Finance Market Update - 5 November 21
Rates are going up. In this fortnights update we talk about why rates are going up, why property prices will correct because of it, and what inflation has to do with it.
20% up and 20% down
In a potential nightmare scenario property prices could drop 20% while the cash needed to service a loan increases by 20%.
While this is unlikely in the short term it is a realistic scenario we might see in the next two years as rates rise which could trigger a massive correction in property prices.
Regular readers will know I predicted record high property prices in 2020 and said we would have record high prices again in 2021, and now I will say we might hit a new peak early next year before a decline.
As soon as the RBA cash rate starts to rise that will mark the end of the boom.
For context since from the peak and correction in 2017 price have risen 30%. If you go back a decade property prices have risen over 70%. So even a 20% fall from new highs next year will still see property prices up on where they have been in the past.
In September this year the aggregate value of all residential property in Australia reached $9 trillion after a surge of $1 trillion in less than a year, according to CoreLogic. If the same growth continued the total value could reach $10 trillion early in 2022.
That growth was underpinned for the most part by record low interest rates.
It is safe to say property prices have been steadily increasing for a long time, but that is not assured going forward. In the short term a common view is that property prices will hit their new peak in the middle of 2022 before a gradual decline.
Over the past few decades, we have effectively had declining interest rates all the way to where they are now, next to zero. And while there is talk in Australia of negative rates and they exist in other parts of the world, the more likely scenario is higher rates.
Higher rates from the RBA and from banks and lenders.
The RBA will increase the cash rate because of inflation, more on that further below, and because of the bond market. Banks and lenders will raise rates because their cost of capital will increase which they want to pass that cost onto borrowers.
And as rates rise property prices will fall.
Because that is what history has proven correct and it is correct because as the cost to buy property goes up via rates which means people can’t afford as much, or importantly borrow as much, to buy for property.
As buying activity slows and is dragged down by lower purchasing power people have via higher rates prices will correct downwards to meet the new market price of where people can afford.
We have talked before about how the more people can borrow the more they will spend, and this is particularly true for property.
If you can borrow more money then at the auction you get a few more waves of the paddle. This is what drives up prices. People’s ability to borrow more money and being willing to spend it.
Right now, people have never had money so cheap or been so willing to spend it.
As rates rise it has a few consequences, one of them is that the amount of debt people can borrow is diminished. The reason your borrowing capacity declines is because the repayments are higher as rates increase, so you can’t afford to repay as much per month so the total loan amount goes down.
We are already seeing this come into effect as this month new servicing rules have been implemented. While not exactly a rate rise, they do in effect have a similar result, lowering peoples borrowing power. This was a tactical move by the banking regulator APRA. Many households in Australia have a high debt-to-income (DTI) ratio between how much they earn as a household to how much debt they have in total. We talked about how the banking regulator APRA would likely target DTI by capping it as one way to reduce risk in home loans.
Another reason prices could drop is that the combined effects of tighter servicing and higher interest rates could force property investors to sell which would further contribute to declining prices, albeit mostly in the apartment market.
As a rate rise and repayment example, for a $1M dollar home loan with a 30-year term at a P&I variable rate of 2.5% the monthly repayments are $3,951. If that rate increases to 4% the repayments are $4,774 per month.
The difference in repayments between 2.5% and 4% per month is $823, as a percent that’s 20% rise in (after tax) cash you need per month for repayments, and per year that is $9,876.
That is a pretty big difference in cash needed for the same loan.
20% and nine grand is a considerable increase in required discretionary cash flow needed to manage the repayments and is a prime example of how much peoples borrowing power will reduce as rates increase.
This potential 20% increase in needed cash for repayments could be too much for many property owners who overpaid for a house whose value could also decline by 10% to 20%.
A fall in property prices by 20% and a rise of 20% cash required for repayments could be disastrous for many property owners who overextended themselves on the purchase and do not have sufficient cash buffer for increased repayments.
If you think seeing the average rate at 4% is crazy it might help to remember that the average variable mortgage rate over the past decade has been about that. We would only need to see the cash rate get to 0.75 or 1% to see bank rates near 4% so it is not a wildly outrageous scenario.
However, let me be clear that I do not see the average rate getting to 4% for another couple of years but and is a medium term situation, so in the short term I remain bullish on property price growth.
In the example above while a 20% increase in mortgage costs is quite extreme it is a situation that could unfold over the next two or three years, and even if we only see a rise half that of 10%, for many people that is still going to hurt.
This might all sound very pessimistic but I remain valiantly optimistic that we will see an economic boom in 2022 and you can read my reasons for that here. Property prices are not the entire economy but they do matter.
The truth is many people have already overextended themselves and will be vulnerable to even minor rises in interest rates.
If you are concerned about rising rates and costs Let’s Talk about what finance options you have.
Inflation is not going away, it is not transitory, it is not just because of shipping, it is not going to be minor, but it will be a slow burn.
You might have seen on the news, maybe even benefited from it yourself or at least had to pay it, higher wages. In many cases 10% to 20% or more is the going rate for the same person to do the same job compared to a year or so ago.
This is an example of inflation, especially for business, employees are often the biggest expense and wage pressures moving upward is not going to abate.
The RBA should be happy with this.
One of their core goals through low interest rates was to boost wages and employment.
So now as wages rise they are slowly but surely meeting that objective. And guess what, as they think it is meeting their objective they are more likely to raise rates, see above.
Wages are rising off a low growth base as they have been basically flat for years, so it is good that people are starting to earn more.
As people earn more the thinking from the RBA is that they will spend more. As spending increases so does economic activity.
Avid readers will know I like to say that buying activity leads to higher prices, and while especially true for property, is a basic fundamental of almost any economic marketplace.
More people want that thing, the seller increases the price until the maximum a buyer is willing to pay is achieved.
This is supply and demand economics.
The issue is that almost everything is going up in price. Fuel, energy, property, food, electronics, so even as people’s wages increase it might not be enough to cope with the rapid increasing in prices.
Some economists will say the price increases are going to go away, that they are ‘transitory’ and not ‘core’ to the economy. I disagree.
As the economy turns hot the RBA will attempt to cool it down by raising the cash rate. That raise will have a knock-on effect like reducing property prices and slowing economic activity.
There is every reason to believe prices are going to remain at heightened levels and continue upward from here.