Box C: Longer-term downside risks to the housing market
Previous Reports have highlighted several sources of downside risk to house prices, and have noted that house prices appear high relative to fundamentals. In particular, even after moderating in recent years, house prices are currently significantly higher relative to incomes and rents than 20 years ago (figure C1). While house prices have risen relative to income, debt servicing costs for a typical first-home buyer have been more stable, since interest rates have trended down and are currently at historically low levels (figure C2).
Figure C1: House prices relative to measures of fundamentals
Source: Property IQ, RBNZ, Statistics New Zealand, Department of Building and Housing.
Figure C2: Mortgage interest rates
Source: RBNZ, Bloomfield, G T (1984) New Zealand: A handbook of historical statistics, G K Hall & Co, Boston.
Conceptually, the response of house prices to lower interest rates depends on the ease of adjusting property supply relative to population. In a very geographically constrained city where new housing cannot be easily built, and with very low labour mobility, house prices may rise substantially relative to income as longer-term interest rates fall. On the other hand, in a town with a lot of room to grow, rising house prices would tend to stimulate construction. This construction would tend to stabilise house prices relative to income and put downward pressure on rents. Where construction sector productivity is rising over time, house prices may even trend down relative to incomes, as Robert Shiller has documented with US data.1
For a relatively land-abundant country like New Zealand, these factors suggest that house price increases following a rise in housing demand will begin to correct over time. In the long run the capacity to construct additional housing will tend to pull house prices back towards incomes. This force will be weaker in areas where the shortages are hardest to mitigate, such as central Auckland. However, as prices in those areas rise some households will move further out within the same city, or perhaps even to a different part of New Zealand.
Scaling up the supply of housing takes time. As an example, some recent research based on a model of house prices in New Zealand regions suggests that after a 5 percent regional population inflow (to Manukau city), there is upward pressure on prices and construction.2 Over a five year time frame, prices rise substantially (about 12 percent) as a result of the population inflow. However, over a longer time frame the increased construction means that much of the price rise is eventually reversed.
While it is possible to build additional houses to cope with rising populations, housing is immobile once it is in place. This means that population outflows from a town or area could cause house prices to fall below construction costs (and decline relative to incomes). There have been dramatic long-term examples of this in the US, such as cities that relied on the automobile manufacturing industry. In some New Zealand towns, population declines kept house prices low in the last decade while prices in parts of the main centres have risen substantially.
As discussed above, there is reason to expect ongoing momentum in house prices in the near term. However, additional construction will eventually stabilise the supply/demand conditions in housing markets, so that house prices are likely to ultimately drift down relative to incomes. This adjustment could happen gradually, through income growth in excess of house price inflation over an extended period. However, a number of factors could cause a faster decline that could destabilise the financial system:
- Interest rates – if mortgage rates rise faster than currently expected, current house prices will be less affordable for buyers.
- Migration and labour market surprises – a downturn in the New Zealand economy that reduced inward migration and increased outward migration to Australia would put downward pressure on prices, particularly in areas facing the largest population and employment declines.
- Changing investor base – population ageing will reduce household formation and cause some older homeowners to downsize and/or sell rental properties to fund retirement.
- Construction technology and regulation – as noted by the Productivity Commission, a range of factors appear to have pushed the costs of building new homes in New Zealand above those in Australia. If developers begin to build larger-scale developments and capture productivity improvements from doing so, and regulatory adjustments make it cheaper to find suitable development land, this will tend to put downward pressure on existing house prices.
Reflecting these risks, a large component of the Financial Stability Report is dedicated to examining the vulnerability of household balance sheets to a substantial fall in house prices. Stress tests of the banking system are also periodically undertaken to gauge the consequences of a substantial decline in house prices for bank balance sheets (see the November 2012 Report for an example).
1 Shiller, R (2006) Irrational Exuberance, Princeton University Press, Princeton.2 Grimes, A and S Hyland, with A Coleman, J Kerr and A Collier (2013) “A New Zealand Regional Housing Model,” Motu Working Paper 13-02.