What's The Likely Impact of Further Interest Rate Cuts on Australian House Prices?

The Reserve Bank is poised to cut official interest rates by year’s end, and it’s increasingly likely that we’ll get a second cut within 12 months. What’s less clear are the effects of the cuts on Australia’s capital city housing markets.

RBA interest rate cuts have historically pushed property prices up, while interest rate rises either slowed price growth or caused prices to fall.

In the current climate, lower rates are likely to have an impact on prices, but the impact will be significantly smaller than in the past. Conditions have changed considerably since rates were last cut in 2016. Most notably, stricter bank lending rules mean lower rates will not allow potential borrowers to get more finance.

Interest rates have been a key driver of property prices

Lower interest rates, due to financial deregulation and lower inflation, were a major contributor to the significant increase in property prices over the past two decades. More recently, price growth in Sydney and Melbourne re-accelerated in late 2016 following RBA cash rate cuts in May and August 2016. Over the 2011 to 2016 period, the RBA cut the cash rate from 4.5 per cent to 1.5 per cent and the national median dwelling price increased by 60 per cent.

Recent RBA research highlighted that interest rates were a major driver of the recent east coast property price boom. The research found that a one percentage point reduction in interest rates boosts property prices by about 8 per cent in the following two years. International research has also found that interest rates have a significant effect on property prices.

Although interest rates are important, they are not the only factor influencing housing prices. Tax settings, banking regulation, population growth, income growth and the responsiveness of new housing supply to growing demand all influence property prices.

Interest rates paid by households are influenced by the RBA, market forces and the banking regulator

Interest rates paid on a home loan are primarily affected by the RBA cash rate, which in turn is adjusted depending on the state of the economy.

Market forces also influence interest rates – higher bank funding costsled to banks raising rates in September last year. The banking regulator, APRA, can also influence interest rates. The cap on interest-only lending introduced in March 2017 to restrict risky lending to investors resulted in a big increase in interest rates for interest-only loans.

Mortgage rates are likely to fall in 2019 due to an RBA interest rate cut

A weaker economic outlook, ongoing low inflation and a growing likelihood of a rise in unemployment all point to the RBA cutting interest rates this year.

The financial market implied forecast of the cash rate predicts a 25 basis point cash rate cut by September, with a second cut expected in early 2020. Most economists also expect the RBA to cut the cash rate in the year ahead.

If these predictions prove correct, the cash rate will be at a record low of 1 per cent by early next year.

It’s likely that most of the cut to the cash rate will be passed on by banks. However, there is a risk that banks may pass only a part of any reductions in the cash rate, due to deposit rates already being close to zero, and because bank funding costs could rise.

Overall, it’s likely that over the next year or so interest rates on a home loan will fall by about 30 to 50 basis points, bringing the typical rate down to around 3.5 per cent.

Indeed, the expectation of falling interest rates has already resulted in banks reducing interest rates on fixed-rate home loans.

How cuts will support prices

Lower interest rates will still provide support to prices, but the impact of lower rates will likely be smaller than in the past. Interest rates affect property prices via a number of channels.

Lower interest rates:

• Make future rental income more valuable (a higher “net present value”), which makes property a more attractive asset for investors;
• Boost cash flows for borrowers (and prospective borrowers) after interest payments, enabling borrowers to take on higher debt levels. Lower interest rates also enable greater spending on other goods and services, stimulating economic activity;
• Give borrowers the option of taking on extra debt to buy another property as they can pay off debt faster;
• May turnaround investor sentiment, and be a trigger for some investors to return to the property market, although investors currently cite access to credit as a primary reason for not investing;
• Will help shift market momentum. Property prices are partly driven by momentum, which means price falls are likely to lead to further price falls. An interest rate cut will at least slow property price falls, which will reduce the effect of momentum pushing prices lower;
• Will lower the Australian dollar slightly, making Australian property cheaper for overseas investors. However, this will have only a slight impact on prices as foreign investors are required to buy new properties, and many factors influence foreign investment  (for example fees and taxes on the purchase of residential property).

Why cuts won’t have the same impact as in the past

But there are a few reasons lower interest rates may have a smaller impact on property prices than in the past.

Most significantly, the way banks are required to calculate mortgage serviceability has changed. As a result, a reduction in mortgage rates won’t increase the borrowing capacity of potential borrowers, meaning they may not borrow more to spend on a property – serviceability is the ability of a borrower to make loan repayments.

APRA now requires banks to consider how a borrower would make repayments if interest rates were two percentage points above current rates or above the minimum floor of 7 per cent, whichever is higher (the interest rate floor used to be based on the average mortgage interest rate over an interest rate cycle). Because most borrowers pay an interest rate of about 4 per cent, the minimum floor of 7 per cent is currently the relevant benchmark. When interest rates were higher, the constraint was the two percentage point buffer, meaning a cut in the cash rate would lead to a reduction in the rate used to calculate serviceability. So even if the cash rate is cut to 1 per cent, lenders must still assess whether a borrower can meet repayments at a 7 per cent interest rate. (There has been some commentary about whether this 7 per cent floor might be lowered, but APRA has stated that this minimum rate will remain).

But even though the maximum loan size for prospective borrowers won’t increase if the cash rate is cut, due to the minimum 7 per cent serviceability rate, borrowers may still be willing to borrow more. Knowing that banks are more conservative and that interest rates are expected to fall and remain low, borrowers may now be more willing to borrow closer to the maximum amount they are offered. RBA researchhas found that only about 13 per cent of borrowers loaned close to the maximum amount they are offered, so a change in behaviour could mean this share rises (the maximum amount a potential borrower can borrow has fallen by about 20 per cent due to tighter lending practices).

Other reasons might be that as household debt is at a record high level, households may not be keen to borrow more even if rates were reduced. But because lower rates reduce the burden of debt and the debt-to-income ratio is stabilising, this may be only a minor factor.

It’s also a possibility that the positive investor sentiment effect described above may be smaller than expected due to Labor’s proposed changes to negative gearing, which are aimed at reducing investor demand for established housing. But offsetting this is that investor demand may be brought forward into the second half of 2019 as investors seek to buy established properties before the negative gearing rules are tightened (if Labor wins the upcoming election).

The most likely outcome

There have been substantial changes to the bank lending environment over the past few years. However, lower interest rates will still provide support to house prices, but the impact is likely to be smaller than in the past. In cities like Sydney and Melbourne, a cut will likely mean either a slowing or an end to price falls, while in cities like Hobart and Canberra, a cut may provide a boost to price growth.