While it is undeniably true that Sydney’s housing market is ‘‘expensive’’, there is also compelling evidence that Sydney’s house prices are based on stronger foundations than the other Australian capitals and that Sydney offers better value from an investment perspective. This outcome is not to say that Sydney’s house prices cannot/will not fall; rather that it is less susceptible to a downturn than some of the other capitals, such as Melbourne (which will be examined in a future report).Sydney’s price premium has erodedThe chart below shows Sydney’s real (inflation-adjusted) house price performance relative to the national capital city average since 2007.

As you can see, Sydney’s housing market out-performed the national average up until 2004, but has significantly underperformed for much of the period since.Sydney’s recent lacklustre price growth has seen its price premium relative to the other capital cities – called the “valuation gap” - fall to near 40-year lows, as shown by the below chart:Whereas Sydney’s houses commanded a price premium relative to the other capitals of around 90% in the early 2000s, this premium fell to just under 30% at the end of 2010 – a level not reached since 1977.Assuming Sydney's housing values in relation to the other capital cities are likely to revert  to some mean level, the current low valuation gap suggests that Sydney’s housing market is likely to outperform the capital city average.Better-than-average rental yieldsThere is further support for the Sydney market in the investment fundamentals of return. As shown below, Sydney's housing market has experienced significantly higher rental growth than the national capital city average. Whereas average capital city rents have increased by 17% in real (inflation-adjusted) terms since 1987, Sydney's real rents have risen by nearly 30% and have recently outperfomed by some margin:

The superior growth of Sydney's rents, combined with Sydney's lacklustre recent house price performance, has propelled Sydney's average rental yields to above that of the other capital cities. The situation is the same for both houses and units.However, despite the higher rental returns available on Sydney homes, Sydney rental yields have typically remained well below the discount variable mortgage rate since 2006 (see below charts). As such, the average dwelling purchased over this period by an investor using finance (rather than savings) has been negatively geared, meaning that the investor has essentially been paying their dwelling a dividend in the hope that the dwelling repays them with some capital growth:The situation is similar for the average investor who purchased a Sydney home outright using cash (i.e. ungeared). Since 2006, Sydney gross median rental yields were below the one-year term deposit rate for all but a brief period between 2008 and 2009. This result provides further confirmation that Sydney housing investors have been investing primarily on the expectations of solid capital growth.The fact that Sydney's rental yields are low in an absolute sense, but high compared with the other Australian capital cities, provides further support to the view that Sydney's housing market is underpinned by stronger fundamentals and offers superior value relative than the other capitals.Supply-side squeezeAnother key factor differentiating Sydney's housing market from the other capitals is Sydney's anaemic rate of new home construction.Sydney's housing market is the most supply-restricted in Australia, owing to a combination of natural barriers (e.g. the sea, state parks and mountains) and the tightest regulatory regime in Australia. Reflecting these supply constraints, Sydney's new home construction actually declined over the 2000s as house prices rose sharply:

In fact, New South Wale's (read Sydney's) annual dwelling completions recently plumbed 30-year lows while the other states (particularly Victoria) experienced a mini construction boom.Although Sydney's dwelling construction rate - defined as the number of dwelling completions per 1,000 head of population - has for 30 years lagged the national average, it has slumped over the past decade. Sydney is now constructing homes at around half the rate of the other states.While Sydney's supply-side squeeze in no way guarantees that homes prices will not fall - San Francisco and the United Kingdom prove that home prices can fall abruptly even when new home construction is anaemic - it does ensure that Sydney will not be hit by a flood of new homes if or when prices start to fall, thereby accentuating the downturn.Overall, Sydney's housing market provides a safer-than-average (Australian) proposition from an investment housing viewpoint, due in no small part to its more subdued price growth, the higher rental yields on offer, and the genuine housing shortage following a decade of lagging new home construction. The full MacroBusiness Sydney Housing Valuation and Investment Report can be viewed for free at MacroBusiness.