RDP 2019-01: A Model of the Australian Housing Market 1. Introduction

The Australian housing market shows strong relationships between interest rates, investment, rents and prices. This paper combines these relationships in one – hopefully realistic – model. The model provides internally consistent projections for housing construction, prices and rents. It estimates responses to interest rates, allowing for feedback between quantities and prices. It helps explain historical developments. It can inform housing policy and taxation policy.

These key relationships include:

1. Interest rates, income and housing prices have strong and clear effects on residential construction.
2. Dwelling completions and changes in population explain the rental vacancy rate.
3. The vacancy rate has a strong and clear effect on rents.
4. Interest rates, rents and momentum have large effects on housing prices.
5. Housing prices and construction are mutually determined, so examining bivariate relationships in isolation can be misleading.

Some of these observations are not new. However, most have not been estimated or publicly documented for a long time, if at all. Nor have their interrelationships been explored. This paper aims to fill those gaps. In doing so, we re-examine these relationships in the light of recent research and data. This gives us a system of equations that, for the most part, fit the data fairly closely, are stable across time, and are consistent with theory and previous research. There are some exceptions to this, which we note below.

Our model quantifies some important developments:

• The model suggests that much of the strength in housing prices and construction over the past few years can be explained by the fall in interest rates – some of this fall reflects lower world real interest rates and some is cyclical.
• A large part of the effect of interest rates on dwelling investment (and hence real GDP) occurs through the channel of housing prices.
• The model suggests that an increase in population growth will reduce rental vacancies, boost rents and housing prices, and increase construction. This helps to explain developments following the immigration surge of the mid 2000s.
• The model is consistent with some important longer-run trends. Construction activity is approximately cointegrated (trends together) with income, although the housing stock is not. The rental yield is cointegrated with the user cost of housing. Rents tend to grow slightly faster than inflation but slower than income per capita.