How have lower long-term interest rates affected housing valuations?

This page contains information from the November 2019 Financial Stability Report.

Rapid house price inflation over the past decade, particularly in Auckland, has led to concerns that a sudden house price correction could threaten financial stability.

House prices have been driven, in part, by substantial decreases in interest rates and increases in rents. One way to analyse the impact of these changes is to use a discounted rents model. This model estimates the present value of future rental income that a house could be expected to generate.1 It does this by discounting future rental income at the expected long-term mortgage rate, with results highly sensitive to the long-term expectations for interest rates and rent inflation.

In the long term, interest rates and rent inflation are not independent. If longterm interest rates are low, it is cheaper to borrow money for building houses. This should cause the supply of housing to increase, putting downward pressure on rents and normalising house prices. However, supply constraints can prevent the market reaching equilibrium in the short term, causing rents and house prices to rise in response to lower interest rates.

Rents have increased 3.7 percent per year since 2009, broadly in line with median income growth. Strong population growth and government subsidies (such as accommodation supplements) have contributed to high demand for housing. Meanwhile, the supply of housing has been constrained by restrictive planning rules and high construction costs.

Interest rates have fallen significantly since the GFC, and have fallen further in the past six months. Part of this decrease is cyclical, as the Reserve Bank has tried to stimulate the economy. But the Bank also believes that interest rates are now structurally lower than they were 10 years ago. The structural level of interest rates is affected by the international environment and longterm economic factors such as productivity and demographics.

Changes in the structural level of interest rates are reflected in our estimate of the ‘neutral’ Official Cash Rate (OCR), i.e. the OCR setting that would be neither stimulatory nor contractionary. The neutral OCR cannot be directly observed, so it must be estimated, and the components of our suite of estimates have been diverging over time (figure A1).

Figure A1: Suite of neutral OCR estimates

Source: RBNZ estimates

As our estimate of the neutral OCR has drifted down, so too has our estimate of neutral mortgage rates (figure A2).2

Figure A2: Neutral mortgage interest rate estimates

Source: Interest.co.nz, RBNZ estimates

Using the model, we can decompose the main drivers of house price growth over the past 10 years (figure A3). Increases in rents and the structural decrease in interest rates can explain most of the house price inflation we have seen in the past decade. These factors have been offset to some extent by a fall in long-term inflation expectations, which should be reflected in lower rental growth in the future. In Auckland however, house prices have risen beyond what these three factors can explain. This suggests some risk that Auckland houses are over-valued, although prices could be sustained by expectations of strong demand and constrained supply. However, risks could materialise if these factors wane or house price growth picks up again from current levels, exacerbating the risk of a future correction.

Figure A3: Decomposition of house price changes since 2009

Source: Minstry of Business, Innovation and Employment, Real Estate Institute of New Zealand, RBNZ Survey of expectations, RBNZ estimates.

As noted above, the model is highly sensitive to changes in long-term interest rates. Uncertainty in the neutral OCR leads to the risk that house prices run up too far on the basis of cyclically low interest rates. While neutral interest rates have almost certainly come down since the GFC, it is unclear by how much, and it is possible that neutral rates have not fallen by as much as we think. This would increase the chance of a correction when interest rates return to their neutral levels.

Footnotes

  • 1 While this model is measuring the value of a house for a property investor, rents are also used as a proxy for the value that owner-occupiers receive from their housing.
  • 2 We calculate the neutral mortgage rate by adding the current spread between one-year mortgage rates and one-year swap rates to the neutral OCR.