This article first appeared on the Yahoo 7 Finance website at this link: 


Housing affordability: Is axing prices the answer?

Improving household affordability does not mean that house prices have to fall. In the crescendo of noise and fury about house prices in Sydney and Melbourne (forget the rest of the Australia in this debate), too many commentators and analysts are suggesting that the only way to improve affordability is for house prices to fall.

That is wrong. Such comments miss the point about how affordability is measured.

Thankfully, the calculation of housing affordability is remarkably straight-forward.

There are three components of housing affordability – house prices, household disposable income and interest rates. The interaction of these three components and nothing else influence how hard or easy it is to buy a house. Affordability in other words.

Some very straightforward calculations show that the price of houses does not have to fall to improve affordability. If either wages increase faster than house prices or interest rates fall relative to rises in house prices and incomes, affordability improves.

Let’s look at an example how this might occur which covers just incomes and prices, and for the moment leaves interest rates out of the calculation. According to the latest data and calculations from the Reserve Bank of Australia, the average Australian house price is about 5 times average household disposable income.

Let’s start with an example based on this where household income is $120,000 a year and house prices are $600,000. Affordability in this narrow measure, which to repeat excludes interest rates, is 5 times.

In a scenario where house prices rise by 1 per cent per annum and incomes rise 3.5 per cent per annum, in just two years, the price to income ratio of affordability drops to 4.8 times; in 5 years, the ratio is 4.5 times and in a decade it is just over 4 times. Remember, that is with house prices rising every year.

A scenario where house prices rise at an annual rate 2 per cent and incomes 4.5 per cent, has the affordability ratio dropping from 5 times to 4.4 times within 5 years and it is under 4 times within a decade.

There can be quite massive changes in this measure of affordability with house prices continuously rising, as long as wages rise at a more rapid rate.

Interest rates must also be added to the affordability equation. The directional influence of interest rate changes on affordability are unambiguous – when interest rates are lowered, it is easier to buy a house (affordability improves) and when interest rates rise, it is more difficult to buy a house and affordability worsens. Difficulties with affordability in the late 1980s / early 1990s and in 2007-08 were linked to high interest rates. The current low interest rate structure has helped cushion the impact of high house prices when it comes to affordability and the ability to service a loan.

Of course, a sharp fall in house prices at a time when household incomes rise and interest rates are low would see affordability improve, but there are a myriad of other scenarios that can have the same end result without prices dropping.

And as was evident during the global financial crisis, falling house prices can cripple the banks, the economy and cause an unemployment problem that means fewer people can buy a house, even if the price is low.