Interest rates are the main story for home prices in Australia. With our deregulated banking system, all demand for mortgages can be satisfied (conditional on servicing criteria). With an active and tax-advantaged investor market, this only adds to the tendency for the housing market to converge to the asset-pricing equilibrium, where mortgage interest on the home price substitutes equally for rent, along with some adjustment for ownership costs and expected capital gains.

Here’s the basic gist of the interest rate effect for a typical home that saw rising nominal rents until recently, but where rents are expected to see no nominal growth over the next decade.

Despite rents in this example rising only 47% in nominal terms over four decades, the equilibrium asset price (where mortgage interest substitutes for rent) increased by 338%.

Notice that the 2% point decline in interest rates has a larger effect when interest rates are lower. Halving interest rates should double prices, all else equal (and vice-versa). But that requires only a 2.5% point drop from 5%, but a 4.5% drop from 9%.

Notice that the 2% point decline in interest rates has a larger effect when interest rates are lower. Halving interest rates should double prices, all else equal (and vice-versa). But that requires only a 2.5% point drop from 5%, but a 4.5% drop from 9%.

The latest bout of monetary policy that took mortgage interest rates from around 4.5% to 2.5% is nearly a halving, which implies scope for a near doubling of prices. Even if Sydney and Melbourne prices were far above the equilibrium due to a recent speculative period, this interest rate decline will bail out speculators and support those higher prices.

This is why I see mostly upside for home prices in Brisbane, Adelaide, and even Perth in the next few years. Gross yields for Sydney and Melbourne houses are around 2.6%. But they are 3.8% in Brisbane, 4.2% in Adelaide, and 3.8% in Perth. A 0.5% point decline in yields in Brisbane, would, for example, see a 15% price gain.

If you can borrow at 2.5% the maths looks like this for a home currently rented for about $400/wk ($20,000/yr).

Annual rent - $20,000

Price at 3.8% gross yield - $526,000

Interest on price (2.5%) - $13,150

Interest on price (2%) - $10,500

If you buy with a 2.5% mortgage instead of renting, you get nearly $7,000 year in your pocket to cover ownership costs and repay the mortgage. If you can get a mortgage interest rate closer to 2%, that gives you nearly $10,000 per year to cover these costs.

Even if you expect rents to fall 10%, this doesn't change the asset-pricing arithmetic much at all.

If you don’t expect prices to fall rapidly, buying makes good financial sense with low interest rates and high housing yields.

If you don’t expect prices to fall rapidly, buying makes good financial sense with low interest rates and high housing yields.

UPDATE: It is now cheaper to pay the interest on a mortgage than pay the rent in the major capitals on average (see blue line dipping below one). The below image is that ratio of the interest rate to the gross yield. It also shows the repayment for a 30-year mortgage as a ratio of the rent in orange.