Will higher interest rates cause property prices to fall?
After more than a decade of interest rate cuts, the Reserve Bank of Australia’s board voted to lift the cash rate target in May by 25 basis points to 0.35%.
The move was widely expected, coming just days after the Australian Bureau of Statistics revealed core inflation rose by 3.7% over the year to the March quarter – well above the central bank’s 2-3% target.
Explaining the move, RBA governor Dr Philip Lowe said “now was the right time to begin withdrawing extraordinary monetary support put in place to help the economy during the pandemic”.
He added: “The economy has proven to be resilient and inflation has picked up more quickly, and to a higher level, than was expected. There is also evidence that wages growth is picking up. Given this, and the very low level of interest rates, it is appropriate to start the process of normalising monetary conditions.”
The brakes are off
While it’s likely to be many home owners’ first-ever cash rate rise, it’s unlikely to be their last, with Dr Lowe signalling further lifts to interest rates in the coming months.
Or, as Westpac’s chief economist Bill Evans puts it, the brakes have now “come off”. Westpac believes the central bank is likely to “front load” its tightening cycle to convince households and businesses it’s committed to returning inflation back to its 2-3% target band.
Accordingly, the bank has pencilled in a series of imminent rate hikes. These include an increase of 0.40 percentage points in June, which would bring the cash rate back to its pre-Covid level at 0.75%.
So Australian home owners will have to brace for more rises to their mortgage repayments – unless, of course, they are on a fixed-rate deal.
But longside the increased borrowing costs looms another big question on many: will higher interest rates put downward pressure on prices?
After all, in its Financial Stability Review, the RBA warned Australians to consider the potential for a drop in property prices, saying a two-percentage-point increase in rates would lower real housing prices by around 15%.
Several commentators, including economists at all the major banks, agree. But some of these people were famously wrong when forecasting a property crash at the start of the pandemic. So are they right this time?
Interest rates and property prices
In Australia, interest rate cuts have historically pushed property prices up – with RBA research finding a one-percentage-point reduction in interest rates boosts property prices by about 8% in the following two years.
Why? Because when interest rates are low, it becomes cheaper to borrow money. This boosts buyers’ borrowing capacity and, typically, encourages people to enter the market. The more buyers there are, the more competition there is, which puts upwards pressure on prices.
So, logically, the inverse should also be true – because higher interest rates reduce people’s borrowing capacity, especially when they are coupled with stricter lending practices.
In October 2021, APRA, the banking regulator, tightened lending rules by instructing banks to increase the “serviceability buffer” they use to assess home loans. As a result, lenders now look at a borrower’s ability to repay a home loan at an interest rate 3 percentage points higher than the actual mortgage rate.
What happened last time the cash rate increased?
The last time the RBA increased the cash rate was in November 2010.
That came at the end of a series of rate cuts, in late 2008 and early 2009, in the wake of the Global Financial Crisis. From October 2009 to November 2010, the RBA then raised rates seven times, from 3.00% to 4.75%.
That rate held steady for 12 months, before being lowered to 4.50% in November 2011.
So what happened to property prices?
Interestingly, the first cash rate hike in October 2009 didn’t cause prices to fall. Rather, prices rose. Why? Dr Diaswati Mardiasmo, chief economist at PRD, believes demand rose because buyers correctly assumed rates would increase even more in the following months.
“Buyers wanted to be able to purchase their property at the new October 2009 cash rate before there were more,” Dr Mardiasmo said.
“It took several cash rate hikes in succession over a period of roughly 12 months before we saw a cooling in price. This suggests there is a time lag between a cash rate hike event and the translation into property prices.”
As the PropTrack graph below shows, at the end of the tightening phase in October 2011, property prices were 6.6% higher than in October 2009.
Interest rates aren’t the only driver
Remember, there isn’t one property market in Australia but dozens and dozens, each at a different stage of the property cycle. So while prices might decline in one location, they might rise in others.
CoreLogic’s April home value index is a great example of this. While Sydney property prices fell slightly over the month (-0.2%) and Melbourne’s were flat, it was a different story in: