I have a friend who is mildly wealthy but not gainfully employed. He has been a customer of the same bank for the past 40 years. Like me, he doesn’t own a house. Unlike me, he has been thinking about it.
So he rolled into his local bank branch recently and asked to have a chat with someone about a potential mortgage. The staff member pulls up his details, sees a bit of cash in the account and tells him he’s in the wrong place. “You, my friend, should be talking to our High Net Worth division.”
A couple of quick phone calls later and my friend is heading to a swish HNW setup in Sydney’s Barangaroo towers. Do you need a parking place, sir?. It’s ok thanks mate, I’ll be getting the train.
Apart from a fancy coffee, he didn’t leave with much. The conversation went something like this:
Bank employee: So I hear you are after a mortgage loan?
My friend: Well, maybe.
Bank employee: How much did you earn last year?
My friend: As salary, not much. I don’t have a full time job. But if I bought something I would only be looking for a small loan relative to the value of the house.
Bank employee: But you must have a tax return or something?
My friend: Yes, I’m sure I can find one of those.
He digs around on his laptop for a while and finds last year’s tax return showing total income of roughly $26,000. Here you go Mr HNW manager, $26,000!
Bank employee: But we can’t lend you anything against that?
My friend: Well I’m not expecting you to. I’m only planning on borrowing 20-30% of the value of the house. You will have plenty of security.
Bank employee: I’m really sorry, but that’s not the way things operate. Without income, we can’t lend you money. Ciao for now.
That was the end of the meeting.
Credit the only thing that matters
It is not surprising that income is important. Obviously someone who earns a lot should be able to borrow more than someone who doesn’t. What is surprising (to me at least) is that it is the only thing the banks care about.
Ten years ago, my (naive) understanding was that a potential home buyer’s first step was to find a house they wanted to buy. Let’s say it was worth $1m and they had saved a $200,000 deposit. Then they would go to the bank, the bank works out whether they can afford to repay an $800,000 loan and respond yay or nay.
I had the process completely the wrong way around. The starting place is a bank (or mortgage broker). The bank assesses the customer’s income, decides how much they can lend against that income, then the borrower goes out and buys whatever they can with that amount of credit.
While banks tell their shareholders all about loan to value ratios and how much security they have, they don’t lend against the value of houses. They lend against people’s incomes. And the amount that they lend is the sole determinant of the “value” of Australia’s housing stock.
On a recent call, UBS analyst Jonathan Mott summarised the situation perfectly:
“House prices are not driven by the demand and supply of housing and population growth. Maybe on a 20-year time frame they are. House prices are determined by the demand and supply of credit availability. When you take your hand down at the auction is when you run out of money. And if the banks aren’t lending you as much as they did 12 months ago, well your hand comes down a couple of hundred grand lower”.
If credit is the sole determinant of house prices, what drives the provision of credit?
Income and interest rates
First, incomes. If incomes grow, banks can lend more money. But there hasn’t been much of that for the past decade. So it can’t have been the main factor driving more debt.
Second, most importantly, interest rates. Here is a chart we’ve put together using data from the RBA. It shows Australia’s house prices, measured as a multiple of disposable incomes, plotted against average mortgage costs over the previous four years:
Statistically, you can explain 81% of the change in house price multiples over the past 20 years by changes in the average cost of borrowing. They are almost the only game in town.
Important exogenous lending factors
The final factor is any exogenous impact on the multiple banks are willing to apply to a person’s income at any given interest rate. Interest rates aren’t rising, incomes aren’t falling. But house prices do seem to be going down. And the reason is that these exogenous factors are very prominent at the moment.
Regulatory pressure and a royal commission into the banking sector has curtailed the amount the banks are willing to lend at low interest rates.
No doubt there are many individual outliers but the chart below shows interest costs as a percentage of disposable incomes across the entire country. As you can see, there is nothing here suggesting a problem. Servicing our debt is costing roughly the same percentage of income as it was 20 years ago.
But the regulators (rightly, in my opinion) are worried about banks assuming interest rates will stay lower forever. For several years they have had to stress test a borrower’s capacity to service their mortgage at a 7% interest rate, more than 2% higher than today’s levels.
It’s hard to fudge the 7%. It’s not hard to fudge the income. The royal commission has uncovered countless examples of absurdly low estimates of living expenses artificially inflating the capacity to service a loan at much higher interest rates.
Forcing them to use 7% and actual living expenses is going to seriously curtail the amount someone can borrow.
And just because you can service the interest doesn’t mean you can repay the principal. A newer, more restrictive regulatory restriction is that banks can now only lend up to six times their gross income. That removes living expenses from the equation. And it provides a cap irrespective of how low interest rates go. It will be particularly restrictive for multiple property owners who have been parlaying their equity into more and more properties.
