Economic update

05 July 2010

A new lease on housing

A surge of first home buyer activity during 2009 took some heat out of the rental market, with only modest growth in rents and very weak investor housing purchases recorded over the year. But, with vacancy rates still pointing to an undersupply of rental accommodation in many States, rents could rise quickly over the next 12 months.

This is an important pre-condition for an increase in investor demand, which looks set to provide some offset to weaker owner occupier activity in 2011. For policymakers, growing rental costs represent another upside risk to inflation (and interest rates) and will therefore need to be watched closely by markets.

It’s no surprise that first home buyer activity has plunged since the start of the year. The winding back of the boosted first home owners’ grant and rising interest rates have generated a sharp fall in owner occupier housing finance, concentrated in the first home buyer market.

In April, first home buyers represented just 16% of all new home loans, down from a peak of 29% and below the long-run average of 20%. This should be expected following a period characterised by an influx of new home owners incentivised by boosted government grants. For example, following the phase-down of the boosted grant at the start of 2002, first home buyer activity remained relatively subdued for an extended period (i.e until the new boost was introduced in late-2008).

During this period, high interest rates and worsening affordability meant that fewer young people were able to purchase a home, placing significant pressure on the rental market. Vacancy rates fell sharply and this contributed to the subsequent surge in rental growth.

Over 2009, however, low interest rates and boosted grants created a surge of first home buyer activity, taking some heat out of the rental market. Over the past year, median rent of 2-bedroom units in Sydney, Brisbane and Perth recorded no growth, while modest rises of 3.2% and 4.2% were seen in Melbourne and Adelaide respectively.

But, this easing in rental growth will likely be short-lived, considering that vacancy rates remain exceptionally low. It is estimated that a vacancy rate of 3% suggests an adequate supply of rental accommodation. In the March quarter, Sydney (1.1%), Melbourne (1.5%) and Adelaide (1.3%) all exhibited considerable tightness, while Brisbane (3.8%) and Perth (4.1%) displayed easier conditions.
If the recent lull in first home buyer activity is sustained, then demand for rentals will expand, causing vacancies to remain low. And in this environment rental growth could be expected to rapidly accelerate once again.

Despite very strong rental growth over recent years, yields have tracked sideways because the rise in rents has been matched by rapid house price growth. This has lessened the attractiveness of residential property investment, but the outlook for rental yields appears to be shifting into more favourable territory.

This is because there is now some evidence of cooling in the pace of house price growth at the same time as the rental market is tightening. This is likely to result in a sharp improvement in rental yields over the year ahead.

This is already causing some divergence in the performance of investor versus owner occupier housing finance. The improvement in investor financing is a welcome offset to weaker first home buyer demand, particularly if investors use funding to build new housing, rather than purchase existing dwellings.

The final consideration is the impact of higher rental costs on inflation, which can be a tricky situation for policymakers to address. That is, if the Reserve Bank responds to higher rental inflation by raising interest rates, this will worsen affordability and dampen housing construction, which in turn has the potential to exacerbate the rental squeeze. This combination of softer house price growth and rising rents would push yields considerably higher.

Conversely, policymakers could temporarily look through the rise in rents, hoping for a supply response to increase vacancy rates and dampen growth in prices over the long-run.

One thing is certain: the supply-demand imbalance in the Australian housing market is not going to be resolved any time soon. As a result, it will likely be a combination of these approaches impacting on housing markets and the policy response for years to come.