The role of inflation in price growth

I was just reading an article about FHB’s in WA saying that most are leaning on their parents for a deposit and it got me thinking.

back when I first bought (in WA) there was no parental assistance, nor did many of my friends have it. All of us bought starter homes/units. None of us expected a good home off the bat, and we all knew we’d have to renovate ourselves. Looking at the WA market today, it’s hardly moved since when I bought in so the only thing I can think has changed is buyer expectation; wanting the bigger better nicer house up front. This lead me to wonder what may drive that change (and not simply blame entitlement).

When I bought, it was on the basis of my townhouse growing at a nominal rate not too dissimilar from what houses would do. I genuinely expected my little townhouse to hold pace with larger homes; any capital difference made up for by growing rents due to its good location.

For the last 5+ years however, FHB’s have witnessed the dream home move further and further away while the starter home/unit barely changes in price. Without inflation, there is far less pressure on rents and accordingly the less desirable homes and units have not appreciated anywhere near the extent of houses. A FHB looking today will see my starter home for the dud it was; low capital growth, low rental appreciation, creating minimal equity OR cashflow over the last near decade. Why on earth would you base a 5-year business case on that as a lever to get you access to the property that has only been getting more expensive?

And so is my theory on the impact of rising inflation; units, townhouses, starter homes, will start to grab the eye of FHB’s and young investors. Inflation will mean they are a far superior investment to holding cash, and the added equity will be a spring-board to the future home.

I really can’t blame FHBs for acting the way they have, and I don’t think it is entitlement at all. They’ve been smart to not lock their equity into zero growth assets, but that’s about to change.

 

JL, thanks for the thought-provoking post.

My take on it would be that rising inflation probably isn’t that good for prices generally as it would also mean rising interest rates.

I put this in a separate thread on long term house price outlook this morning, basically arguing that prices over time are driving by purchasing power, made up by income growth and changes in interest rates. So rising incomes, and falling rates, are both good for prices.

If inflation leads to rising incomes, then that would be a positive, but it probably also causes rates to rise, which obviously wouldn’t help.

Put another way, we have had a massive boom in asset prices over the last decade and last 3 decades, in property, shares, bonds and everything else, to a large degree due to ever falling interest rates, driven by falling inflation. So it’s a bit of a challenge to say that that factor reversing would also be a positive driver of prices.

 

the wage growth vs. interest rate is an interesting one.

I think it will hit different states in very different ways. Last time rates rose considerably was 2001-2007, during which time they went up from (i believe) around 4% to 7%. During this time Perth property more than doubled. Of course growth in the resources sector played a big role, but that is also what we are seeing early signs of again now.

Rising wages were of course a major reason, but it cant be dismissed that apart from the 70's oil shock, rising rates have always been bettered by rising wages (i.e. no stagflation). Rising rates IMO tips the scales to different asset types doing well. Notably, its harder to get away with capital gains assets (i.e. pure land, run down houses in good locations), because (a) their returns cover less of the debt, and (b) land's value has to be linked to the cost to develop/renovate it; if that development cost is notably rising, it erodes possible margins on the land's gain.

I'm quietly confident that we will see a dip over this year/next, but inflation and wage growth will quickly catch up. Oddly, its the first time I've felt confident about property in some time. Just the right ones in the right cities, and i think what is currently perceived as "the right investment to make" will change over the next few years.

 

So far this thread has the most sensible commentary I have seen on PC.

 

JL, I would suggest having a look at my other post from this morning on income growth and interest rates if you haven’t already.

Perhaps you could think of it this way. Let’s say wages growth is 4% in a year, up from 3% the prior year. What happens to purchasing power from that factor alone? Your purchasing power goes up by probably mid-single digits. But if interest rates go up by 1% over the same period, purchasing power drops by at least 10% under the mode in my other post. If you believe the RBA’s work, the drop could be much larger than that (c.30%).

The economics of rising interest rates, (and rising discount rates in investment terms) is consistent irrespective of the state or country you are looking at.

Your point about Perth going up in the mid-2000’s while rates were rising is an interesting one. I’d make a few observations. 1) the price performance since that booms suggests it wasn’t really that sustainable, 2) the mining boom then was associated with a capex boom as the mining companies massively increased their productive supply in response to the realization that China needed lots of stuff (iron ore etc). Building a new mine or expanding an existing one is very labor intensive. But after that’s done, running a mine is no where near as labor intensive. So Perth has seen the boom and it’s unlikely to be repeated in anywhere near the same scale.

commodity prices are also sky high now, but this is not due to a massive increase in Chinese demand, in fact it’s despite Chinese demand currently being weak and likely to remain so. The boom in Chinese demand came from the building of its cities, which is now done. Real estate developers there are now struggling as demand slows and they try and fix their overleveraged balance sheets, all while the govt tries to stop them building apartments nobody needs. The Chinese iron ore boom is well and truly done.

Todays commodity boom is more about supply disruptions coming from a number of causes, and some over-stimulated economies (eg US) which are now overheating and will be cooled through higher rates.

