There is an old saying that if you put two economists in a room and ask a question, you will get three answers. I understand a bit about economics after reading for years, but there are some basics that seem to get lost. One of the favourites is the economics of house prices. Any slight change seems to bring out a multitude of comments from economics that are totally contradictory. Maybe the answer is to get back to basics on this. Put up scenarios and use common sense to project what might happen.

It is all about supply and demand. When there is more supply than demand, prices come down. When there is more demand than supply, prices go up.

Equilibrium

Take this totally hypothetical example. Imagine there are 1,000 houses for sale, and there are 1,000 buyers. Everyone is happy right? Not right. Those 1,000 buyers have to each want the type of house for sale. If there are too many expensive houses and too many buyers after cheap houses, we have a problem.

The basic laws of supply and demand say that if there are lots of customers for a product, the price will go up. Conversely if there are not enough buyers, the price comes down. In this case if there are not enough buyers for expensive houses, the owners will have to drop their price to make a sale. If there are too many buyers for cheaper houses, the owners can raise their prices. Cheap house buyers pay more and expensive house buyers pay less.

Types of buyer

The buyers fall into a number of categories:

• First Home Buyers. They have saved for their first home and probably getting support from family or government schemes. The banks are wary of their borrowing risk and charge them higher interest rates.
• Upsizers. These people have a home and for whatever reason decide they need a bigger home. Banks are more lenient with rates because they bring a high proportion of equity to the home.
• Downsizers. Typically older people who have kids who have left home. They want to sell their home and buy something cheaper.
• Investors. They are only interested in the return they can get from their property and the tax benefits it brings.

Types of seller

Sellers fall into a couple of categories.

• Forced Sellers. People who no longer can afford to own their home. Many of these situations arise through economic changes however health-related, job loss and divorce can also be drivers. These people are always there but during a period of economic upheaval are likely to increase the number of sellers.

• Upsizers or Downsizers. People who have changed personal circumstances and need to change their dwelling. It could be children or children who have left home. While higher birth rates are likely to increase the demand, an aging population can have the same impact.
• First Home Buyers. This is largely a combination of demographics (how many people in the 20-35 age group), interest rates and migration. The more people the more demand.
• Deceased Estates. This is not just natural attrition. Think of the Covid impact in the USA or UK and what it will do to the number of properties on the market.

Change the supply

Imagine nothing else changes, but there are more houses on the market. Buyers have more options so prices will come down. If for every buyer there were 2 or 3 properties for sale, sellers would have to reduce prices to attract those buyers.

A surplus can come from a number of sources. For example, an apartment building boom as has happened in Sydney over the last few years can create surplus properties. Since the lead-time between planning and delivery of a new property can be a couple of years it is difficult for developers to guess what the situation will be when the property is completed. If it all looks rosy today and lots of developers start building, they might find that on completion, the economy has changed, or a pandemic has hit. The buyers they anticipated are not there. They have to cut prices to sell the homes.

This is particularly relevant to unit development. It relies on the new home buyers getting a start in the market with a one or two bedroom unit. What was started two years ago did not anticipate Covid. The demand dropped due to a stop in immigration which accounts for half the population growth in Sydney, nor a nervous group of first home buyers who had jobs in jepordy.

At the other end of the spectrum, more expensive houses may be in a state of oversupply if investment returns fall. Imagine retirees in expensive family homes who no longer can live on low interest rates. They are capital rich and income poor. The solution is to downsize. More properties on the market than potential buyers will cause expensive properties to drop in price.

Consequently, an oversupply in one sector can cause a price drop. Other segments may be unaffected. It is also clear supply in different segments can be caused by different factors. Maybe apartments through oversupply, and expensive houses through lower investment returns.

In summary, the building of new houses is reliant on a crystal ball so when the dwellings are finished, there may be too many or not enough people to buy. That will drive the price up (if too many buyers) or down (if not enough buyers)

For existing properties, external factors such as population growth, economic factors, mix of age groups in society and job opportunities can drive prices in either direction.

Change the demand

There are two groups of buyers who create the demand. Those looking for a home and investors.

Those looking for a home have to make a decision. Do they buy or do they rent? In Europe, there is more of a culture of rental. Homeownership is much lower than in Australia. The market is more geared to long term rental than in Australia. My grandmother moved into a rental property when she was married in her early twenties. They carried her out of the same property 70 years later when she died. That is almost unheard of today.

The decision to buy or rent is driven by cultural issues, the availability of money which is highly reliant on interest rates, and the number of people at an age where they are looking for a home.