Implications for house prices
It is clear that today’s marginal buyer has less access to credit than they did 12 months ago. That arm at the auction is coming down earlier and you are already seeing it in the official house prices. It explains why Sydney is suffering more than anywhere else. Six times your income won’t buy you much in the harbour city, whereas it still gets you a house in Hobart.
UBS anticipates a 5-15% fall in the short term and I don’t see any reason to argue with it.
For more dramatic falls, though, you would need to see interest rates rise, incomes fall via rising unemployment or a change in the Australian psyche.
While I don’t see any of those as imminent, the days of house prices rising faster than incomes are over. Interest rates are not the binding constraint at the moment, so further cuts won’t make any difference. If six times income is the cap on lending, six times income will be the cap on prices.
That, for much of the country, is going to take a lot of getting used to.
21 thoughts on “Credit Availability IS Australia’s House Prices”
Maths is not my forte, but I don’t see how prices will only fall 5-15% with a 6x income lending cap, when median house prices are currently 13x median income (Sydney) and 10x median income (Melbourne)?
Own deposit of 50% + loan of 50% of the value of the house at 12x median income will explain it.
In practical terms, this will mean that the market will have a higher proportion of upgraders for a while.
Fewer first home buyers and fewer houses bought for investment.
“Own deposit of 50% + loan of 50% of the value of the house at 12x median income will explain it.” If you are relying on upgraders to hold up the market I can tell you – they won’t. Investors and FHB’s striking out due to a lack of access to credit is going to hammer the market.
I agree with KW. A 5 to 15% drop in the market seems like the very optimistic case.
I’m a bit late to the discussion but I’d be interested to know how banks or regulators consider 6 x gross income to be prudent.
A couple earning combined gross $200K can borrow $960K with a 20% deposit.
If rates rose to just 7%, the annual P&I repayment would be around $82K or 54% of the borrowers net income. The repayment to income target used to be around 30%. This recently changed to 40% in order to increase borrowing capacity and bank profits, but I’m not sure how 54% of net income could pass any stress test.
If this is considered more conservative than the rubbery living expenses method, I wouldn’t want to be a bank shareholder or a property holder if or when interest rates do hit 7%.
Yes the size of deposit saved should be a key variable. Especially in this day and age when employment is much less secure, lending a huge amount based on a high income seems reckless without a serious assessment of the sustainability of that income into the long-term future. Loans need to be repaid over 20/30+ years whereas a lot of job tenures these days are much, much shorter. e.g. Telstra just cut 8,000. Unfortunately a client who presents as needing only $200-300k might be far less “interesting” to the bank than one who needs $800k.
“Unfortunately a client who presents as needing only $200-300k might be far less “interesting” to the bank than one who needs $800k.” – From the bank manager’s perspective who is incentivised to focus on the short term and write loans and make money now – Yes – a $200k loan secured against a $1m house with $800k of equity is boring (even though this is probably getting close to being a risk free investment). Yet, loaning 800k on a $1m house to someone who’s job is about to become automated is enticing to the bank!
The incentives are for banks to take enormous risk, and so in turn they support enormous risk by lending to home buyers and property investors that gearing up to their eyeballs.
As we know with the GFC, if it all blows up, bank execs walk away with golden handshakes, and then the troubles are everyone elses problems.
Our next door neighbours have just sold there house for $4.5m. They started the selling process 6 months ago and made a few mistakes but the short of it is they started at $5.5m asking price which was not unreasonable at the time. They were bid $5.2m and turned it down. The market continued to soften and they ended up at $4.5m. Thats a price drop of nearly 20% in less than a year in Randwick. Property markets have lots of different components and sub markets but clearly this one has softened.
It’s actually quite a common problem. A home can become stale very quickly. The longer a property is on the market, the more potential buyers ask, “why hasn’t it sold” and what’s wrong with it?” They then become reluctant to pay the asking price. The way to get around this is to only keep a home on the market for a maximum of six weeks, i.e when you sign your agreement with your real estate agent, make sure it is for a maximum of 42 days, not 90 as many agents will ask for. This guarantees the agent will work harder on your property, otherwise they will lose the listing. If it has not sold within 6 weeks, and the asking price was reasonable, pull it from the market as the listing has gone state. Try again with a new agent in 6 to 12 months with a real estate agent agreement of 42 days.
Excellent article. The other point that is frequently overlooked is the reflexive impact a housing boom has on incomes as well. There have been many Australians feeding at the trough of the housing boom, from mortgage brokers and bankers, to real estate agents and construction workers, not to mention other retail and service industries feeding off the wealth effect. Consequently, in a housing downturn it is reasonable to expect incomes to fall and unemployment to rise.
A perfect storm could be brewing if US & global interest rates start to move sharply higher from here. For the last 30yrs economic policies in the US have favoured capital over labour, pressuring middle class wages. Free trade has shifted jobs overseas, boosting profits but hollowing out manufacturing jobs, while liberal immigration policies have further boosted the labour supply, suppressing wages & also boosting profits through population growth (more customers). Real estate values have also benefitted from population growth and falling interest rates, as a weak middle class has reduced inflationary pressures, and high corporate profits have boosted savings.
