What influences property pricing trends?

While it might be obvious that a household's disposable income plays a key role in shaping property price trends, there are other factors that have to be considered. Private Property spoke to Erwin Rode, whose qualifications and merits include, among others, those of being a property and land economist, professional valuer, and a pioneering property researcher, who outlines the other factors that are driving the current residential property market.

Q: What are the short- and long-term factors that drive house prices and why is it important to understand the difference?

A: The shorter-term drivers are interest rates and consumer disposable incomes. These two determine affordability. When houses become unaffordable to a large section of the population, house prices stop growing, and may even decline.

The long-term factor is building-construction cost. The short explanation for this is: why would you pay R100 for a house that you can erect for R90 (the replacement cost) ? At times, prices would exceed replacement costs when participants in the marketplace extrapolate a few years super growth, thereby creating a bubble (known as irrational exuberance). When the bubble bursts, prices could decline to below replacement costs - depending on the depth of the recession.

Of course, under such a scenario, housing developers cannot sell their stock, thereby creating a serious cash-flow problem. It's important to know that houses age, like anything in this universe; such, that in the long run an existing house's value does not keep up with building (replacement) costs. Does this mean that returns on houses do not beat inflation? No, because total return consists of income return plus capital return. In the case of an owner-occupied house, the income return is of course notional, but you cannot ignore it.

Q: What are the consequences of Environmental Impact Assessments (EIA) on new builds?

A: In a world that has become sensitive to the damage that humans wreak on the environment, EIAs have in principle become unavoidable, although one can quibble about the detail. However, these studies are expensive and take about two years; thus, the unintended consequence is that it becomes more expensive to erect houses.

Q: Household income vs affordability - what do we need to know about how this drives the market?

A: The beauty of the free market is that it is self-correcting. Thus, periods of excessive house-price growth (growth faster than disposable incomes) will inevitably lead to houses becoming unaffordable for a growing number of households.

In successful cities like Cape Town, Melbourne, Sydney, San Francisco, Vancouver and such, this cyclical unaffordability eventually becomes structural (a permanent feature). This leads to political pressure to stop 'gentrification'. You can say super success in an urban area is irreconcilable with affordability for the poor and not-so-poor. Thus, to make a city centre affordable for the poor and not-so-poor, you must first turn the city into a failure. This explains why the Johannesburg CBD does not have a gentrification problem.

The only sustainable solution to this conundrum is to improve access through quality public transport and to encourage economic decentralisation to the suburbs. The latter has fortunately been happening in SA over the past 50 years. To erect an 'affordable' block here and there in a successful CBD like Cape Town, is no substantial solution as you cannot fit all the good citizens of the Cape Flats and Bellville into the CBD of Cape Town - it is physically and economically impossible.

Q: Are there any global formula's that SA can adopt to encourage home ownership in a flat market?

A: No. There is no magic formula. It all starts with jobs and the quality of jobs. But even in developed countries, where there are few jobless people and where the quality of jobs tends to be higher, the problem is as acute. In fact, the problem will get worse as the 4th industrial revolution is going to exacerbate the difference between the rich and the poor as a result of the growing demand for higher-end jobs and the diminished demand for lower-end jobs.

What will help globally is when interest rates are normalised from their zero levels to more normal levels. The exceedingly low interest rates are boosting asset prices - be it stocks or real estate. However, in South Africa our interest rates are 'normal'.

Q: How do we judge the true value of a property - is it really all about 'what a buyer is prepared to pay' or what other neighbouring properties sell for?

A: The 'true' value of a property is known as its fundamental value. The best estimate of the fundamental value of a property is today's cost to erect it new, plus the cost of the land, less depreciation for ageing, plus a reasonable profit for the developer.

During periods of irrational exuberance, psychology does play a role (I must buy before houses become unaffordable). But in the long run, it is fundamental factors as those described above that determine the price. Shorter-term fluctuations are created by interest rates and movements in disposable incomes, which in turn are affected by the state of the economy.

Q: Are you prepared to predict what we can expect to happen in the residential market within the next six months, given the latest repo rate and resulting prime lending rate reductions?

A: The effect of the lower interest rate will be too weak to cancel out the negatives (a tanking economy). Thus, house prices will continue to grow at a rate lower than the inflation rate.

Article Courtesy Private Property