I do agree that rising rates impacts asset prices to varying degrees though. That’s often to do with the duration of the asset. One maybe worth googling.

 

Thanks for sharing, i had missed your thread. super interesting model and i love that comparison chart, cant argue with the numbers!

I also really appreciate the use of averages; as a secondary investigation, city deviation from averages could be an interesting way to determine which sub-markets present value and which are over-valued. Looking at the ABS house price index which starts in 2003, Base-lining them to 100 would imply that perth is now below the long-run average and as you rightly point out, it was massively over-valued in 2007. When i get some more time i'll read your thread in a little more detail and maybe try to over-lay the ABS index to see which sub-markets present value.

Just a side-note regarding Perth and capex projects, i wouldnt be surprised to see another capex boom in the next decade, notably around green hydrogen and lithium. For green hydrogen in particular, its an industry i work very closely to and WA has by far one of the world's greatest potentials for this. The scale needed is just phenomenal; expect a minimum 4x increase Australia's power generation sector as a result, with WA certainly to get a lions share

 

TBH the model isnt a complicated one. Basically take the ABS's discounted new lending rate, average household income, and average house price, and assume 80% LVR and 25yr mortgage and you're nearly there. The model done really well has a few adjustments for median vs average income, interest income and a few other things. (at a state level, some might like to adjust for the fact that incomes are quoted by state while prices by capital city, but dont think that's really necessary). But its certainly doable.

Agree we could be in for another capex boom out of perth. I would just caution that 1) iron ore and coal could well slow from here, 2) Perth and the mining industry now being so much larger means it takes a much much bigger spike in capex to have a similar impact to what we saw in the 2000s.

 

But the model is Australia wide based on interest rate and income, which makes sense over a very long term and on average. But since we talk about Perth here - how do you adjust for income in different cities and house prices? For example, Perth has the same interest rate as Sydney; similar income but house price is about 1/3 of Sydney?

 

The model is really just based on 'relative to history' as it takes an arbitrary point in time around 1980 and calls it fair value. So it is doable for a state or city, but as with most models it works better with bigger numbers (So its more reliable at a national than state/city level).

So in modeling say Perth, you could do it and it wouldnt compare Perth to sydney. It would compare Perth today to Perth over the last few decades. Yes Sydney has a higher price/income ratio. But this model wouldnt compare that. Its just looking at what would happen to the average house price in Perth if the average income household spent a consistent % of their income the repayments for a new home purchase over time.

 

There are so many other factors though. The percentage of peoples take home pay that they are willing to spend on a mortgage can change over time (most people do not borrow the maximum that the bank lets them). In a tough market people will be willing to spend more on repayments to get a foot in the door. And the amount that people can save for a deposit affects their purchase price too (e.g. in covid people spent less, so could save more for a deposit). You have also not factored in investors. E.g. investors can deploy their money to many different things, property, shares, crypto etc. If investors are spending a larger portion of their investment money on property it can lead to price rises. And then there are other factors like supply issues, immigration, foreign investor interest.

People always get fixated on one particular element causing price rises (recently everyone thinks its a simple as, low interest rates = prices go up, high interest rates = prices go down). But in reality there are many different factors and people should make sure they don't assume the property market is decided by one single factor.

It's also worth mentioning that in the 70's/80's, house prices rose at the same time interest rates were rising. There is no guarantee that rising interest rates will cause a decrease in property prices.

 

10k, thanks for the message. I have a couple of thoughts.

Completely agree that interest rates and household incomes dont account for all of the variables. But if you check out the other thread on long term house price outlook from a couple of days ago, you can see that over long periods this 2 factor approach does a surprisingly good job of forecasting price growth.

Why is that the case? Simplistically i think its a case of the 80/20 rule. 80% of the variation in prices can be explained by 20% of the factors, which is the case for many things (Hence the term the "80/20" rule I guess). I havent done a full regression model, but i bet that over long periods interest rates and income growth dominate the other factors in terms of their impact on prices

In the case of house prices i think we could say:
1) purchasing power, defined by income and interest rates, are bigger factors as single home buyers dominate the market (relative to those investors buying a 2nd or 3rd house), and domestic buyers dominate foreigners in terms of volume.
2) for these and the other factors you flag, as relevant as they certainly are at different points in time, they are much more volatile than purchasing power, which is a constant across every cycle.

The cycle will often flush out variations in those other factors. Foreign buyers and investors are both hot and cold. People can increase the % of income they will allocate to repayments, but generally that corrects over time too.

If you see my other thread where i explain the model you will see i note its not great in the short term given all the other factors you mention. But over the long term, across cycles, its really pretty good. Consider that over a period of 42 years since 1980, the model is only off on its forecast of house prices by 10% in total. That's 0.23% p.a. And if current consensus forecasts for house prices are correct, the gap will be much lower than even that by the end of this year.

 

What model are you both referring to?

 

Sorry it’s explained in the thread called “long term house price growth potential”.