Will high interest rates cause our property markets to crash?

A reporter from a major daily paper recently asked me recently what I thought of the latest doomsayer economist who was predicting the property market was going to crash. I think I shocked him when I agreed saying, “He is right – our property markets will crash.” Then I went on to say, “but not in the next few years and not by the predicted 30 or 40%.”

You see, all property booms pave the way to the next property downturn, just as every property bust sets the scene for the next boom.

So let’s look at the most likely scenario for the property markets over the next few years and what factors will cause this property cycle to end and, as a property investor, what you should do about it.

Property booms occur because demand outstrips supply, as has been occurring for the last 18 months, with strong population growth and an undersupply of property, but eventually one of four factors tends to bring the property cycle to a halt. These are:

1. A recession – and nobody thinks this is likely in Australia over the next few years.
2. High unemployment – and homeowners can’t afford to keep up their mortgage payments. Again I think you would agree this is unlikely over the next few years.
3. An oversupply of properties – with Australia’s housing shortage this is unlikely to be the catalyst for the next property downturn, but I am concerned about the number of inner city high rise apartments that are coming on stream in Melbourne and Brisbane in 2012.
4. High interest rates – this is the most likely factor that will end this property cycle.

So the questions savvy property investors are asking are: how high will interest rates need to go to stifle the market, when will this occur and what should I do about it?

The simple answer is that interest rates of about 9% (which would equate to an RBA cash rate of about 6.5%) would most likely stop property investors and homeowners in their tracks. Interest rates won’t have to rise to 20% like in the 90s because with our inflation rate at 3% or so, interest rates of 9% will have the same effect as those higher rates had when inflation was rampant in the 80s and 90s.

When will this occur? According to the BIS Shrapnel’s Long Term Forecasts report, the Australian economy will rebound and inflationary pressures will force mortgage interest rates above 9% within three years.

The economic forecasters predict that economic growth will accelerate to average 3.8% annually between now and 2013 and that our unemployment rate, which currently stands at 5.3%, will fall below 4% by early-to-mid 2013.

BIS Shrapnel senior economist Richard Robinson explains that tightening labour markets and increases in household spending will lead to a higher CPI. This in turn will prompt the Reserve Bank to raise interest rates and Robinson forecasts that the cash rate is likely to reach 6.5%, up from its current level at 4.5%. And with the margins the banks put on this, the interest rates that homeowners will need to pay will push up to above 9%.

In the report Robinson explains: “We still have a number of critical policy issues that need to be addressed, including a serious housing shortage, ongoing infrastructure deficiencies and bottlenecks and, of course, a skills shortage.”

He says these issues will lead to inflationary pressures, which will almost certainly result in higher interest rates.

The good news is that property investors and homeowners can expect the value of their property to surge over the next few years as our economy flourishes, wages rise and inflation increases.

Robinson agrees saying that the current undersupply of housing is not likely to be addressed, given that mortgage rates are already around neutral levels. The resulting combination of significant pent-up demand, strong rents, rising incomes and an easing in funding for property developers is expected to sustain a recovery in housing activity over the next two to three years.

So will our property markets crash in a few years time?

I don’t think so. In Australia excesses in house prices are usually corrected by house prices remaining flat for awhile rather than property values crashing.

It is unlikely that we will be in recession, there will not be rampant unemployment and our housing markets will not be in oversupply. But high interest rates will make houses unaffordable for many would-be home owners and will stop investors buying further properties.

Robinson also predicts that the housing market will enter a “controlled downturn” by 2014 once higher interest rates take hold. “Labour shortages and a synchronisation of construction cycles will lead to a build up of inflationary pressures… and the RBA will be forced to respond,” he says.

This is just the way previous property cycles have behaved – there’s nothing new here.

The take home message is that the window of opportunity is closing, so take advantage of the current property cycle and be prepared for the inevitable downturn.

Of course, you can’t just buy any property and hope it does well. Some properties are going to out-perform others over the next couple of years. Properties close to infrastructure, close to but not in the CBD, close to amenities and lifestyle facilities and water will grow in price significantly more than those in outer areas, which will still be hurting from relatively high interest rates and affordability.

Michael Yardney is the director of Metropole Property Investment Strategists, a best-selling author and one of Australia’s leading experts in wealth creation through property. For more information about Michael visit www.metropole.com.au and www.PropertyUpdate.com.au.