House prices: Karratha and Sydney - why the divergence

Wed, 22 Feb 2017  |  

This article first appeared on the Yahoo 7 Finance website at this link: https://au.finance.yahoo.com/news/a-jump-in-demand-to-do-something-about-the-supply-of-houses-034305361.html

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House prices:  Karratha and Sydney - why the divergence

The thousands of students heading off to university this month to start their economics degrees can do so knowing that the basic laws of the discipline still hold. “Yay” – they might say as they sit down to their first Economics 1001 lecture.

Supply and demand is king.

Shortages, gluts, price booms and crashes reflect the supply and demand dynamics. These are the most basic concepts in the study of economics and they apply to the real world.
These basic economic laws apply to the Australian housing market which is going through extraordinary turmoil with prices booming in some areas and crashing in others.

It is not just housing where economy theory turns into reality. In looking at the market for bananas, widgets, fine art or concert tickets, the interaction of supply and demand will always determine the price of those items. But let’s look at housing and think of the following issues and questions.

Based on detailed data from SQM Research, why is it that since 2012, house prices in Karratha Western Australia have fallen by around 65 per cent, while in the lower North Shore of Sydney, house prices have risen by around 120 per cent?

In other words, someone spending $1,000,000 in Karratha in 2012 would be lucky to have $350,000 left in housing assets, but if they had invested $1 million in Sydney, they would have around $2.2 million.
Both areas are, obviously, in Australia and are subject to the same interest rates and are subject to the negative gearing and capital gains tax rules. These issues do not account for the full extent of the price divergence.

By definition, some other issues must be at play in these two extremes. It is obvious but often overlooked that key drivers of these extraordinarily different price changes is supply relative to demand with tax rules, interest rates and the like having only a temporary impact.

In Karratha, the collapse in mining investment and with it mining employment has seen a mass exodous of people from the town. Even without one more dwelling being built (which would add to supply), this reduction in demand has lead to a severe over supply of properties that are now empty and just about impossible to rent or sell.  As a result, owners must rely on severe discounts to have any hope of attracting a buyer. Compared to 2012, demand has crashed, relative to supply, which all those Eco1001 students will learn, leads to a severe fall in price.

In Sydney’s lower North Shore, there is a limited supply of dwellings or even an ability to add to supply other than at the margin with apartment building on small parcels of land. Sydney’s population growth is booming, domestic and foreign investors are wanting to buy properties and are doing so on the expectation, which has been correct for the last few decades, that solid long term capital gains are in store.
Indeed, the tax laws on negative gearing and capital gains tax encourage demand which pushes up prices. But those generous tax concessions are only sustainable as long as rental yields are positive and the capital gains are achieved. Tax benefits would be of little relevance if rental yields were weak at a time of protracted weakness in prices.

It is a similar issue with interest rates. The current record low interest rate structure is a cyclical, not structural element to the house price cycle. It is adding fuel to the upside in house prices that presumably will be reversed when the interest rate cycle turns higher.

The record level of dwelling approvals in 2016 is doing a lot to address the supply side issues in housing, although that is very much a city-by-city, area-by-area event.
Reflecting this, the outlook is for house price growth to moderate in the next year or two as this supply comes on stream. At the same time, demand is likely to be pushed along with the sold rate of population growth which sees Australia get an extra 1 million people every three years. They all need to live in a house so construction needs to remain strong to meet this demand and prevent further price gains.

If the housing affordability issue in Sydney and Melbourne is to be fixed, which means that house prices need to fall relative to incomes, supply needs to outpace demand for a considerable time. Changes to negative gearing and capital gains tax will help to ease demand for a time and are good policies for equity and fiscal reasons.

It appears that any effort to reduce demand from, say, lower immigration levels is not on the agenda of either major political party which means that the issue of housing affordability must come down to supply.
It will be important for the house building construction cycle to keep chugging along at a strong level for a few more years which will, in time help take some of the heat out of the housing market where prices are currently strong.

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