Housing first, the economy next?

Media reports on the housing marketthroughout 2008 were dominated by pessimism.   But recent property marketreports have pointed to some improvement in property market sentiment.   Salesvolumes have stabilised, buyers are being drawn back into the market, mortgagerates have been incredibly attractive, and housing has started to become moreaffordable.

If prospects for the housing market arestarting to brighten (and that’s still a big "if"), does that mean the economywill follow suit?   Is there any theoretical basis for believing the housingmarket gives us any information about the economic outlook?   And what doeshistory tell us about the correlation between property market and economiccycles?

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

Understanding this relationship isperhaps best approached from an agricultural example.   Dairy farm prices areessentially determined by the revenue stream someone can expect to receive fromfarming the land over, say, the next 50 years.   Broadly speaking, there may betwo reasons why that expected revenue stream can change.

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

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

Expected returns make sense indetermining farm values, but how does that relate to residential property?   Anew subdivision near Pukekohe, for example, has a clear value related to theexpected productive potential of the land.   Existing properties in Epsom are nolonger valued on their own productive potential, but instead on the value ofPukekohe 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 holdsin the long-term, our graph illustrates that the property market and thegeneral economy may not move together in the short-term.   To determine whetheran improving property market gives us any immediate pointers for the economy,we need to examine the micro-level factors currently influencing the housingmarket.

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

Low interest rates have helped reawakeninvestor demand.   The effect of lower interest rates on the spending ability ofmortgage holders is obvious, but households are currently adopting a cautiousapproach towards spending.   Increased saving by New Zealand households meansthat the interest rate stimulus helping the housing market may be lesseffective in boosting broader economic activity.

A collapse in residential constructionwork has been a significant drag on GDP over recent quarters.   All other thingsbeing equal, higher house prices should start to stimulate more buildingactivity again.   But with fewer developers around, finance for propertydevelopment difficult to obtain, and residential construction capacity havingbeen eroded over the last 1-2 years, a rebound in house building could provedifficult to achieve, limiting the scope for any positive contribution toeconomic growth.

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

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