The New Zealand housing market may now be overvalued by as much as 40%, with an increasing risk of a sharp correction in prices, according to finance house First NZ Capital.
First NZ director of economics and strategy Chris Green in a comprehensive NZ House Prices Strategy Update has gone back years through house pricing data and come up with three potential scenarios on the future direction of house prices – with the “medium scenario” suggesting a possible 11% drop in prices over a period of about two-and-a-half years up to June 2018.
Green said that “despite the popular perception that the NZ house prices continuously increase” there have been six episodes of declining real annual house prices since the March 1970 quarter, as the graph below shows.
“In modelling NZ house price scenarios, we have used as a guide the historical cycles in quarterly real house prices going back to the March 1970 quarter.
“As a starting point, we assess that given the recent rapid acceleration in NZ house price growth, the elevated starting point for NZ house prices, together with the broad range of metrics suggesting reasonably substantial (30-40%) overvaluation, then the housing market risk assessment is skewed towards the downside. Against this backdrop, we have prepared three house price scenarios; a high, medium and low.”
The next two graphs below (Figure 59 and 60) highlight the projected impact of these scenarios.
“Under the medium term house price scenario, we attempt to take some account of the currently assessed overvalued characteristics of the NZ housing market,” he said.
“As a guide to the likely duration and magnitude of a potential housing market correction, we have looked at past cycles of housing market downturns. From this analysis we have observed that the average and median duration of a downturn has been in the order of 9-11 quarters in length. As such, we have assumed a downturn duration consistent with the middle of this range of 10 quarters from peak to trough.
“Similarly, in terms of the magnitude of the potential decline, we have used as a point of reference the average and median real price movements in previous downturns, which have been in the range of 8-13%. Using this as a broad guide, we have assumed a real medium house price decline of 11% from peak-to-trough – this decline is also very similar to the estimated magnitude of the decrease of an evenly weighted average of the three house price scenarios,” Green said.
“From this trough in the house price cycle in the June 2018 quarter, we have then joined on the medium to long-term quarterly house price track used in the high house price scenario, ending up with the same equilibrium annual growth rate by the end of the forecast horizon of 4.5% YoY.”
Green said that on the basis of First NZ’s “five fundamental house price valuation metrics” (see graph below), the average and median estimates of these measures suggests the NZ housing market to be significantly overvalued by around 30-40%.
“While we readily acknowledge that there are fundamental economic factors which have underpinned recent house price growth, our analysis suggests that the recent acceleration in growth rates has moved house prices – particularly in the Auckland region – to levels in which there is an increased risk of potentially a sharp correction.”
In looking at the duration of real house price cycles since 1970, the latest upturn thus far to the September 2015 quarter was around both the average and median length of 17 and 19 quarters respectively. In terms of the magnitude of the current upturn, the rise in real house prices to date of 38.9% (see graph below) was also around both the average and median increases recorded over the previous six cycles of 41.3% and 37.9% respectively, Green said.
“We assess that given the recent rapid acceleration in NZ house price growth, the elevated starting point for NZ house prices, together with the broad range of metrics suggesting reasonably substantial (30-40%) overvaluation, then the housing market risk assessment is skewed towards the downside.”
Green said that one of the anomalies of the recent house price cycle was that rents have remained relatively less volatile, largely ignoring both the rapid rise in house prices over most of 2000’s, and more recent decline over the 2008-09 period, together with the rapid acceleration in house prices experienced over the past year.
“In particular, the house price-to-rents ratio has continued to increase and is currently estimated to be around 82% above its average level. However, we suspect that this housing valuation metric is distorted by the significant government intervention in the NZ housing market.
“In particular, estimates suggest that around 60% of all rentals in the NZ are subsidised by the Government, one house in every 16 in Auckland is a Housing NZ property and around NZ$2bn is spent on accommodation subsidies. This intervention is likely to dampen rents and therefore result in some unquantified degree of additional overvaluation in the house price-to-rent ratio metric.”
Green said that relative to house price upturns, the duration of downturns is somewhat shorter, with the average and median downward cycles of 11 and 9 quarters respectively.
“Moreover, the past housing market downturns have seen prices fall by an average of 13.3%, while recording a median real decline of 8.4%. However, it should be noted that together with a reasonably small sample set of downward cycles, the range of declines is relatively wide, with the smallest cycle decline being a modest 3.9%, while in contrast the largest real house price cycle has been a substantial 39.2%.”
Green said that on the basis of the past six cycles, the ratio of the total size of the downturn relative to the magnitude of the preceeding upturn averages around -0.5 over the past six cycles, while the median ratio is around -0.3.
“On the basis of this rule-of-thumb reversion estimate, this suggests that major house price upturns tend to be followed by downturns which historically have retraced around 30-50% of the rise. Using these ratios as a simple guide and assuming that the increase in real house prices of 39% until the September 2015 quarter represents a peak in the current cycle, then this implies a potential real decline using the average and median estimates of around 12-19%.”
*An early version of this article had ‘First’ and ‘NZ’ transposed in the headline. Apologies for the error.