Housing bubble combined with low rates could be a toxic combination

What happens when you combine what is now confirmed to be a housing price bubble with record low interest rates that can only realistically go up from here?

Over time we are going to find out with respected economic modelling from The Housing Fever website showing huge chunks of the Australian property market are in a bubble that can no longer be supported by fundamental factors such as rents, interest rates, income and housing supply.

Instead, prices are being driven higher by fear of missing out and low supply which is leading to panic buying and speculation.

Big capitals lead the way

The main bubble areas that have left fundamentals behind – according to the modelling – are in Sydney, Melbourne, Brisbane, Adelaide and Canberra.

According to Macquarie Business School professor of economics Shuping Shi, even when you take account of low interest rates and low housing supply, that still doesn’t explain the rate of increase in these cities.

The really difficult thing to know in advance is how even a significant market bubble will end – with a gentle deflation over time or a burst that causes property prices to fall hard and fast.

Professor Shi said she does not expect property prices to fall substantially, although they might level off or fall slightly in the future.

Records still being set but rises are slowing

Some local statistics show how dramatic the rises have been, with Core Logic numbers showing several capitals at new record highs, although the pace of rises is beginning to slow.

Dwelling values are now up 13.5% over the past year, after having jumped another 1.9% in June to a median of $645,454, according to the Core Logic Home Value Index.

That is the strongest annual growth since April 2004, with houses recording more than double the growth of units – possibly as a reaction to the COVID-19 pandemic.

That included growth above 20% for Darwin, Canberra, regional New South Wales and Tasmania with Sydney (19.3%) and Hobart (19.2%) not far behind.

Household debt is huge but less costly to service

So how are people able to afford such high prices, especially when household debt is already uncomfortably high?

The answer is record low interest rates, which are making even the elevated levels of mortgage debt being racked up quite affordable.

Reserve Bank of Australia household finances data for the March quarter of 2021 show the ratio of household debt interest payments to income fell to 5.8% in March 2021, less than half the peak of 13.3% that was reached in December 2008.

Looking just at mortgage debt, the ratio of mortgage payments to income fell to 4.9% in March 2021, less than half the peak of 10.6% in December 2008.

Some figures from the Bank for International Settlements reinforce that trend, with principal and interest debt repayments as a share of household disposable income fell to a 17-year low of 13.6% in the December quarter of 2020, 4% lower than the June 2008 peak of 17.6%.

What these figures show is that even as the pile of mortgage and household debt climbs higher, it is still becoming more affordable – although that effect will wane as the rash of refinancing at lower rates starts to slow.

What happens when interest rates move higher?

The big question is what will happen when interest rates turn – will that cool property prices as debt repayments gradually soak up a greater proportion of household income or will the assumption that property prices will keep rising faster keep the bubble inflating?

It is a difficult question to answer and probably not one that will be definitively answered until afterwards but based on previous Australian property booms, eventually interest rate rises will take heat out of the market.

Picking the speed of that transition in advance is difficult but in general, the Australian property market tends to adjust to changes by trading sideways for a period of time while fundamentals catch up with boomtime prices rather than falling rapidly.