Does it stack up?

In assessing the housing market, a range of gauges can be used.

They are all pointing toward excesses in the market - so those expecting a continuation of double-digit price gains over coming years could be sorely disappointed. Nonetheless, residential housing remains a good long-term investment.

The simplest way to assess the housing market is to compare where prices are relative to history.

The average New Zealand house price, as measured by Quotable Value, rose 11.6 per cent in the year to December 2004, down from its peak growth of 25 per cent a year ago.

When adjusted for inflation - that is, the movement in prices more generally - house prices are 8.7 per cent higher than a year ago. Cumulatively, houses are nearly 50 per cent more expensive than in mid-2001, inflation adjusted.

Some of the growth in prices can be explained by cyclical factors.

For example, the net population gain from migration has been historically high. Mortgage rates have been relatively low. Employment growth has been strong and the unemployment rate is at 19-year lows.

Demographics, such as smaller household size, have also raised underlying demand, while the supply of housing is traditionally slow to react and building takes time. However, these factors do not account for all of the rise in house prices over the past few years.

Depending on the way house prices are examined, this "unexplained'' component suggests house prices are anywhere between 5-10 per cent overvalued.

Prices are not the only way to view the property market. Debt levels and debt servicing can also give an idea of how stretched the market is.

Household debt-to-income levels have risen over the past 14 years. More recently, the rate of increase has accelerated and it now sits over 130 per cent of income. The lion's share of this is housing debt.

Rising household debt levels are a natural consequence of banking deregulation (structural) and improvements in households' balancesheets and low interest rates (cyclical) but debt levels cannot increase indefinitely. And with higher debt levels, consumers are more sensitive to increases in interest rates as debt servicing eats up a larger proportion of their take-home pay.

As borrowers on fixed rates come to reset their mortgages, higher interest rates will start to bite, further tightening the noose on highly indebted households.

A traditional way to assess the return of residential property is with its earnings, or rents; commonly called a price-to-earnings (P/E) ratio. The P/E ratio is more than 40 per cent above its long-run average level. Lower interest rates may justify a shift upward in this trend by offsetting lower rental yields with lower servicing costs, but it is not enough to explain all of the surge.

In the long-run, the market value of an asset should equal the cost to build the same item (this concept is known as `Tobin's q'). If house prices have risen by so much, then surely building more would be the answer?

Indeed, there is a lot of investment in residential housing underway but while demand for construction has pushed up building costs by 20 per cent over the past three years, house prices have outstripped them. As a result, the Tobin's q ratio has continued to rise.

The ratio of house prices to income (affordability, where a higher figure means less affordable) has also surged. Demographic change - specifically an increase in the number of dual-income households - increases the ability to repay debt. But even with this taken into account, the ratio is still nearly 35 per cent higher than three years ago.

Just because house prices are expensive across a range of indicators does not necessarily mean that they are set to fall. However, when assets are expensively priced, the probability of a correction increases.

Lauren Rosborough is an economist at ANZ Bank.