Why you should buy in the inner city

24 May 2014

The Australian Financial Review, 24 May 2014

By Christopher Joye

New Reserve Bank of Australia analysis suggests that the residential property market is just 1.9 per cent off its valuation records set in the 2007 and 2010 upswings.

And as densities in Australia’s “low-rise” cities climb on the back of population growth, which give us 15 million new residents by 2050, the RBA’s research offers a steer on where punters should buy.

The RBA’s work on housing valuations, which contrasts the change in average dwelling prices with disposable incomes, confirms analysis published by The Australian Financial Review in March that found fundamentals were getting stretched.

At that time, we argued that the Australian housing market was 1.7 per cent shy of its valuation watermarks– and 10 per cent above the average since 2000 – using similar methods to the RBA.

We also cautioned that after the ratio of Australian dwelling prices to incomes last hit these levels in 2007 and 2010, home values retrenched by 6 and 8 per cent respectively.

The RBA supplied the Financial Review with its own summary price-to-income ratio estimates after an information request.

This previously unreported data indicates that as at March 31, national housing valuations were 1.9 per cent off their 2007 and 2010 records.

Since March, home values across the capital cities have corrected modestly by 0.9 per cent, according to RP Data-Rismark’s index. While this apparent improvement in affordability is welcome news, it does not necessarily mean alarm bells should stop ringing.

Preferred benchmark

RP Data’s index, which is the RBA’s preferred benchmark, shows that home values continued appreciating by 0.6 per cent between March 31 and May 5 2014. All of the weakness has registered in recent weeks. Some optimistic pundits claim that the softening in auction clearance rates and prices heralds a moderation in activity where capital gains will not exceed Australia’s 3 per cent household income growth rate (to avoid heading into bona fide “bubble” territory).

One of the RBA’s top housing guns, Luci Ellis, who produced the analysis cited here, also appears comfortable with recent price movements.

Ellis’s narrative is that the run-up in house prices is the expected result of the RBA slashing interest rates to historic lows.

And while unprecedented speculative investment activity – anticipated in this column with the advent of self-managed superannuation funds leveraging into housing – has given her “pause”, Ellis says that many of the key metrics, like credit growth, are “very different” to what was observed in 2002 and 2003.

This overlooks the fact that Australian household debt relative to incomes is 28 per cent above the level that prevailed in December 2002 (based on the RBA’s numbers).

And it also ignores the fact that the dwelling price-to-income ratio is 15 per cent more expensive than it was a decade ago.

Seasonal airpocket

Ellis agrees that we cannot afford to sustain more double-digit price rises.

So will the boom over the last year persist, or will it be replaced by a new period of prudence?

There are some reasons to think that the May slowdown is a seasonal air pocket. Analysis shows that during the months of April through June, inclusive, house price growth is normally about 1 per cent weaker than it is over the rest of the year.

Sales volumes and auction clearance rates also decline. Unsurprisingly, the market then picks up again in spring.

If there are no rate hikes this year and the marginal buyer supposes (irrationally) that the record low 4.8 per cent mortgage rates they can get are here to stay, there is scope for them to bid up prices another 5 to 10 per cent.

Asian investors who are less constrained by domestic borrowing costs, and who might be encouraged by further falls in the Aussie dollar, could add to this ­buy-side momentum.

My own perspective is that we are unlikely to see any real correction in prices until borrowing rates normalise.

That in turn requires hikes from the RBA, which is currently entrenched on the sidelines.

The concern is that when the RBA does recalibrate rates, home values could decline sharply.

Investors must therefore focus maniacally on getting value for money.

Assuming one has that objective squared away, Ellis helpfully sheds light on trading opportunities.

Remarkable low density

Her research shows that despite our robust population growth rates, “Australia’s cities are unusually low-density”.

“This low density is all the more remarkable given that many of the cities . . . are geographically constrained,” Ellis says.

“They cannot expand in all directions: oceans, mountains and national parks block some sides.”

Other than this low-rise characteristic, Ellis’s research finds that our metropolises behave like counterparts overseas with densities increasing as you approach the city’s centre, which also happens to be where most jobs are located.

Interestingly for investors, Ellis discovers that the rate at which both job and population densities are climbing over time is greater in the already dense inner-urban areas.

“The trade off between space and place is getting steeper,” Ellis says.

“Locating on the fringe is relatively less attractive than it used to be because . . . many of the inner areas have become even greater job magnets in recent years.”

She proves this point by comparing the prices of properties located in both the “inner” and “outer” rings of Australia’s cities. In Sydney, Melbourne, Brisbane, Perth and Adelaide homes in the city’s inner ring are 1.5 to two times more expensive than those in the “outer ring”.

What is fascinating is that this inner-city price premium is expanding. “Inner-ring properties have, if anything, become more expensive relative to outer-ring properties in recent years,” Ellis says. “And the larger the city, the greater is that premium.”

The bottom line: target properties that are near major jobs markets.

Read more: http://www.afr.com/f/free/blogs/christopher_joye/buy_in_inner_cities_rba_1h7GXqxYYCZC2P8XLX1IFJ

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