Sydney has long commanded a house-price premium over Melbourne but that premium has recently hit historic extremes.

The latest data shows the typical house in Sydney currently fetches a 70% premium relative to the typical house in Melbourne, or put differently median house prices in Melbourne are approximately 41% cheaper than in Sydney. This gap represents a more than $600,000 difference in median house prices in August 2024.

This is the cheapest houses in Melbourne have been relative to Sydney at any point in the past 20 years, and a significant deviation from the average discount over the past decade (29%).

Sydney has always been Australia’s most expensive capital city, commanding a premium over Melbourne.

One factor is housing supply - completions per capita across Victoria versus NSW have historically been higher. Over the past decade Victoria on average completed 9.5 dwellings per 1000 people each year whilst NSW only completed 7.

Another is land scarcity. Sydney's geography is more constrained by natural features like its harbour and national parks, which limit the available land for housing development. This scarcity of land contributes to higher land values due to the limited supply, thus impacting the comparative expense of Sydney versus Melbourne.

Sydney's status as a global city with robust economic fundamentals, iconic landmarks, and international appeal, has also added to its long-standing desirability.

Limited housing supply and strong demand, especially in desirable areas around beaches and the harbour, contribute to a long-term trend of higher home values.

The cost to build is also higher in NSW with a recent report by The Centre for International Economics (CIE) finding that the cost of building new dwellings in Sydney was far more expensive than in other capitals. The report showed that red tape, taxes and charges were 50% of the average new dwelling in Sydney compared to just 37% in Melbourne, expanding the total cost to build.

Sydney’s property market is also influenced by its proximity to water. Waterfront homes in Sydney typically command a premium, likely a contributing factor to the premium Sydney historically holds over Melbourne.

Although homes in Sydney typically fetch a premium relative to Melbourne, that premium has expanded significantly over the past three years with houses in Melbourne now historically cheap relative to Sydney.

Supply and demand variations have played a critical role in this deviation.

Melbourne underperformed through the pandemic and has underperformed in the period since, making Melbourne the weakest performing capital city since March 2020.

During the pandemic, the price increases in Melbourne were less significant compared to other cities as Melbourne recorded large net losses of people. Subsequently following the decline in prices in 2022, the recovery has also been much slower in Melbourne and values remain 4.7% below their 2022 peak.

Melbourne has been the second most expensive market for over a decade but this recent underperformance in Melbourne has led to the city dropping back to fourth place in the rankings of Australia’s most expensive capital cities, with both Brisbane and Canberra now ahead. If current trends continue, values in Adelaide and Perth may eclipse Melbourne next year.

Throughout most of this year, conditions in Melbourne have remained subdued and Melbourne home prices fell 0.18% in August, marking the fifth straight month of declines.

Part of this could be an overhang from the underperformance experienced through the pandemic. Many buyers and sellers anchor expectations from recent sales momentum, which can embed trends in market results - one factor as to why housing prices can exhibit persistence.

Economic conditions are also softer in Victoria and unemployment slightly higher relative to NSW. But there are other forces in play, housing completions relative to population remain higher in Victoria, consistent with the trend seen over the past decade.

At the same time, land tax increases for investment properties in Victoria have discouraged investment and made owning an investment property less attractive. As a result, more investors have been selling properties in Melbourne, whilst the state hasn’t seen the same uplift in new lending to investors that other states have.

And looking at stock on market, buyers in Melbourne have consistently enjoyed more choice over the past year relative to Sydney. In July 2024, total listings in Melbourne were the highest since November 2018 and 24% above the prior five-year average for total listings, with this accumulation of total stock on market likely creating opportunities for buyers.

In the months ahead Melbourne is likely to continue to underperform relative to Sydney, and see ongoing small declines with above-average stock on market and the influence of the higher taxation environment. This is likely to continue widening the gap between Sydney and Melbourne values.

But looking at historic swings in price performance and comparative affordability, a time will likely arrive when Melbourne is viewed as undervalued given house prices are their cheapest relative to Sydney in a decade.

If policy changes have deterred investors and Victoria remains less attractive relative to other states, then it may eventually contribute to lower levels of new buildings to the extent that pre-sales to investors finance new development, particularly in the multi-density segment.

At the same time, the cost of construction and delivering new dwellings has increased and Victoria, like other states, is completing fewer than expected homes, against the backdrop of Victoria forecast to see the strongest population growth of any state over the next five years.

All factors that may eventually contribute to the price gap narrowing from current historic extremes.

Though, Sydney will likely always command a premium given its geographic features in comparison to Melbourne's urban sprawl which facilitates a more effective response to increased housing demand.