A discussion paper issued by the Reserve Bank of Australia this week asked the question, ‘Is housing overvalued?’ and drew the widespread media conclusion that the researchers said renting was better.
The researchers, economists Ryan Fox & Peter Tulip, said if the house price growth rate slipped below the long-term average since 1955 of 2.5%, the average household would probably be financially better off. But they also showed periods when it was definitely better to own.
They are sceptical about claims of extreme overvaluation, saying these claims used equations which were incomplete or had ignored the declining user cost.
They haveargued that the rent-versus-own criterion is useful for assessing housing overvaluation, but warn that most research has been flawed because of faulty comparisons: “We use a new Australian dataset, which includes prices & rents for matched properties, letting us value housing in levels.
“We find that if real house prices grow at their historical average pace, then owning a home is about as expensive as renting. If prices grow more slowly, as some forecasters predict, the framework used in this paper suggests that the average homebuyer would be financially better off renting.
“We decompose house prices into contributions from rents, interest rates & expected capital gains, which may help policymakers in the detection of housing bubbles. Recent data do not show signs of a bubble.
“The decomposition may also be useful to market participants, policymakers & others who need to understand the reasons for house price movements. For example, we find that the boom in house prices in 2002–03 can largely be attributed to expectations of further capital appreciation. That has implications for lending & prudential standards.
“Interest rates & rents have been more important determinants of house prices at other times, with a different set of policy implications. Our estimates can be readily updated, which may assist in the early detection of bubbles.”
The researchers said their findings related to average housing conditions, around which individual circumstances would differ: “For example, a household expecting historically average capital appreciation will be better off owning than renting if it values home ownership for non-financial reasons, if it expects to remain in the house for longer than average, or if it has substantial financial savings that it cannot profitably invest elsewhere.”
The authors said they only examined purchases by owner-occupiers: “Investors make similar decisions, but these are complicated by taxes.”
They also focused only on whether households were financially better off one way or the other, leaving subjective factors aside.
The authors took a quick shot at research based on price:income ratios, citing reports last year by the Economist that Australian house prices were 24% overvalued, and by the OECD, that they were 21% overvalued: “A limitation of the price:income ratio is that its purpose is unclear. Being told that a house is expensive relative to incomes does not tell you whether the purchase is sensible. For that decision you need to know the cost of the alternative.”
However, they added: “The price:income ratio could be used as a guide to future price movements if the series was mean-reverting. But in Australian data, it is not.”
Another popular approach is to compare price:rent ratios to their long-term averages. On this basis, the Economist (2013) & the OECD (2013) concluded that Australian house prices were 46% & 37% ‘overvalued’, respectively. The Australian researchers said: “These comparisons are incomplete. Potential homebuyers look not just at the price of a house, but also at interest rates, running costs and other elements of the user cost of housing. The price:rent ratio is not stationary, but moves with these variables.
“Indeed, the price:rent ratio in Australia has increased over the past few decades, reflecting a decline in the user cost. Unless the user cost is expected to revert to its average, neither will the price:rent ratio.”
The annual cost of owning a home can be written as Cost (in dollars) = P(r + c + s + d – π),where P represents the price of the property; r the real interest rate (a composite of the mortgage rate & the opportunity cost of owner’s equity); c represents other running costs, such as repairs, rates & insurance, as a proportion of the price; s represents buying & selling costs (stamp duty, agent commission etc.), also as a proportion of the price, averaged over the period of home-ownership; d is the physical depreciation rate; and π is the expected real appreciation rate of the property on a constant-quality basis (that is, excluding the effects of improvements & depreciation).
“We are sceptical of estimates of overvaluation at a point in time where expectations are proxied by a short rolling average. This approach leads to conclusions that housing is undervalued at the peak of the bubble.”
The researchers also highlighted the importance of the length of tenure: “Home ownership is more attractive the longer a house is owned, because transactions costs are amortised over a longer period. However, because housing tenure affects the user cost non-linearly, the size of this effect is not obvious.”
The paper shows break-even appreciation rates for varying lengths of tenure in figure 7 (at top of story): “With historical average real house price expectations of 2.4% represented by the green dashed line in figure 7, buying is less expensive than renting for anyone expecting to stay in their house for more than 8 years. This contrasts with a threshold of 10 years using the static model.
“If real appreciation over the previous 10 years (1.7%) is used as a guide (the purple dashed line), buying is less expensive than renting only with extremely long expected tenure (in excess of 30 years).
“Consistent with conventional wisdom, households expecting to move again in a few years’ time are better off renting, unless they believe they can sell the property for an unusually large capital gain.”
In their conclusion, Mr Fox & Mr Tulip wrote: “Real house prices have increased at an average annual rate of slightly less than 2.5% since 1955. If this rate of appreciation is expected to continue, then our estimates suggest that houses are fairly valued.
“That said, many observers have suggested that future house price growth is likely to be somewhat less than this historic average. In that case, at current prices, rents, interest rates & so on, the average household is probably financially better off renting than buying.”
They thought several extensions of their results would be interesting: “First, although our paper only reports results for owner-occupiers, we have also examined whether buying a house is worthwhile for investors. This question is complicated by taxes and we have not found a simple way of summarising this.
“Second, to infer expected capital gains from existing house prices, we assume that the rental premium is constant. Variations in credit restrictions might help to explain variations in the premium over time.
“Third, whereas we have focused on variations in the user cost over time, cross-section variation could explain who owns and who rents.
“Fourth, the implications for lending standards might be worth considering. When financial institutions set loan:value limits, should the denominator be the fundamental value or the market value?
“Fifth, and perhaps of most use to potential owners, would be guidance regarding likely capital appreciation. Related to that, our measures of overvaluation may help to predict future house price growth, but that remains to be tested.”
The bank says its discussion paper series is intended to make the results of the current economic research within the bank available to other economists. Its aim is to present preliminary results of research to encourage discussion & comment.
Attribution: Reserve Bank of Australia.