Tony Alexander November 2021

The balance of factors shifts

There are a great number of factors in play which will contribute to an ending in coming months of the unusually large surge in NZ average house prices over the past 18 months, ten years, and three decades. The biggest of these will be rising interest rates.

In 2008 and early 2009 the Reserve Bank rapidly cut interest rates in response to the recession they created in 2008 to fight high inflation, and then the economic impact of the Global Financial Crisis. Come 2010, with evidence of good growth returning in New Zealand they raised their official cash rate from 2.5% to 3.0%.

But growth fell away again, inflation eased off, and with the Christchurch
earthquake chosen as a trigger, they cut the cash rate back to 2.5% early in 2011. They then took the rate up by 1% to 3.5% in 2014 when again growth was strong, and inflation was expected to return.

But inflation did not appear, so they cut the cash rate eventually back to just 1.75% in 2016. They then cut the rate to 1.0% in 2019 when inflation again surprised on the low side. In fact, between 2013 and 2019 the rate of inflation in New Zealand averaged well to the end of the 1% - 3%target range at 1.3%.

With the outbreak of Covid-19 they cut the cash rate again in March 2020 to just 0.25%.

Why did inflation turn out to be so low here and overseas following the GFC? Partly we can cite low unionisation and job worries, along with increasing international competition. But perhaps the bulk of the blame can be placed on businesses not raising their selling prices because consumers could easily go online and find alternative suppliers in a way never before possible.

In response to interest rates falling for six years and reaching record lows we have seen a strong surge in NZ house prices in recent years, with a 35% jump on average since March 2020. But now the situation has changed.

Inflation is no longer surprising on the downside. Instead, the pace of price increases is turning out to be surprisingly robust all around the world. Just six months ago the Reserve Bank predicted inflation in New Zealand would currently be 2.5%. The rate in fact is 4.9% and could exceed 6% in the next few months.
While there is some upward pressure on inflation because of higher housing costs and higher wages, the main culprits are higher fuel costs and the disruptions to supply chains caused by Covid-19 which have pushed up prices of materials and shipping costs aggressively.

Initially, the popular view was that these disruptions would be transitory. But that view is now disappearing with widespread expectations that the problems besetting supply chains will not substantially resolve themselves before 2023. This changes the dynamic of what transitory means quite substantially.

The longer seemingly temporary price increases go on, the greater the chance that they will lead to higher demands for wage increases from employees seeing their cost of living soar. Will people extract higher wages growth from their employers? Probably yes. Labour is also in short supply around the world.

The question then becomes this. Will higher business operating costs, including for wages, be passed on into still more price rises? The answer looks to be yes because of the inability of consumers to easily go online and find alternative products which can be delivered within a reasonable time have diminished substantially.

In New Zealand and offshore the risks of small wage/price spirals occurring and high inflation becoming entrenched have soared. Hence, so far, our central bank has raised its official cash rate by 0.25%. But the markets are pricing in a rise to at least 2% come 2023, and in my view (which has been more bearish than the markets for some time), a cash rate of 3% is quite likely.

In response to sharp increases in wholesale borrowing costs, banks have strongly lifted their mortgage rates to the point where the popular three-year rate is now back to where it was before the cash rate was cut from 1.75% in 2019. Other rates are still lower than back then.

It will take some time, but higher borrowing costs will make a housing purchase unaffordable for an increasing number of people as the months go by. This will naturally lead to a reduction in FOMO (fear of missing out) and the pace of price rises will decline.

But at the same time as this large effect will be happening, there are other factors which will also restrain the pace of house price growth. One is reduced availability of credit.

Banks can now only have a maximum of 10% of their home lending book exposed to borrowers with less than a 20% deposit. Up until recently that was 20%. The minimum deposit which investors must have has also this year been raised to 40% from the 30% before March last year.

Banks are also having to meet new legislative requirements (CCCFA) for proving that they are properly assessing borrower income and expenses before granting loan requests. A desire by banks not to be caught out by the legislation is leading them to cut the proportion of income from the likes of tenants and boarders which they will count towards total income. They are also deeply scrutinising all expenses.
Banks are also starting to apply a debt-to-income maximum ratio of six, ahead of the Reserve Bank probably officially imposing such a limit itself at some time in the near future.

Then there are other factors which are working to slow house price growth. The number of consents being issued for the construction of new dwellings is running at the highest ratio to the NZ population since the 1970s. The government has also announced that from late next year councils in our five largest cities will lose the right to prevent three units of up to three storeys being built on practically any section in an urban boundary.

The tide is turning on the housing market, but with Auckland yet to be properly freed from lockdown there is probably a lot of pent-up demand still to be satisfied. Summer is still likely to produce above average growth in house prices for the country as a whole.

But as we head towards the middle of next year and most borrowers will find themselves exposed to resetting their largely one-year fixed mortgage rates at a cost eventually 3% higher (come 2023), prices growth nationwide will probably stall.

Will prices on average fall? In some locations yes. There are parts of New Zealand where average house prices have bounded ahead of reality and long-term trends amidst a nationwide scramble during the global pandemic for property exposure. But in our biggest city, prices are below trend and scope for falls looks minor.

Christchurch is also below trend and a period of price catch-up over 2-3 years appears to have started.

Wellington presents as somewhat over-priced and vulnerable to a loss of population to Christchurch.

Overall, on average NZ house prices tend only to fall when we are in a recession and that recession has been preceded by extremely high interest rates. Borrowing costs are highly likely to rise over the next two years and reach levels people have not seen for a long time and do not currently believe will arrive.

But there are strong factors which suggest the economy will continue to grow and the labour market remain firm. On that basis, the next five years for the moment looks like producing a period of flattening in average prices for the country as a whole. Falls are likely to be limited to currently over-stretched locations.

By Tony Alexander

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