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Predicting the bottom: The impact of interest rate hikes on the Australian Real Estate Market

Interest rates are rising, asset prices are falling, and inflation is putting upward pressure on the cost of living for everyone. In December. a further 25 basis points raised the official interest rate to 3.1% per cent following the Reserve Bank’s announcement of its eighth increase in the cash rate in as many months.

The financial risks that have been growing in the real estate sector will be brought to light as a result of these events and how people respond. CoreLogic is reporting almost as a monthly copy and paste, that house prices in Australia are falling at their quickest rate since the global financial crisis, and market conditions are worsening as interest rates rise.

The Impact on House Prices

House prices in Australia are expected to decline anywhere from 12 all the way through to a dizzying 40 per cent, according to the range of economists, forecasters, and pundits.  Whilst hard to predict the correct timeframe – there are no credible predictors of near-term property growth. In any case, the drops are already here – although there have been overall gains in SA, WA and NT in 2022, every part of Australia has declined in value over the last quarter of 2022 according to Corelogic’s Home Value INdex

Sydney is leading the downward charge with a 12-month change in dwelling values of -10.2% across the city.  Some suburbs are faring worse than others with REA reporting pre-pandemic levels in some areas – Rhodes NSW for example is actually 21% lower than in March 2020.  More recently, the AFR reported on 200 suburbs Australia wide which have seen the average house price reverse through the fabled $1 million benchmark.

Different factors to observe

A feeling of despair can easily be forgiven with all the current negative sentiment and predictions of further doom and gloom.  However, in all likelihood, no matter how high cash rates rise with a corresponding drop in home values – there will come a moment when the bottom is reached and the next cycle of growth begins.  Eventually, the most recent property peak will be surpassed and median house prices will continue their long-term trend upwards.

What are the factors that are creating the downward slope, and what events are needed that can halt the decline?  Here are four examples of commonly occurring situations that could help to indicate where the market will bottom.

1. Joe the first home buyer.  Encouraged by his broker, Joe has been busy saving his deposit to enable the great Australian dream of owning his own home.  Up until now, Joe has been a rent-payer.  The pandemic and its curtailment of discretionary spending actually accelerated Joe’s savings to the point that at the beginning of the year, 2022 was anticipated to be the year his dream became a reality. On Joe’s average salary and 2% bank rates, he could afford a mortgage of $780,000.  Fast forward to today and bank rates creeping over 5%, he can now only service $630,000.  Almost 20% less.

Joe’s position:

  • The property market will have to decline by 20% which is when he can re-enter the market.  If the property is declining by 1.5% per month, then expect to see Joe at an auction in September 2023

2. Jill the new homeowner.  Jill is in the opposite situation to Joe.  She already bought her first home in 2021, and with interest rates hitting the lowest levels in decades, was able to stretch to get the home she wanted, despite the shocking rise in house prices.  In January, Jill was paying $2,900 per month for her mortgage.  This has since increased to over $4,000.  Jill can afford the rise – but would not be able to tolerate infinite raises.  She’s hoping, and probably right – that the RBA knows this also.

Jill’s position:

  • If interest rates continue to rise at the current 0.25% per month, then in less than 6 months, Jill will be unable to service her monthly mortgage anymore.  She, and many like her, are betting that the interest rate rises will taper and not rise much above another 2% in total before stabilising sometime in the middle of 2023.

3. John got a fixed rate.  John is a long-term homeowner who has changed homes several times, with the value usually depending on his servicing capacity.  Early in the pandemic – he moved house and fixed his new mortgage at ultra-low rates for 3 years.  He’s not perturbed by the daily chatter of rate rises – yet.  His rate still has another 6 months to run so his monthly payments haven’t changed.

John’s position:

  • If 6 months from now, interest rates are the same or higher than today, then John would have to consider a change in property – either relocation or downsizing a little. 

4. Jane the investor.  Jane is an investor. She has a portfolio of properties and is always on the lookout for new opportunities. She was impressed by the high returns that Australian property investors typically enjoy.  Jane felt confident that she could find further good rental properties as the market turns that would provide her with a steady income stream.  However, rental yields are now below debt servicing costs in most investor locations.  No matter how attractive negative gearing sounds, there is a point where Jane will not be able to supplement debt servicing from employment income – especially as the costs of living rise.

Jane’s position:

  • If Jane still holds on to her investment properties for the next year, the higher interest rates will have eaten into her profits, as rental yield have not kept pace with the increased servicing costs. This will force Jane to start selling, as she is no longer able to make a profit from her investment property, or service debt payments.

Trends point to mid term

These are just a few of the behavioural models that could determine when, and by what quantum, the bottom of the market is reached.  Early expectations were for any downturn to be somewhat rapid and short lived.  However, higher interest rates, inflation and stagnating property prices look to be more entrenched than first hoped.  The models described suggest the bottom being further away with longer versions being up to 2 years away.   

Drawing parallels with other historic downturns, there’s still much to be positive about.  Fundamental economic factors remain strong:  Australia is currently enjoying an export boom, and despite the pandemic pausing immigration for 2 years, the ABS logged a positive increase in net migration at the end of the last financial year.  More recently, the government forecasted Australia’s poplulation to hit 30 million by 2033.  Though 2 years later than previous forecasts, these Australians will still need a home to live in.