Disclaimer: I am not a financial adviser, and this is not to be taken as financial advice. It is my personal academic opinion, and I welcome comments.
The short answer: the Auckland house market is a bubble – and it is going to pop.
What is a financial bubble?
“A market phenomenon characterized by surges in asset prices to levels significantly above the fundamental value of that asset.”
What causes a financial bubble?
Group-think. Also known as herd behaviour, this is a well-known phenomenon in behavioural economics. It defines a situation when people do something (such as buying assets) because everyone else is. Group-think is something we see a lot in everyday life – fashion is defined by group think. Fashion, however, does not cause financial meltdowns.
People often like to think of themselves as rational, especially when they are making important decisions, such as investments. However, this is often not true. We cannot help but be influenced by what others think – and in investment sometimes this is necessary.
Financial markets, including the Auckland housing market, are often defined – not by what something is worth, but by what people think it is worth, and sometimes this can be a self-fulfilling prophecy.
The Auckland Housing Market meets this definition
Every day people are buying houses, not because they believe it is worth x million dollars, but because everyone else is and because they believe unwaveringly that it will skyrocket in value. This is herd behaviour and for many years it has been a self-fulfilling prophecy, people buy houses because they ‘know’ that in the future there will be more people wanting to buy houses just like them – no matter what. This theory works… until it doesn’t. Once people stop believing in the Auckland House religion, the capital gains side of the equation will collapse. The bubble bursts.
When people no longer see their housing investment as an investment in capital gains, there will be a sharp correction in the market, especially at the upper end.
The fall of the Auckland Housing Religion
There are many things which can cause a typical bubble to burst, but I think there are two main concerns particular to the Auckland housing market.
- Change in Interest Rates/Over Leverage
At the moment, home loan owners are enjoying some of the lowest interest rates we have ever seen. These low rates make it easier for the first home buyer (and other buyers) to enter the market, continuing to fuel the price rises. But what will happen if these rates do not last? People will find it more difficult and less appealing to buy houses. More worrying, however, is the potential for homeowners to suddenly struggle to meet the higher interest payments.
Note: if interest rates rise to where they were predicted at the start of this year (to 7-8%) people would suddenly be facing close to double the interest they are paying now.
- Upper Limit
Unlike shares, houses are not an asset which can be split up indefinitely – real people need to be able to live in them and afford to live in them. The 1% is just that. There are only so many people that will be able to afford multi-million dollar houses.