The Impact Of Interest Rates On The Property Market

Yesterday, the RBA handed down yet another rate hike to borrowers, with the decision marking the 12th increase in the cash rate since May last year. In the same week, new figures from CoreLogic revealed that national home values rose by 1.2% in May; the sharpest monthly rise since the property market surged in 2021.

Traditionally, property prices have been closely linked to the rise and fall of interest rates. 

Low rates encourage greater levels of consumer borrowing and spending, thereby fuelling market activity and driving up the demand for property. Higher interest rates have the opposite effect by tightening household budgets and restricting the borrowing capacity of hopeful homebuyers.

This trend was evident during the first two years of the pandemic. Spurred on by a record-low cash rate of 0.1 per cent, property prices skyrocketed to unseen levels throughout 2021, with the median house value in Melbourne surpassing $1 million for the first time in history.

But, amid soaring inflation, the Reserve Bank of Australia was soon forced to ramp interest rates up swiftly, leaving property prices to fall at the sharpest rate in many years.

Fast forward to 2023 where property prices have displayed surprising resilience in the face of continued rate hikes. Over the last three months, the median home value in Melbourne has risen by 1.6 per cent, a notable turnaround following a near 10 per cent decline over the preceding calendar year.  

In this article, we wanted to look at what is causing this unusual trend and whether interest rates play an overstated role in shaping the property market.

A game of supply and demand

Just like any other market, property prices are primarily influenced by the interplay of supply and demand. When home values are rising, it signifies that the current demand for property is surpassing the available supply of housing.

As interest rates rise, consumers face limitations in the amount they can borrow, resulting in fewer potential buyers with the means to afford property. This leads to a decrease in demand and, in theory, a decrease in the price of property.

However, whilst interest rates are an important part of the property price formula, they only affect half of the equation. 

Australia is currently experiencing a housing supply crisis as inventory levels hit record lows across the country. Recent CoreLogic figures have found that inventory levels in May were 24.4 per cent below the previous five-year average, and 15.3 per cent lower than the same time last year. In the capital cities alone, stock levels are at their lowest point in over 15 years.

This crisis has been caused by a number of factors.

The first of these can be put down to general hesitancy from sellers. As national housing values fell 9.1% between May 2022 and February 2023, many sellers have opted to hold off from selling their homes with the plan to sell at a better price once the market recovers.

Another big factor has been the turmoil the construction industry has endured since the pandemic began. Rising costs, supply issues and a labour shortage have led to the collapse of both minor and major builders, leaving less capacity for new constructions and housing projects to get underway. 

Demand is also on the rise, largely driven by the return of strong immigration numbers into our capitals. Following a hiatus in overseas migration during the COVID-affected years, the gradual processing of pending visa applications, coupled with a prevailing labor shortage, is anticipated to generate unprecedented levels of immigration in the coming years. According to data from the Australian Bureau of Statistics, approximately 85 per cent of Australia's net overseas migration is directed towards urban areas, with only 15 per cent for the regions.

These conditions have led to a seller's market once again, where the limited supply of housing outweighs the affordability constraints faced by buyers.

The traditional effect of interest rates on property values

Over the past two decades, a clear correlation between property prices and interest rates emerges when looking at property data.

With the exception of the Global Financial Crisis in 2009 and the onset of the pandemic in 2020, Australian housing prices have typically displayed robust growth during periods of declining interest rates, while tending to slow down when rates have been tightened.

Research from Domain in March found that for every 1 per cent rise in mortgage rates, Australian house prices fell by 1.34 per cent. This is pretty significant, especially considering Australian housing prices have grown by an average of 7.25 per cent annually over the last 30 years.

Other major factors during this period include the tax changes brought in by the Howard Government that aimed to incentivise investment in property. The government's decision to reduce the capital gains tax rate by half in 1999 triggered a surge of investment loans that continues to impact the property market to this day, playing a substantial role in driving demand.

But whilst these factors play a part, Australia’s ever-growing population has arguably been the biggest force behind property prices. Domain’s research found that for every 1 per cent increase in Australia’s population, cumulative house prices rise by 8.18 per cent. 

An expected 1.8 million new households will be created over the next 10 years, which is set to leave further housing shortfalls as the supply of new builds continues to dwindle. The NHFIC predicts that the number of apartments and medium-density dwellings brought into the market in 2025-26 will be 30 per cent below pre-pandemic levels. With this trend expected to continue over the coming decade, Australia appears ill-equipped to keep up with the needs of our growing population.

What to expect in the coming months

Where interest rates and property prices go from here is hard to say.

Almost all economists and industry experts have struggled to predict property and finance trends since the beginning of the pandemic in 2020.

In an article we wrote at the beginning of the year, we noted that none of the big four banks forecasted the cash rate to exceed 3.85 per cent. As of yesterday, the target sits at 4.1 per cent, and we don’t appear much closer towards the RBA’s goal of getting on top of inflation. With the industry's leading experts struggling themselves, we certainly can’t offer a definitive prediction over future interest rates.

Property prices, however, look set to continue their steady recovery for the time being. 

Whilst it will likely be some time before the property market reaches the same dizzying heights of 18 months ago, the historically low supply of housing is expected to continue tipping the market in favour of the seller.

The cost of property in Australia has never been more unaffordable and, if both interest rates and housing values continue to rise, this trend will only worsen.

If you’re looking for any assistance in navigating the recent rate hikes or with your next home loan application, please reach out to a member of our finance team.