Why house prices need to rise to fix affordability

Property developers will have no incentive to build new houses if prices fall.

Composite image of Australian Prime Minister Anthony Albanese and tilers on the roof of a house
Anthony Albanese's freshly passed policy aims to build 30,000 houses over the next five years. (Source: Getty)

The current housing crunch, both in terms of prices and rents, is the result of strong demand for homes - thanks to rapid population growth - relative to only tepid growth in new supply - courtesy of low levels of new construction.

With demand for dwellings over the next few years set to remain strong, given the government’s strategy for high levels of immigration, a surge in new supply is essential to not only meet this fresh demand, but to add to the number of homes available for the existing population to buy or rent.

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The government has a couple of good policies aimed at lifting new supply.

For social housing, the government has a strategy to build 30,000 homes over the next five years - a useful contribution to what is a large problem.

In addition to that, there is a goal for 1.2 million new homes to be built in the five years from July 2024. These will be built by the private sector and, if the target is met, will go a long way in helping to correct the demand/supply imbalance which, in turn, means it will go a long way towards improving affordability.

Incentives to build more dwellings: Prices must rise

For property developers, there is a simple formula that must be met for them to go ahead and undertake a project:

  • The price they receive for a completed new dwelling must be greater than the cost of building, including land and all associated services, plus a margin for the builder’s profit.

In other words, if the expected sale price for the completed property is less than the cost of construction, the developer will not build it. Plain and simple. This has been part of the problem for the past few years.

New suburban homes currently under construction in row
The cost of building materials has skyrocketed over the past two years. (Source: Getty)

Despite the recent lift in house prices since the low of February 2023, prices in most cities are still below their early-2022 peak. For many property developers, there is considerable uncertainty around how house prices will perform over the next two years. This is discouraging new development.

At the same time, over the past two years, there has been a huge lift in the cost of building materials and the price of labour used in the construction industry. The aggressive interest rate hiking cycle from the Reserve Bank has been a killer blow for some builders, adding to the ‘top down’ costs associated with building.

All of this means that, not only are actual and potential house prices weak in the eyes of developers, but their costs have risen appreciably. It is no surprise in these circumstances that the number of new building approvals has been hovering around its lowest level in a decade.

What is needed?

For there to be a strong and sustained lift in new construction - including for the target of 1.2 million new homes over five years to be met - the financial mathematics for builders must be favourable for them.

In other words, and perhaps perversely, house prices need to be firm, and costs - including things like labour and interest rates - must be contained, at least relative to prices.

This simple maths is one reason why house prices have an unrelenting tendency to increase. Costs and wages go up over the long run and for new construction to be viable, dwelling prices must rise.

For there to be a much-needed increase in the supply of homes relative to demand, the selling prices for new homes need to remain firm.

To be sure, the cost of the land is an important part of the equation for builders. This is inexorably linked to zoning laws and land release from state and local governments. Extra land supply in amenable areas will keep this important cost in check. This is a critical aspect of the government’s foundations for the 1.2 million target.

Suffice it to say, if there is ever going to be a situation where Australia has a plentiful supply of properties relative to demand, house prices cannot fall sharply. Builders and developers will simply not build them if prices are falling relative to costs.

Building costs, land prices and interest rates are, of course, moving parts of the house price equation. But if these rise at about the long-run average in the low-inflation era of the past 30 years, house prices will need to rise by around 2-4 per cent per annum, on average, for construction to be robust enough to meet the 1.2 million new dwelling target.

Anything much weaker than this for house prices over the medium term will leave Australia with a muddle-through approach to meeting the goal of improving rental and price affordability.

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