Jake's View

Abnormal interest in home affordability

Understanding the effects of unusually low mortgage rates is the key to calculating the real price of a home in Hong Kong’s property market

PUBLISHED : Thursday, 11 October, 2012, 12:00am
UPDATED : Thursday, 11 October, 2012, 3:03am

Hong Kong home prices are continuing to break records, while rents are rising at a slower pace and even dropping in some sectors, according to the latest figures. The difference in the trends of prices and rents might be a sign that demand for homes is decreasing …

SCMP, October 10

No, a slower pace in rents is not a sign that the pressure on home prices may soon ease. It is only a sign that the property market is driven by abnormally low interest rates.

I grant you it is counter-intuitive. How could low interest rates alone drive home prices to such ridiculous heights? Surely there must also be a shortage of housing to cause it.

But, no, there is no shortage of housing. In fact, official figures show that more than 250,000 flats, more than 10 per cent of our housing stock, lie vacant. Building more homes will not bring prices down. It will only create more opportunities for mainland speculators.

Here is the critical concept to understand: the real price of a home is not the list price in the developer's brochure.

It is rather the monthly mortgage payment to which you pledge yourself when you borrow money from the bank to make the purchase.

And the critical period of that mortgage is its first few years. This is when you have yet to build up residual equity in your home and before rising skill in your career rewards you with higher income.

This period is the hurdle you know you must jump when you ask for a mortgage.

Examine your mortgage over that period more closely and you will find that by far the bulk of the payments you make goes to paying off interest on the principal you have borrowed. Only towards the end of the mortgage do you pay off more principal than interest.

Thus tweaking those mortgage interest rates only slightly is enough to make an enormous difference to your ability to afford your home. It is by far the biggest variable in the housing affordability equation.

And interest rates haven't been tweaked just slightly. For the last four years they have been wrenched out of normality, with borrowing rates forced to the very low single-digit levels.

It would never happen under normal conditions. A thriving economy with an overheated property market would normally see interest rates rising to cool things down again.

But our conditions are not entirely normal. The HK dollar is pegged to the US dollar and US monetary policy at present calls for economic stimulus through ultralow interest rates. We're out of kilter with the US economy. It can happen occasionally and now is one of those times.

Low interest rates explain the first chart. Home prices now exceed their 1997 highs by more than 20 per cent but Centaline's affordability index suggests that mortgage payments for a new private flat still absorb only 44 per cent of average family income, compared with 112 per cent in 1997.

Low interest rates also explain why home prices outpace home rents. Whether you take annual rent as a percentage of price or annual interest as a percentage of a sum of money, it's all yield and interest yields (interest rates) have pulled down property yields, as the second chart shows.