Answer :

Executive Summary

The Australian economy is poised for growth as seen by the macroeconomic indicators, such as growing GDP, both in absolute and per capita terms, controlled inflation (it is showing signs of picking up), unemployment is declining and the positive trade balance. Further, the economy has been strengthened by better trade relations with almost all trading partners.

However, it seems that the wage and inflationary pressures are setting in and government has its eyes on this. Further, the housing market went through a heated cycle of increases. This is a tricky market as indebtedness levels are high. If after the sky rocket increase in housing prices as witnessed, there is a sudden and steep decline in prices, it may cause turmoil in the market something similar to what happened in the United States in 2007-2008. Further, given the high indebtedness level in the sector, it will further create problems of defaults.

Hence, the sector is receiving continued attention from the RBA and government so as to keep this on track. Through government intervention by various policies, the housing market has started to cool down a little bit now (RBA, 2018).

The following pages present analysis of a person’s financial state who has just started working with a salary of $80,000 per annum and is looking to purchase a house in Australia to realise the ‘Great Australian Dream’. Through a series of forecasts regarding housing prices in Australia (Sydney or Melbourne). Further, the person’s savings have been calculated by deducting forecasted expenses from forecasted income and the same has been discounted at a discount rate of 10% to calculate present value of the funds. At the same time, the housing prices have been forecasted by averaging the house price indices in eight major cities of Australia. This data is available for three categories of housing, residential property, established property and attached dwellings. Further, the data is available on quarterly basis. The data has been averaged to arrive at consolidated indices and then the same has been forecasted over a period of 10 year horizon. After this, the accumulated savings of the person have been analysed against the house prices to see if the situation is conducive for realizing the ‘Great Australian Dream’. 

Given the positive interest rate environment where interest rates are at an all-time low of around 3.7%, and housing loans are easily available, this seems possible in Year 3 where accumulated savings are sufficient to pay 20% of the house value in form of upfront amount and undertake a housing loan for the remaining 80% of the house value. 

However, the economic environment is always fraught with risks and forecasts are full of assumptions which may or may not turn out to be true. Hence, the person is advised to invest the savings such that a corpus is formed for purchasing the house as well as there is a cushion to meet unforeseen uncertainties. This will also provide a hedge against risks such as increased house prices, change in job or wages scenario, increased expenses, changed interest rate environment etc. 

1. Australian Housing Market Prices Forecast

The following graph depicts the historical housing market prices for a decade form 2008 till 2018 (ABS, 2018):

Source: Australian Bureau of Statistics, 2018

It can be seen that the housing market presents a cyclical trend in the market. It seems that the latest peak came around 2017 and now the prices are on a downward trend. This is also in-line with the forecast provided by the same website for the Australian housing market prices as follows (ABS, 2018):

Source: Australian Bureau of Statistics, 2018

Basis data above, the price index in Australian housing market can be forecasted. The forecast and related assumptions are available in excel spread sheet.

The forecast for the Australian economy as presented by ABS (2018) can be depicted as follows:

2. Income forecast

It is already mentioned that a job of $80,000 has been secured. Hence, this is the income flow which will be further increased. The assumed increment rate is 7%. This is based on the economic forecast as discussed above. The forecast mentions GDP will grow at a rate of *%. Keeping this mind and still taking a conservative view, annual increment of 7% has been assumed. Since 10 years is a very long time frame, the realistic scenario is not possible to predict accurately as many changes in job scenario are possible.

For example, the person may change jobs and get an immediate jump in the salary. Or, the company may go bankrupt and person may be out of job. Or, there may be economic downturn and person may not receive any increment. 

However, for purpose of our analysis, we have assumed that the same job and same increment rate will continue for the period.

3. Net Income forecast

The spread sheet provides a break up of possible expenses for the person. The expenses have been assumed on annual basis (Australian Trade and Investment Commission, 2018). Further the increment rate has been assumed at 2.5% which is the inflation rate forecast.

The expenses also include rent component which will be there till a house is purchased. It is assumed that rent will increase at 5% per year. For housing calculations, rent will be excluded from respective components.

The tax has been calculated basis current slabs and ignoring levies and surcharges.

The housing loan rate seems to be around 3.5-4% in the current environment.

4. Affordability

Given the savings excluding rent and further assuming that the bank will provide 80% of the house property value and the person will put in 20% of the value up front, the person can currently afford a house worth around $155,000 which translates to a housing loan of $124,000 and upfront payment of $31,000. This will swipe away all the savings for Year 0 but after that, the person will need to pay only EMI.

However, if the house selected is not in the budget, then the person can opt for insurance and pay less than 20% upfront payment.

5. House Purchase

If we assume a price of $305,000 for the house selected by the person, the upfront payment comes to $61,000 in Year 0 which is not affordable as of now.

However, if the person keeps saving and accumulate funds, we can compare the accumulated funds through present value concept and see if the person can buy house anywhere within 10 year horizon.

It can be presented as follows (calculations in spread sheet):

From above table, it is clear that at given assumptions, the accumulated savings of the person will be sufficient to initiate a house purchase in year 3. This is assuming that the house price will be around $342,317 and the 20% upfront will come to $68,463 where accumulated savings of $82,958 exceed this upfront payment enabling the person to take a house loan.

6. Increase in Mortgage Rate

Using a loan amortization schedule and assuming 3.7% loan for 30 years, EMI came to around $1,261 per month. After three years of payment at increased interest rate of 7% and loan amount outstanding of $258,037 for remaining 27 years, the increased EMI came to $1,775 per month. This comes to a total annual payment of around $21,300 which can be managed by the person.

The interest rate risk can be managed by investing remaining savings in instruments such as interest risk hedge or, even traditional instruments of savings.

7. Recommendation

 Seeing above analysis, it is best for the client to accumulate savings at the assumed rates and then purchase a house in Year 3 by taking out a house loan. Till then, rental accommodations can be used.

To increase the savings further, these can be invested in low risk investments so as to increase the corpus and cover for unforseen events or change in underlying assumptions which have been discussed above in relevant sections.