Housing first, the economy next?
Tue 14 Apr 2009 by Gareth Kiernan in Construction

Media reports on the housing market throughout 2008 were dominated by pessimism.   But recent property market reports have pointed to some improvement in property market sentiment.   Sales volumes have stabilised, buyers are being drawn back into the market, mortgage rates have been incredibly attractive, and housing has started to become more affordable.

If prospects for the housing market are starting to brighten (and that’s still a big "if"), does that mean the economy will follow suit?   Is there any theoretical basis for believing the housing market gives us any information about the economic outlook?   And what does history tell us about the correlation between property market and economic cycles?

On average, house prices in New Zealand have risen 8.9%pa since 1951.   Nominal GDP growth over the same period has also averaged 8.9%pa.   The similarity is no coincidence – property prices can be expected to match nominal GDP growth over the long run.

Understanding this relationship is perhaps best approached from an agricultural example.   Dairy farm prices are essentially determined by the revenue stream someone can expect to receive from farming the land over, say, the next 50 years.   Broadly speaking, there may be two reasons why that expected revenue stream can change.

Firstly, the dairy pay out may increase.  This price change, if sustained, implies that the return on investing in farmland has lifted.   Recent history in New Zealand has shown that higher dairy pay-outs (eg in 2001/02 and 2007/08) had a positive impact on rural land prices.   This story is simply one of inflation across the broader economy being replicated in land prices.

The second possible factor behind a change in expected revenue is the productiveness of the land.   Improved fertiliser, irrigation, or selective breeding are examples of ways that the output of milk from a farm could be increased over time.   From an economic perspective, these changes are akin to the "real" or "volume" component of GDP growth.   And if we compare real GDP growth with real house price growth (adjusted for consumer price inflation) over the last 56 years, the average growth rates are again almost identical: 2.74%pa and 2.78%pa respectively.

Expected returns make sense in determining farm values, but how does that relate to residential property?   Anew subdivision near Pukekohe, for example, has a clear value related to the expected productive potential of the land.   Existing properties in Epsom are no longer valued on their own productive potential, but instead on the value of Pukekohe land plus a premium for the lower commuting costs (time and money) faced by workers compared to the longer journey from the outskirts of Auckland.

Although this type of relationship holds in the long-term, our graph illustrates that the property market and the general economy may not move together in the short-term.   To determine whether an improving property market gives us any immediate pointers for the economy, we need to examine the micro-level factors currently influencing the housing market.

Net migration plays an important role in demand for housing.   The last few months have seen a drop-off in the number of people leaving New Zealand for Australia, as job opportunities across the Tasman have dried up.   The weak global economy is likely to see annual net migration increase from 6,160 towards 10,000 this year.   Faster population growth does not necessarily imply stronger economic growth, but it is a step in the right direction.

Low interest rates have helped reawaken investor demand.   The effect of lower interest rates on the spending ability of mortgage holders is obvious, but households are currently adopting a cautious approach towards spending.   Increased saving by New Zealand households means that the interest rate stimulus helping the housing market may be less effective in boosting broader economic activity.

A collapse in residential construction work has been a significant drag on GDP over recent quarters.   All other things being equal, higher house prices should start to stimulate more building activity again.   But with fewer developers around, finance for property development difficult to obtain, and residential construction capacity having been eroded over the last 1-2 years, a rebound in house building could prove difficult to achieve, limiting the scope for any positive contribution to economic growth.

Perhaps the biggest contribution a more stable property market could make to the economy currently is by reducing the level of uncertainty.   Fear of the unknown has undermined economic activity over the last year – no one knows how far house prices will fall, how far unemployment will rise, or what lasting effects the financial crisis will have on the global economy.   If house prices in New Zealand start to stabilise, the first of those unknowns will have been resolved.   We’ll be one third of the way back towards a less fearful approach to spending by households and thus more "normal" economic growth.

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