors were negated by the increased cost to borrow
  • By 1997 – interest rates were the same as they were in 1970 – but this is where after this point – we start to see the downtrend in interest rates as well as the changes to APRA regulations due to Basel 1, 2 and 3

Property doesn’t always go up – Over the past 22-year property price boom since the 2000s where prices have increased 160% at an annualised rate of 10% p.a.  – there were 5 times that prices dropped – in 2008, between 2010 and 2011, in 2015, from 2017 to 2019 and then a small decline in 2020 – what happened during these dates?

  1. Why are each of these dates significant – Looking at the declines in the market – we can look at the total loan levels, interest rates and changes to lending standard that APRA has set forward that banks need to follow
    1. 2010 – in 2009 the cash rates were at 3%, after being 7.25% in 2008 – then in November in 2009 rates were increased to 3.5% and reached 4.75% by November 2010 – an increase of 1.25% over a 12-month period –
      1. This created a drop in new home loans from about $12.5bn down to $9bn – Credit growth slowed massively – to almost 0% and stayed below 5% until 2012
      2. What happened to prices? Well they dropped by almost 10%
    2. Around 2015 – plans were introduced by APRA that were implemented in full by 2017 – This was the next decline in property markets – wasn’t due to interest rates, as these were declining the whole way – but what did occur is APRA tightened up lending standards – particularly on investors
      1. Interest rates on investor only rates went up by over 0.75% – and investor PI rates went up 0.5% – reducing servicing costs – Started to reduce credit growth for investors
      2. From 2017 to 2019 saw massive slowing in credit growth – where it averaged at around 5% p.a. – there was actually a drop in new home loans from almost $15bn down to $12bn – this was due to changes in serviceability assessments by APRA that they placed on ADIs to ensure that a borrower retains a reasonable income buffer above expenses – essentially there was a changed assessment methodology reducing credit growth
  • What happened to prices – they went down – 2017 to 2019 prices declined by around 11%
  1. On the other hand – The recent boom we have seen in the past 18 months saw an increase in the new loan applications from $12.5bn to $23bn – a massive boost of around 84% – why?
    1. Was it population growth? No – there was no immigration – was it wage growth? No, there was subpar wage growth in many areas – was it due to record low cash rates? Allowing a huge increase in borrowing capacities?
    2. I would day that interest rates were one of the major reasons – there were also incentives given by the government to build – but regardless of why people borrowed more, they did – translating into more demand capacity coming from credit growth
  2. However – where we stand is we are back to 0% credit growth – so lending is starting to slow – again, why? Because due to the borrowing capacitates and peoples affordability declining with increasing interest rates

In summary –

  1. APRA had introduced banks capacities to lend whatever people could afford back in 1988 – then all that mattered was what people were allowed to and could afford to borrow –
  2. Over time, in periods in which lending regulations either allowed for people to borrow more or less – property prices soon reflected these movements
  3. This is why I believe that credit growth in the form of mortgage borrowings is what has had the biggest influence on property prices
    1. When people compete for something like property and they are allowed to borrow more to fuel competition, prices will inevitably increase
    2. This doesn’t mean that other factors are important as many things impact property prices – but population size can stay the same, wage growth can be frozen – and as long as borrowings increase, prices will too

https://fred.stlouisfed.org/series/QAUR628BIS

https://www.orangefinance.net.au/historical-interest-rates/

https://www.apra.gov.au/sites/default/files/141209-Letter-to-ADIs-reinforcing-sound-residential-mortgage-lending-practices.pdf

Credit growth – https://www.ceicdata.com/en/indicator/australia/domestic-credit-growth#:~:text=in%20Mar%202022%3F-,Australia%20Domestic%20Credit%20increased%208.7%20%25%20YoY%20in%20Mar%202022%2C%20compared,table%20below%20for%20more%20data.

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