Real Estate

What does high inflation mean for the Australian housing market?

While inflation has implications for housing demand, housing itself influences inflation. By understanding how inflation and housing fit together, the market outlook for the year ahead becomes a little clearer.

ABS figures showed the highest annual rate of inflation in June 2022 in almost 32 years. As we head into the new financial year, annual inflation is expected to peak at over 7%, according to the Treasury and the RBA. This means household budgets will be tighter, savings will be reduced and housing demand will likely be lower.

While inflation has implications for housing demand, housing itself influences inflation. By understanding how inflation and housing fit together, the market outlook for the year ahead becomes a little clearer.

How does the housing market impact inflation?

A good place to start is looking at how housing is factored into inflation (see figure 1). Inflation measures the change in the Consumer Price Index (CPI), which tracks the cost of a basket of goods and services consumed by households, specifically bought from other sectors; governments and businesses.

Because established dwellings are traded within the household sector, the change in established dwelling prices over time is not factored into inflation. Land purchases are also not included, as land is considered an asset, not a consumption good.

Mortgage interest costs were excluded from inflation from 1998, in part, because the RBA started setting interest rates in the early 90’s to target inflation. Continuing to measure interest costs made it difficult to understand the impact of monetary policy on genuine cost pressures in the economy.

The cost of new dwellings purchased by owner-occupier households (minus land value) is included in inflation calculations, as well as changes in rent values. Other property-related expenses, such as rates and charges, property repairs, maintenance and renovations, are also factored in.

The housing component of the consumer price index is given the biggest weight of goods and services in the CPI (around 23%, 8.7% for new dwellings, and 6.2% for rents). This reflects the relatively large expenditure households put toward housing costs. As a result, inflation is heavily influenced by changes in rents, new dwelling prices and utility costs. The annual change in the total housing component of the CPI was 9.0% in June 2022. This was the second-largest increase of the CPI components, behind a 13% surge in transport costs.

Figure 2 shows the rolling annual inflation in the cost of new dwelling construction within the housing category. In the June 2022 quarter, the annual increase in new dwelling costs for households was 20.3% (a series high). This is well above a series average of 3.9%, highlighting the extreme conditions in the housing construction sector.

Building material supplies have been constrained by supply chain disruptions, while the various construction incentives introduced through the pandemic (such as HomeBuilder, and the ‘new homes’ edition of the first home loan deposit scheme) caused a sudden surge in demand. Though construction pipelines and costs are still inflated, the expiry of these government grants has further added to inflation in this category, with grants and subsidies being factored into CPI.

June also saw a 1.6% annual increase in the value of rents.

There is currently a large discrepancy between the CPI measure of rents, and CoreLogic’s rent value index. This is because they measure two different things. CPI rents are measured from a sample of rental properties across private and government housing, to ascertain changes in rents actually paid. The CoreLogic series uses a hedonic regression model across all private dwellings to understand changes in rental valuations.

CoreLogic’s model typically leads trends in rents paid, because it is estimating value based on listings information. This is important, because it can inform future movements in a heavily weighted component of inflation. If CoreLogic’s rent valuations are higher, this indicates households will be facing higher rents actually paid when they go to renew their lease. The fact that annual growth in CoreLogic rental values has shown no signs of slowing, suggests the rent component in inflation could also see further upward pressure in the coming quarters.

The only early indications of a softening in rental growth may be in the combined regional Australian dwelling series, where rolling quarterly growth in CoreLogic rent valuations softened through June and July. It’s early days, but this could indicate rental growth moving through a peak, and a (very) early sign that inflationary conditions could ease as a result.

As overseas migration returns as Australia relaxes travel restrictions, it may take longer for capital city rent growth to slow. This is because many overseas visitors and migrants have housing demand skewed to renting in the capital cities.

Over the past two years, these trends in new builds and rents have contributed to higher inflation. But in turn, the high inflationary environment can impact the housing market in several ways.