The other factor driving demand is population growth. If we had no population growth, and an unchanging situation regarding age distribution, theoretically there would be no need for new homes to be built. Of course some would reach the end of their life and need to be rebuilt, but the total number of dwellings required would remain unchanged. So natural growth of the population and immigration cause an increase in demand. If supply remains the same, prices go up.

Other factors have more long term impact. For example employment opportunities drive demand in different areas. Rents and prices soared in mining towns in the early part of the century when the mining boom hit. They crashed when fly-in fly-out workers started to happen. Other long term changes can be things like divorce rates. Two people plus children in one house now require two houses.

So demand is driven by a number of factors. The economy, cultural attitudes, population growth and immigration, and changing social factors.

The other group I mentioned are investors. They are primarily concerned about a stable feed of income to allow them to pay off their debt. They also hope prices will go up so they will make a capital gain. All this is wrapped in tax benefits. While the capacity to borrow is positive with low rates, the uncertainty regarding guaranteed income is dubious. There are too many uncertainties around to be comfortable you can find someone to pay the rent regularly.

Australia today

Supply. Most cities are in the middle of a three year lag between commitment to build and delivery. This is particularly evident in the apartment market where lead times are longer. There are lots of apartments coming on the market and a bunch of nervous developers.

Demand. Demand is subject to a number of forces. It is lower due to a stop to immigration since Covid. It is higher because interest rates are as low as they have been for decades so more people can borrow. Demand is lower due to job uncertainty. Another demand issue within the mix is that there are fewer investors and more homeowners in the market.

As you can see there are a number of competing factors in both supply and demand. Prices have been stable in most cities or risen slightly over the last twelve months. This is really just a response to one positive for a buyer, being cancelled by a negative factor.

Subsidies

Governments within most states give some form of incentive to first home buyers. The intention is to get more people into the market to stimulate the building industry. I guess there also might be some votes in it. But does it actually work?

If supply is constrained, or even just meets demand, imagine this situation. A house is for sale at auction. There are two first home buyers. Each has a subsidy from the government of say $20k. It might be in the form of a reduction in stamp duty or a tax reduction or direct payment. So the auction gets to $1m which is about the limit for buyers. Hold on. The two first home buyers have an extra $20k to bid. Who wins? Obviously the seller.

Subsidies to first home buyers do two things. Firstly they drive up property prices. Secondly, they disadvantage second home buyers. Were these the outcomes that the government was trying to achieve when they introduced these grants? I think not.

Where are we going

There are some things we do know and lots we don’t. Let me concentrate on what we do know.

Population. Since migration has stopped, the demand for new homes will be decreased. Less people mean less demand. This puts downward pressure on prices.

New Homes. Developers will not be as keen to build new apartments as they were three years ago. On the other hand, governments are putting a lot of effort into keeping the construction industry going in order to keep employment. This could result in a slight drop, but not strangle the industry. In other words, probably a neutral impact on prices.

Interest Rates. The Reserve Bank has said interest rates will be low for at least three years. Lower interest rates mean upward pressure on prices.

Number of Potential Buyers. Lower interest rates mean more people can get a loan however after the Royal Commission on Banking, banks are more selective about loan applications. Some will win and some loose. My guess is a small increase which is an upward push to prices.

Economic Confidence. As we slowly stagger out of Covid, which might take three or four years, will people still be confident enough to sell their existing house or buy a new house? Selling requires confidence that you can get your price, and that you will be able to move to another property which usually, but not always, be more expensive. In other words confident enough that you will be able to meet mortgage repayments. Who is sure about anything today? If confidence is down with sellers, it means fewer properties on the market. Less supply means higher prices.

On the demand side, the number of purchasers is driven by confidence certainly but also two other factors. The first is low-interest rates, and the second is government subsidies. Balance this against the uncertainty that will impact the ability to repay a loan, and maybe they cancel one another out. Of course, this is all guesswork.

The net impact of confidence may end up being neutral or maybe slightly less supply. Less supply equals higher prices.

Conclusion

My crystal ball may be as cloudy as everyone else but I can see more factors that will push up prices than I can see pushing them down. Looking at supply and demand, it seems to me more likely that after we digest the wave of apartments recently completed, or nearing completion, the number of dwellings for sale will contract. Less supply.

On the demand side, maybe there will be some contraction, but the big drivers are low-interest rates and government subsidies. Of course, you also have to take out the migration numbers. My guess is that numbers will not drop significantly.

The net result will be rising prices after we work through the apartment glut. Please don’t hold me to it. This post self destructs in six months.