We look to potentially be in the early stages of a reversal of all these policies, with Trump favouring job-supportive and middle-class supportive policies that will boost labour at the expense of profits. Massive fiscal stimulus, import substitution & and a booming shale O&G sector could well also contribute to overheating in the US.
Suffice to say that if inflation and much higher interest rates are just around the corner, leveraged housing markets in current account deficit countries like Australia, NZ, and Canada look very vulnerable – particularly if commodity prices, which are economically sensitive, also take a stumble. At the very least the AUD looks set to go much lower.
A married couple earn $150,000 combined. Husband earns $100,000 and the wife earns $50,000. Is the 6X factor 6X $100,000 or 6 x $150,000.
Given the banks’ seeming inability to exercise self restraint & stretch what is regulatorily permissible to the limit, you’d have to assume the latter.
I see this situation a lot. A couple delays having children to save for the deposit. Then if they can still manage to conceive, they have a baby, and then the wife has to dump the baby into childcare only a few months after childbirth before the baby can even walk or speak a word.
All in the name of increasing workforce participation and GDP.
Thanks Steve, you are 110% correct.
We have just done a circuit of 3 banks and their credit requirements are much tougher.
AND there is more paper-work.
Also, as Lyall pointed out sellers expectations remain high.
Maybe we are at a tipping point, and the new taxes on foreigners investing and other restrictions – it looks like a ‘fragile’ market.
The property marked has been kicked up the hill and without more stimulus from somewhere it may roll down.
Unless we win the world cup and then it will go on till the next world cup!
Another very well written and informative article. Thanks Steve
Hi Steve The one important factor you have left out is the Asian money pouring into the country. This is a key driver in Sydney and Melbourne. I cannot see this stopping anytime soon.
This mirrors my experience of the rental market. Three or four years ago I was looking to rent a small dump somewhere. At the time, I had no job or income but enough financial assets to cover the rent for many years. In fact, I had enough to put a large deposit on these places. Yet the real estate agents all look at the same things: occupation, weekly pay, refences. I think many do a rental/credit history check also. But that’s it. No one seems to care about your debt or financial assets.
In desperation, one agent contacted me asking why my income section was blank. I had to explain that you don’t get welfare payments if you have to much money! Yet, it was too hard for this agent, and the rest, to process. Their dumps went to someone else or sat empty.
Thankfully, naivety extends to existing tenant too. As long as the rent is payed and the place is looked after, they don’t care. So, I just stayed renting where I was!
Great article Steve
Also i have heard that a drop in credit growth is the best or most reliable indicator of a recession because GDP growth is what we spend from our income and what we borrow and if credit growth slows or stops we dont grow as fast. There is also the wealth effect house prices go up people borrow and spend more money. Banks also depend on credit growth to grow profits as bad debt provisions are currently very low. I think there is also the fact many myself included have not experienced a recession and so are to optimistic about the future and truly believe this time is different. I am fortunate that i read alot of history and my Dad told me what the late 80s and early 90s were like.
Can’t argue with the analysis but want to make sure I understand your conclusion that the days of housing prices rising faster than income are over. Should I presume you only meant this for the next few years? Presumably in the long run prices of assets, including shares and houses, will likely rise faster than income? Long-term data seem to support that.
As you point out the conditions for a large fall in housing prices are higher rates, falling wages or change in Australian psyche, which are not currently present.
So if prices can go up 80% and fall only 10% (the midpoint of the UBS estimate) based on the performance of Sydney housing in the past few years, the risk/reward of investing in housing should continue to look attractive to most investors.
Is that not the right way to think about it?
The long term return from housing has to equal real income growth + inflation. People pay for housing out of their incomes, so if rent or the cost of owning a house rises faster than incomes forever, you end up with more than 100% of income devoted to putting a roof over your head. The long term return from resi real estate in Australia is about 3% p.a. (over the past 50 years), roughly in line with real income growth. Note that this is the capital appreciation component, not the total return (which would include rent).
The same is true of shares. Real appreciation in the capital stock can’t outpace GDP growth forever, as corporate profits are a subset of the total GDP. The total return we be higher – because we receive dividends every year and consume a portion of them – but the capital appreciation is bound by some natural limitations.
I want to know what Steve regards as mildly wealthy….
Hi Steve a very well written article.I have a query in the current credit crisis for a new investor on 37cents tax bracket annual household income of 130k investing in stocks/managed funds OR real estate is better in the medium to long term 5 to 10 years.I have been bombarded with agents stating property can double in 7 years and i can buy next property in 3-5 years based on equity from 1st property I am a bit confused.I was there at Perth road show and you were showing a return of 8% is achievable in International fund but I need some direction if i go and buy stocks or managed funds or property.please shed some light