Australian property prices have increasingly diverged from income growth. A long-standing tension between supply and demand is the main cause. The prospect of lower rates will only exacerbate this tension given the relative inelasticity of supply; it takes time to bring more housing online.

S&P Global Ratings believes imbalances between incomes and property prices create economic imbalances. These risks can make households more exposed to property price corrections by increasing the magnitude of market value declines in more stressful economic periods.

We recently published a request for comment to revise our approach for assessing residential loans in Australia, New Zealand, and Singapore. (See "Request For Comment: Global Methodology And Assumptions: Assessing Pools Of Residential Loans (Australia, New Zealand, Singapore)," published on RatingsDirect on March 25, 2024.)

The Widening Gap Between Property Prices And Income

In our view, a multitude of factors are behind the growing gap in Australian house prices and income since 2000 (see chart 1). On the demand side, these include mostly low interest rates, taxation advantages for investment-property ownership, first-homeowner grants, and strong population growth. Against this, planning and zoning restrictions and more recently, higher housing construction costs, and labor shortages have constrained supply.

We estimate that Australian home prices are currently overvalued by around 20%-25%, based on our proposed broad measure that considers current house price-to-income ratios relative to longer-term averages.

Chart 1

Rising Property Prices Relative To Incomes Add To Higher Household Indebtedness And System Imbalances

The widening gap in house price and income growth has also contributed to high household debt in Australia, most of which is associated with housing debt (see chart 2).

Chart 2

Higher household debt increases systemic risks, by adding to economic imbalances. High property prices relative to income could influence how much property prices decline under some economic downturn scenarios. On the surface, it makes households more vulnerable to property price corrections and interest rate rises; it also increases the loss in the event of borrower default during a period of economic stress.

Property Price Growth Is Moderating But Demand Still Outstrips Supply

We expect Australia's property price increases to moderate to around 4% in 2024, as a likely slowdown in the broader economy weighs on housing sentiment. However, the price trend could accelerate again in 2025, given we expect interest rates will start to pivot.

Price appreciation is one factor behind our view that arrears for Australian residential mortgage-backed securities (RMBS) will remain low in 2024. The relatively high seasoning of most loan portfolios, coupled with Australia's prolonged periods of property price appreciation means many borrowers have significant equity in their homes. That can be used to manage consumer financial stress, with over 50% of loans benefiting from property price appreciation of more than 35% across the Australian RMBS sector

Measuring Over- or Undervaluation

Over the long term, house prices generally tend to be positively correlated with income levels. But other factors can also be significant, such as the structural features of the market, mortgage regulation, and prevailing interest rates. These can result in significant house price movements that are not correlated to wage growth.

As outlined in "Request For Comment: Global Methodology And Assumptions: Assessing Pools Of Residential Loans (Australia, New Zealand, Singapore)," we are proposing to incorporate an estimate of over/under-valuation in our market value-decline analysis in the Australian, New Zealand and Singapore markets. This assessment will be informed by an analysis of national data on current ratios of house prices to incomes using various data sources that are available from statistical authorities. This later informs the scale of market value declines we would assume in our rating stress scenarios.

In those RMBS markets where we already apply an estimate for over/undervaluation by application of the Global Methodology And Assumption: Assessing Pools of Residential Loans, we generally estimate the level of over/under-valuation of the relevant property market by comparing the prevailing house-price-to-income ratio against its long-term average.

We overlay these calculations with qualitative assessments of other factors including structural features of the market, mortgage product features, macroeconomic outlook, demographic trends, and policy settings. Such factors help to inform what time horizon affordability ratios should be measured over, and how relevant past performance is to future expectations.

These estimates are designed to look through current property-cycle dynamics to establish a medium-term outlook for housing affordability relative to longer-term averages. Examples of S&P Global Ratings' estimates of over/undervaluation for some European countries are shown in Chart 3.

Chart 3

Property Indexation And Over/Undervaluation

RMBS originators typically provide the original property valuation recorded at loan origination in their loan data files. Under Global Methodology And Assumptions: Assessing Pools Of Residential Loans, we would index this valuation through the date of our analysis, based on updated index information available. The indexation method typically uses publicly available information on house prices in the relevant jurisdiction. The overall effect on a mortgage pool would depend on the valuation date of the properties backing the loans in the pool and its current seasoning.

Changes in our over/undervaluation assessment can lower or increase assumed loss severities by rating category. Similarly, the application of indexation can move overall estimation of loss severity upward or downward.

How Would Over/Undervaluation Affect Loss Expectations For RMBS And Covered Bond Pools?

Estimates of over/undervaluation influence how much property prices could move in certain economic scenarios. A greater correction in property prices is more likely in an overvalued market than in an undervalued one. This is reflected in the explanation of Repossession Market Value Decline (Repo-MVD) as shown in the example below:

In our "Global Methodology And Assumptions: Assessing Pools Of Residential Loans," up to 50% of the overvaluation amount is added to the Repo-MVD, while 20% of the undervaluation is subtracted from the Repo-MVD.

We use a constant percentage of any undervaluation across all rating levels (i.e., 20%). By contrast, the adjustment for overvaluation is linked to a particular rating level, and is highest for 'AAA' ratings. This is because a 'AAA' issue rating typically reflects greater stability than other ratings, relative to a long-term trend in property values.

Our estimates of over/under-valuation would be subject to review on a periodic basis. The over/under-valuation we derive is specifically for the purpose of our RMBS and covered bond ratings. It would not represent a view of the overall property market.

Related Research And Criteria

• Request For Comment: Global Methodology And Assumptions: Assessing Pools Of Residential Loans (Australia, New Zealand, Singapore), March 25, 2024
• Asset Price Risks: Overvaluation Persists For Europe’s RMBS And Covered Bond Markets, Oct. 4, 2023
• U.S. Home Price Overvaluation Continues To Ease But Remains High, Aug. 7, 2023
• Global Methodology And Assumptions: Assessing Pools Of Residential Loans, Jan. 25, 2019