High House Prices

High house prices are perhaps the most recognised and easiest to identify of all the housing challenges given the availability of house price data. The affordability problems created by high house prices are also well known, including the need for large deposits and the resultant barriers to home-ownership. However, there is much more debate about why house prices are high and how to fix them.

The most popular explanation and the one underpinning central Government policy is that the long-running under-supply of new homes is at fault. While a lack of new supply may contribute to rising housing prices, a lack of supply is typically seen in the rising cost of housing. It is these two uses of a home that can create confusion: house prices reflect the value of a home as an asset while housing costs reflect its use as somewhere to live.

An asset can be priced by capitalising its income with a discount rate. For a home, the income is reflected by the housing cost (see next section) while the discount rate reflects mortgage rates and alternative investment returns. Under this model a lack of supply would typically be seen in rising housing costs which would then push up house prices via capitalisation.

Instead, if housing costs are fixed, the other way for house prices to rise is changes in the discount rate. The chart below compares a simple model of house prices to actual ones. The model is based on average earnings as a proxy for housing costs and prevailing mortgage rates as the discount rate. The model suggests that falling mortgage rates have had the biggest impact on house prices over the last three decades, though the late 1980s and early 2000s booms clearly require further explanation.

As the local level analysis shows, high house prices are a serious issue across the country. However, it is dangerous to simply assign the challenge of high house prices to a lack of supply, low interest rates or some other cause without assessing other measures such as the cost of housing and demographics.