As we all know, house prices have gone up massively over the last couple of decades, and much faster than inflation. On the other hand, rents haven’t gone up so quickly – lucky for the 35% of Kiwis (or 38% of Aucklanders) who don’t own the home they live in.
As someone with more than a passing interest in inflation, rents, yields and prices, I’ve thought for a long time that the growing gap between rents and house prices must have a lot to do with the switch from a high inflation environment to a low inflation one. It’s exactly what economic theory would predict. And luckily, another economist, Rodney Dickens, has come along and taken a look at it (hat tip to Bob Dey for the link).
First, some background. Up until the 80s, New Zealand often had very high inflation, as per the chart below:
Inflation was particularly high through the 1970s (oil prices sustained at much higher levels than ever before, plus the switch to a floating exchange rate, and various other factors besides) and the 1980s, except for a brief period in the 1980s where Muldoon thought price freezes were a good idea. The 1989 Reserve Bank of New Zealand Act put a new focus on inflation targeting, and it wasn’t long before inflation rates dropped to well below 5% a year, where we’ve been more or less ever since.
Unsurprisingly, mortgage rates tended to follow a similar pattern to inflation, although they didn’t fluctuate as much:
Floating mortgage rates topped out at more than 20% in the late 80s, and fell dramatically through the early 90s. They’ve stayed below 10% for most of the time since.
So, if you’re an investor in the 1970s, and inflation is at 15%, and you can borrow money at around 15% (or put it in the bank and earn at least 10%), what kind of return do you expect on your rental property? You might expect a yield, or return, of 20%, say. Flipping that around, the property value is five times the net rent you receive.
OK, so now it’s the 2000s. Let’s put aside thoughts of capital gain for now – assume you just want a fair return on your money. You can borrow it at 8%, and put it in the bank at maybe 5% or so. Property seems like a fairly safe investment, so perhaps you’d be happy with 6% return. That means your property value is now nearly 17 times the net rent.
Of course, we wouldn’t expect the runup in asset values to happen just for property. We’d expect it for all types of income-producing asset – shares, capital goods, human capital. You’ll see it as a drop in yields for these assets, as for Rodney’s graph below, which shows yields both for residential property and for government bonds:
As Rodney says:
“CPI inflation has been consistently lower since the early-1990s. In the first house price boom after 1990 – between 1994 and 1996 – rental price inflation increased much as had been the case earlier. But it would seem that by the time of the 2002 pickup in house price inflation the low inflation environment had taken over. It would appear that landlords began to struggle to justify or achieve higher rental inflation in an environment of sustained low general inflation.
This new, inflation-constrained behaviour is reflected in CPI and rental inflation living in similar ballparks since after the government interventions resulted in rental inflation turning temporarily negative in 2001. The result was that the relationship between house price and rental inflation largely broke down”.
He goes one step further, and looks at an issue closely related to housing affordability, as Stu has written before. Here’s Rodney on the issue:
This can also be viewed from the perspective of rents compared to incomes. This is another means by which lower general inflation, including lower income growth, will put a ceiling on rental inflation. The [chart below] compares the ratio of the national average house price to the average annual gross income (black line) with the ratio of the average national annual gross rent to the average annual gross income (blue line).
Prior to 2000 the two ratios largely moved in synchrony while since then the rent/income ratio has fallen and the house price/income ratio has skyrocketed.
I quite like the way Stu puts it: housing is a commodity like anything else, and “you don’t measure the affordability of cookies based on the cost of buying the cookie factory”.