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House prices in some Australian capital cities have risen sharply in recent years, especially in Sydney and Melbourne.

It’s stirred a feverish debate in the community as to whether prices are in a bubble, and prone to a significant correction. To some, the bigger the price gains have been, the larger they will fall.

While that debate looks set to rage for some time yet, few will disagree that house prices are expensive across many parts of the country.

These charts from JP Morgan underline that point, looking at a variety of valuation metrics to show how expensive house prices are compared to what’s been seen in the past.

The first shows price-to-income (PTI) ratios for Australian capital cities, simply the median price for a property compared to median household incomes in each city.

Source: PTI

Unsurprisingly, the PTI for Sydney and Melbourne has grown rapidly in recent years, diverging from the levels seen in other capitals.

Sydney’s PTI stands at 9.5 times income, up 39% over the past five years. Melbourne, at 8.7 times income, has also risen strongly, lifting by 30% over the same period. In comparison, PTIs in other capitals have been largely steady, or actually gone backwards in Perth and Darwin, Australia’s mining centres.

Henry St John, Australian and New Zealand Interest Rates Strategist at JP Morgan, says that Australian PTIs are both by historical standards and relative to other countries, something he says is “often cited as a cause for concern”.

“If house prices deviate persistently above residents’ ability to pay for them, it suggests a speculative rationale for buying a property,” he says.

Other valuation metrics, such as price-to-market rents ratios (PTR) — the price of a home compared to annual cost to rent it — are also increasing in many capitals, indicating that prices are rising faster than rents.

Source: PTI

Again, like the PTI ratio, the strongest gains in the PTR ratio have been in Sydney and Melbourne.

“As the RBA has eased steadily since 2011, ongoing price inflation and the relaxation of rules around sales of new property to foreign buyers helped incentivise a surge in residential investment in Brisbane, Sydney, and Melbourne,” St John says.

“The glut of new supply is weighing on both prices and rents in Brisbane, as the city’s stable PTR attests.

“Meanwhile, strong population growth, perceived market stability, and stronger foreign buyer interest allowed Sydney and Melbourne price inflation to outpace sluggish rental rates consistently.”

So housing is clearly more expensive than what it was in the past in some capitals based solely on these metrics, but does that mean prices are in a bubble and likely to pop at some point in the future.

While no one knows for sure whether or not that will happen, St John says these two metrics, along with actual price growth and other housing-related costs, can be used as a guide to the probability of a price decline of 15% or more in the next five years.

So which Australian capital cities are more at risk of a price correction? The answer is found in the table below.

Source: JP Morgan

Based on this modelling, the city at the greatest risk of a significant price decline is Melbourne, says St John, closely followed by Sydney in second place.

“Sydney and Melbourne exhibit significantly higher likelihoods of correction than the other capital city markets, at 18% and 19%, respectively,” he says.

“In Sydney, the core drivers of this estimate relate to the significant acceleration in real price and PTI growth over the last five years.

“Melbourne did not experience as exaggerated a bull market as Sydney in 2001-04, but didn’t have as deep a pull-back either, so its long trend leaves ratios well above average, implying a high chance of market correction.”

Many will agree, but there’s sure to many who don’t.

While St John admits that the modelling is simple, he says it remains a useful guide as to what may happen with prices in the future.

“With household housing debt to income the second highest in the developed world, and domestic mortgage rates more likely to be biased higher by global monetary tightening in 2018, household balance sheets are highly constrained,” he says.

“With these dynamics keeping owner-occupier demand subdued, PTI and PTR ratios become a more useful anchor of how earlier speculative activity in the market may drive future price performance.”

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