Plenty of people will happily raise a family in a smaller but more central apartment with better services rather than a SFH in the suburbs. And worst case upzoning doesn't mean we have to use that zoning capacity - if it turns out people would rather build SFHs (and are willing to pay what they cost) then they can still do that.
But yeah, if they were better quality I imagine people would move into them.
Poorly-regulated lending means that it's the banks who are willing to lend the money. Home owners pay what they have to out of necessity, not willingness.
(speaking as someone who owns a house in Sydney)
It boils down to how sure people feel they can keep paying the huge loan over the next 30 years.
Why do we assume rational actors when we keep proving to ourselves people are not acting rationally?
The fundamental cause is taxation policy changes around 2000.
The solution is further policy changes, but the wicked problem is that the democratic majority do not want these changes; or can be easily persuaded these changes are likely harmful for them.
So Australia socially and economically exists in a death spiral; where wealth channeled into real estate is not consistent with its productive utility.
If you bring down the new build cost, supply will explode and prices will come down. Of course this would also crash the property market and ruin a lot of boomers' retirement plans so don't expect that to happen any time soon.
My favourite Real Estate investment analyst Chris Bedingfield said it because when he said that Australia isn't in a "Housing Bubble" any more than it's in a "Cigarette Bubble". The reason that both houses and cigarettes in Australia are so comparatively expensive is that they're heavily taxed.
Further, Australia is operating an EXTREMELY aggressive population expansion policy. This can and should be reduced significantly.
The solution is some mix of your suggestion and mine. Unfortunately most Australians own or live in an owned property. They won’t vote for this. In a few decades they will be in the minority, and life-long renters will be in charge. When that happens we can expect some wild policy swings. Similar patterns are developing all over the Western world.