Sydney housing is sitting on a knife edge. It’s close to being the least affordable it’s ever been, and it’s achieved that with the lowest ever interest rates.

How did we get here? Well, house prices have always risen. If we adjust for inflation a property now is worth more than three times the average Sydney property in 1991. Home buyers and investors alike assume this trend will continue, so they are buying up for fear of losing out.

Buying property seems like a low risk. Even when the market spikes, the adjustment has never been harsh. As the red line in the graph above shows, there are lots of years when growth is a long way into positive territory and any dips into the negative are relatively shallow. Even the slow down from 2005 to 2009 was quickly corrected by a massive increase in 2010.

This year it seems we’re seeing a similar spike in the market (18 percent or more) and, for investors, this is a better deal than stocks and shares. The ASX 200 is less than one percent higher than this time last year. You’d have been better off keeping the money in the bank, despite the abysmal interest rates. Or you could have made a motza buying and selling a house.

Naturally, interest rates have a significant impact on house prices. As the graph below shows, prices tend to peak when interest rates fall below seven percent. 

The short term thinking, that sees people make a 25 year commitment on the cost of repayments today, is at the heart of the problem. We have reached the edge of what’s affordable, and we don’t have to look too hard to see what happens next.

We’re now paying proportionately more for a mortgage, with banks advertising interest rates of 4.5%, than we were in 1991, when interest rates were at 13 percent. Back then, a weekly repayment on a 100% loan would equate to 72 percent of the average Australian weekly salary. Today the figure is 77 percent.  It was worse in 2008 when repayments peaked at 85 percent of salary, but back then interest rates were at nine percent and the housing market responded with two years of falling prices (more than 4 percent each year).

If the RBA added another percentage point to interest rates, with house prices where they are today, we’d be in the same situation as 2008 – 85 percent of average income equal to the weekly repayment on a 25 year 100% loan. Presumably, as history has shown, we’d be ready for a fall.

To maintain this 85% affordability level, a two percent hike in interest rates would see prices drop 9 percent, a three percent rise would see them drop 17 percent. 

If interest rates were forced up to 2008 levels then housing values would have to drop by close to a third.

This is a cautious prediction. We’ve never sustained mortgage repayments at 85% of average wage for more than a year, so the sensitivity to changes in interest rates could be stronger than I have predicted.

That has to be a stark warning to anyone buying right now. It’s okay to speculate on an asset, but it’ll only ever be worth what people can afford to pay for it.