Likelihood of ‘significant correction’ in house prices has increased, Reserve Bank says

The likelihood of a “significant correction” in the housing market has increased and the government’s recent property investment tax changes is one of the factors behind it, the Reserve Bank says.

Speaking after the release of its six monthly Financial Stability Report deputy Reserve Bank governor Geoff Bascand said it believed there was a greater risk of a correction than a number of years prior.

“It has been building a little with house prices rising. The challenge is whether house prices move ahead of the fundamental drivers before that.”

Bascand said what it had seen recently was population growth starting to slow, increased house building and the government announce a number of tax policy changes as well regulatory initiatives instigated by the Reserve Bank itself.

“We think the fundamental drivers for long term house prices are probably softening and in which case if prices move in the opposite direction the chance of correction is higher.”

“It is not a flashing red alert but it is a concern and what we are expressing is a desire to see some stabilisation.”

House prices have risen 24 per cent in the year to March, a rise much higher than that seen in other countries.

The RBNZ report said house prices appeared to be “stretched” by several metrics including house price to income ratios and the affordability of entering the market.

Its data shows the 20 per cent deposit on a median priced house has risen from around $135,000 in 2004 to over $220,000.

The Reserve Bank report noted resilient household incomes, bolstered by wage subsidies, strong migration flows prior to the border restrictions and low domestic interest rates had all contributed to the recent surge in demand for housing.

“The cost of servicing a new mortgage compared to renting remains relatively low, and the rental returns based on concurrent house prices have declined to a lesser extent than
long-term risk-free rates in recent years. These factors point to a degree of sustainability in the current level of prices.”

But it said the current demand and supply conditions may prove temporary and were subject to uncertainty citing the example of mortgage interest rates.

“…the future path of mortgage interest rates depends on the evolution of inflationary pressure and adjustments of the monetary policy stance at home and abroad relative to neutral rates, as well as credit risk in the housing market. Estimates of trend interest rates
are higher than current levels…”

The report also cited that the Government’s March 23 announcements to extend the bright line property tax and the phased removal of interest expense deductibility would over time reduce the returns on property investment, particularly at high levels of leverage.

“Taken together, the various downside risks to house prices mean that the likelihood of a significant correction has increased.”

The report also noted that a longer-run determinant of the house price level was “inelastic housing supply”.

“If land development and construction could respond effectively to price signals then any change in demand would have only a short-lived effect on house prices. Ultimately, for the housing affordability problem to be resolved, policy constraints on supply need to be addressed.”

The report warned that New Zealand households face significant risks in the medium term including the potential for higher debt-servicing costs and a significant decline in house prices which could amplify an economic downturn.

Higher house prices have boosted home-owners’ equity but has also driven household debts higher with mortgage lending growing 10 per cent in the year to March 31.

At the same lending standards have slipped.

“…the resurgence in mortgage lending growth has occurred alongside an easing in origination standards.The serviceability test rate levels that banks use to assess new borrowers have generally declined over the past year.”

New mortgages taken out in the last two years now make up 30 per cent of mortgage lending and the Reserve Bank says newer borrowers are more vulnerable as they have repaid less principle and have seen smaller equity gains.

The size of new mortgages relative to borrowers’ incomes has increased with the share of new investor lending with a debt to income ratio above five rising to 69 per cent in the March quarter from 55 per cent a year earlier.

The share of high debt to income ratio lending for owner-occupiers had also risen but off a low base.

Meanwhile the share of new lending on interest-only terms had trended down over time.

Reserve Bank estimates suggest for a typical recent owner-occupier borrower an increase in the one year mortgage rate to 5 per cent – it is currently around 2.25 per cent – would increase their debt servicing ratio from around 30 per cent to above 40 per cent.

“Large increases in debt serviceability burdens can produce negative feedback effects on the economy, as highly indebted households reduce their consumption spending and distressed borrowers default on their loans.”

Bascand said a high proportion of new lending had been done at high debt to income and loan to value ratios which made recent borrowers more vulnerable to a rise in mortgage rates and exposes households and the financial system to a fall in house prices.

“We will be watching how market conditions respond to the Government’s recent policy changes. If required, we are prepared to further tighten lending conditions for housing using LVR requirements or additional tools that we are assessing,” he said.

The Reserve Bank is assessing four policy options for addressing the issue of sustainable house prices; further LVR tightening, restrictions based on debt to income, restrictions on interest only lending and changes to sectoral capital requirements.

The report noted that if further tightening in policy settings was needed in the short term the easiest approach would be to tighten LVR restrictions further.

“However the marginal benefits are likely to decline as LVR restrictions tighten further while efficiency costs would rise.”

Instead it viewed the best option as a debt serviceability tool. This could come in the form of debt to income lending restrictions which would limit how much someone can borrow based on their income.

“Restrictions on interest-only lending would likely have less impact on overall lending conditions than the alternative, while being challenging to implement.”

The Reserve Bank already collects data on DTIs but said further work would be needed to finalise the design of the tool and update bank systems.

It estimates it would need a six month lead in to implement the tool.

Bascand said it would be reporting to the minister in the coming months on the options.

For now it was in a watch and see phase on how current measures would play out, he said.

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