should we be worried? – Advisor Forbes Australia

The most important fact in the economy right now is not record unemployment or even record inflation of 6.1%.

It is housing prices that, as shown in the chart below, suddenly fall. The RBA’s aggressive interest rate hikes have made mortgages much more expensive and people are responding by pulling out of the housing market, especially the Sydney housing market.

Sydney’s property market was the first to fall. It was also the first place to record a decline in house prices in 2017-18, the last time the Australian property market suffered a correction. Melbourne is hot on Sydney’s heels. In both cities, house price declines are greatest in the expensive segment of the market, which matches exactly the pattern we saw last time: the falls started in the more expensive parts of the market , then spread.

As CoreLogic Research Director Tim Lawless said in May this year: “Historically more expensive housing markets tend to lead the recovery, but also lead the downturn. If we get the same pattern as last time, falling house prices will spread from expensive Melbourne and Sydney suburbs across the country. »

Australian property prices matter

It would be easy to get the wrong impression about real estate prices. Some commentators can only call them important insofar as they divide society, fuel demographic debates or generation wars, pitting baby boomers against millennials, who complain of being excluded from the market.

But real estate prices aren’t just about the headlines. They are a giant moving part of our economy and the first to be affected by any change in interest rates. As a result, the RBA needs to watch property prices carefully because of how it expands its influence over other moving parts of the economy.

Recently, new home loans have skyrocketed, meaning that new borrowers are particularly sensitive to rising interest rates. As the following chart shows, loan sizes have changed significantly over the past two years as interest rates have fallen. The average homeowner’s mortgage starts at over half a million dollars in Australia, largely thanks to Sydney’s incredible property market:

It is these new borrowers who have the most to repay and who will suffer the most from rising interest rates. In addition, new borrowers who had a minimum deposit are most likely to find themselves underwater when house prices fall, i.e. owing the bank more than the value of the home. Even if you had a 20% down payment, if the market value of your new home drops more than 20%, you’re underwater. And some buyers start with even smaller deposits.

Australians are inclined to continue paying off their mortgages when they owe more than the house is worth, RBA search found. We don’t tend to default like US borrowers do when they’re in trouble. This means that banks are relatively safe even if property prices fall. With one exception: if there is also a big economic calamity that puts a lot of people out of work, it can change the tendency of Australian borrowers to continue paying the mortgage.

The combination of being underwater and losing your job is enough to trigger faults. This is the other key reason why house prices are so important.

Falling property prices can trip the entire economy

The national economy is made up of 24% investment (purchase of machinery, construction of new warehouses, construction of new roads) and 76% consumption (payment of dentists and lawyers, payment for cleaning and deliveries, as well as consumables such as fuel, food, etc.). House prices are an important driver of both, but they drive consumption first and faster.

It works in two main ways

  1. Consumption effect. Property trade causes consumption. When you sell a property, you can pay a painter and landscaper to spruce things up. When you buy a property, you pay real estate agents, mortgage brokers, conveyancing brokers and moving companies. Then you’ll often get trades to fix a few small aspects of your new location. And finally, you will often get new furniture. When many houses change hands, the cash registers ring at Harvey Norman.

When property prices rise, people trade for more properties: sellers are eager to come on the market, places stay on the market for a short time, and people want to buy before prices rise further. The reverse is true when house prices fall. The rise in real estate prices therefore leads to consumption in a very direct way.

However, although the impact on consumption is strong, it only applies to the small proportion of people who buy or sell a house each year. There is another, even more important effect, called the wealth effect, which applies more broadly.

  1. Wealth effect. When people’s homes increase in value, they feel richer and therefore spend more. The effect is greater the richer people are, and the wealth effect therefore applies more strongly to older households. They’ve been lucky recently, but that luck is turning now.

The RBA is, as I mentioned earlier, terrified that falling property prices could bring down an economy. A sharp fall in real estate prices triggers a significant wealth effect that compresses consumption. This in turn can drive up unemployment, which of course makes it even harder for people to repay their home loans.

Rising interest rates: how much is too much?

The interest rate hikes that the RBA is triggering right now have to be very carefully calibrated. The perfect amount of rate hikes will lead to lower inflation and simple modulation of house prices. But too much could drive down property prices and drag the economy down a hard-to-reverse descent with it. Especially when the federal government has a lot of debt and is less likely to come to the rescue with spending.

Interest rate hikes take a long time to have their full effect on the economy, so this year’s cuts will put the brakes on things again in 2023. Will the RBA go too far and crush by inadvertently the Australian property market and the economy with it? Time will tell us.