Research from the Reserve Bank of Australia (RBA) indicates that Australian house prices are 30% undervalued according to the Sydney Morning Herald.
That seems a bit of a stretch. Many financial commentators argue that Australia’s housing market is overpriced so badly that it constitutes a ‘bubble’ and the RBA Governor Glenn Stevens himself has expressed concerns that house prices have risen too far.
It’s also quite a departure from the same research from the Reserve Bank in April last year that indicated house prices were about fairly valued. With housing prices having actually risen 10% between then and now, housing “values” must have risen by 57% (or around $2 trillion) across the country to create the undervaluation. That’s quite a movement. So where has all the extra value come from?
Poking through last year’s research publication (no sign of this year’s on the RBA website yet) the researchers have compiled all the costs of owning a house, including the cost of atually funding it. They then offset the expected capital gains on the house, and compare the result with the cost of renting the same place. Their rationale is that if the cost of owning after capital gains is less than the cost of renting, then housing is undervalued.
I’ll address the assumption that past capital gains equal future capital gains in another blog post, but the assumed interest rate numbers alone make me squeamish. The real cost of funding (after inflation) was assumed to be 3.3% in last year’s research. That 3.3% is supposed to be a blend of the cost of bank debt and the higher return required by investors for their equity in the house.
It looks way too low. The rate is based on the ten-year mortgage rate, which is similar to the rate most people currently pay on their mortgage after inflation. Interest rates are low right now. But it’s a mistake to use that rate to value a house.
As we argued with respect to Telstra in a previous blog, a ten-year debt rate isn’t suitable for long duration assets such as shares or, in this case, housing. These assets, with low yields and incremental growth, deliver their returns over decades. If interest rates start reverting to more normal levels from year 11 onwards, that makes a major difference to what you can pay for a house today. To conclude that housing is undervalued you need to assume rates stay low for a lot longer than ten years.
That’s a risky assumption and a bet against long-term reversion to the mean. But the researchers seem confident in low rates. The updated finding that houses are now 30% undervalued is based on a big fall in funding costs from last year’s 3.3%. From co-author Dr Peter Tulip:
What has changed since then is that real long-term interest rates have fallen substantially. That fall made housing more attractive relative to renting, despite the increase in prices.
So that’s how you create $2 trillion in value out of thin air. On paper at least.
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