Australian house prices. It’s the topic of the week, month, year and decade, and it seems everyone has an opinion. The list of house-price ‘culprits’ is long – negative gearing, concessional capital gains tax, immigration, low interest rates and record housing debt.
But blaming these issues for high house prices rarely stands up to any real scrutiny.
It is useful to define property into two broad buckets: ‘commodity’ and ‘franchise’.
Franchise property has very high barriers to entry – either by planning or location constraints.
No amount of capital is capable of replicating the asset. Best-in-class malls, on-campus student accommodation and manufactured housing are examples of franchise property.
Commodity property is easily replicated or substituted at a price. Office property, industrial and storage are good examples – as is residential property.
With commodity property, when prices are above replacement cost, a profit motive exists to supply the market with new stock.
Conversely, when prices are below cost, supply is constrained until prices recover. As a result, prices oscillate around replacement cost, which generally increases in line with inflation.
The law of unintended consequences – Part I
Since 2012, in response to the fall in business investment (mainly mining), the Reserve Bank of Australia (RBA) sought to stimulate the economy by lowering interest rates.
The strategy succeeded and residential investment replaced business investment, so much so that today the rate of new supply dwarfs anything we have seen in Australia for almost 40 years.
Chillingly, Australia’s current rate of relative supply resembles that of the US market in the period leading up to March 2006, and it’s hard to ignore the parallels between today’s Australian residential market and the US housing market of 2006, just before it collapsed.
In the US, the 2000 ‘dot-com’ bust was successfully replaced by a residential construction cycle thanks to low interest rates.
This boom inevitably led to a housing bust and prices fell back below replacement cost.
In Australia, the mining investment bust of 2012 was successfully replaced by a residential construction cycle also thanks to low interest rates.
Valuations in Australia today are clearly stretched and the risk of some type of price correction is inevitable.
In the US, the rise in default rates was the catalyst, but we don’t think the same dynamic will occur in Australia. There is another theory.
The law of unintended consequences – Part II
Since 2012, as prices pushed above replacement cost, housing approvals – which eventually convert into new supply – have subsequently increased, particularly in Sydney, Melbourne and Brisbane.
The Australian Bureau of Statistics says it takes between 11-18 weeks to convert a dwelling approval to a dwelling start.
Once construction starts, average completion time is approximately 32 weeks for houses.
Adding approval and construction time, it should take around 12 months for approvals to convert into completions (longer for apartments, shorter for houses).
Therefore, despite the recent decline, approvals still remain well above the long-term average.
We can expect approximately 55,000 additional dwelling completions per quarter for at least the next four quarters, or 220,000 over 12 months.
At the same time, bank regulators and the RBA are seeking to cool the residential market.
This includes placing a growth limit on investor loans to less than 10 per cent per annum ($55 billion), and reducing ‘interest only loans’.
These measures could not come at a worse time, despite being for the purposes of financial stability and the overall health of the housing market.
Based on the estimated 220,000 dwelling completions expected in 2017, around $176 billion is required to settle the new supply, assuming an average settlement price of $800,000 per dwelling.
The final credit requirement could be as much as $150 billion.
This may require the banking system to exceed the 10 per cent threshold limit for investor loans, and unravels most of the effort to contain investor credit growth since 2015.
Non-settlement of new supply may be Australia’s version of ‘rising default rates’.
What does it mean?
Of course, the property market may not play out this way. The banks may simply ignore the regulators and push through additional credit to ensure settlement.
Cash sales may be greater than we expect, or non-bank lenders may step in and fill the void.
But as long as prices remain materially above replacement cost, new supply will continue, with a further $150 billion of settlements required for 2018.
If a housing correction does occur, the downside will not be limited to residential developers.
Housing construction will collapse and the economy will slow. Local office REITs will suffer as banks react to an economic recession by cutting staff (and office requirements).
Local industrial property will suffer too, as business investment contracts. This is likely to place pressure on the Australian dollar as the RBA reacts by cutting interest rates.
These events will benefit any unhedged global investment strategy. As a manager with an unconstrained global investment approach, we invest a vast majority of our investor capital outside Australian REITs.
The risks are building, and the limits being imposed on new investor borrowing at a time of record new housing deliveries may turn out to be the tipping point.
One irrefutable point is clear: it is not the time to have all of one’s eggs in the same ‘economic basket’.
Chris Bedingfield is principal and portfolio manager at Quay Global Investors.
