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CEO AllenWargent Property Buyers, & WargentAdvisory (institutional). 6 x finance author.

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Monday, 23 March 2015

Rising house prices - good or bad for small business?

Lending for "housing" expands

Each month I analyse the Reserve Bank's Financial Aggregates data in order to understand to the best of my ability the latest trends in lending for business, personal lending, home ownership and property investment.

The latest round of data showed private sector credit expanding +6.2 percent over the past year, with business credit growth now climbing at +5.5 percent which is the strongest rate of growth we have seen since February 2009.

Looking at business credit in aggregate shows the lull through the financial crisis when Australian business experienced "recession like" conditions, although there has been a recovery of late. 

Housing credit in aggregate is currently growing at a significantly faster pace (+7.1 percent) with property investor credit in particular expanding even more rapidly at a double digit pace which has attracted interest from the regulator.

This has led to a range of articles on the hot topic of lending for property effectively "crowding out" lending for business, and rising house prices stymieing entrepreneurship.

Business financing

It should be noted that are many ways in which contemporary businesses can finance expansion.

Firstly, while bond issuance by mining companies has of course declined substantially since 2008, corporate bond issuance in the domestic market is alive and kicking with $2.5 billion of  corporate bonds issued over the last quarter alone.

Hybrid issuance over 2014 was very strong indeed - in fact, a record $14.5 billion was raised in the last calendar year, mainly by the largest banks.

Between November 2014 and February 2015 six financial entities raised a total of $2.6  billion of hybrid debt, which included the first "RMB-denominated" Tier 2 hybrid debt issuance by Aussie banks.

There has also across recent months been significant growth in foreign currency denominated business credit (source: RBA), which has effectively been boosted by valuation effects associated with the depreciation of the Aussie dollar.

Meanwhile initial public offering (IPO) capital raisings are tracking at their highest level in 18 years with consumer and healthcare listings leading the charge (cf. the $5.7 billion Medibank privatisation, which was the largest IPO in Aussie equity markets since the initial Telstra offering way back in 1997).

Naturally, my chart below does show that secondary capital raisings are tracking at a lower level than was the case through the financial crisis when there was a great flood of recapitalisation, but look at the aggregate for initial capital raisings go!

But where are the entrepreneurs?

Now sure, many of these forms of financing apply to the mid-tier and larger Aussie firms, but what about the start-ups and entrepreneurs?

I know from my own experience that rising dwelling prices in previous cycles did make me feel considerably more confident about setting up my own small business as I saw my net worth grow.

On the flip side, rising dwelling prices in Sydney (and I assume here that we are talking largely about Sydney house prices as dwelling price growth elsewhere has been much weaker) might conversely make one become more aligned to the salaried pay cheque since entry prices on family homes do not come cheap, and lenders do typically like to see a reliable income stream.

But it's not really important why I think. What is important is what the Reserve Bank thinks, and the bank has released a draft research paper of the very subject here.

How house prices affect entrepreneurship

The draft paper noted that there are several “channels” through which dwelling prices can affect entrepreneurship, including:

i) - Business loans: rising dwelling prices increase the value of housing collateral against which entrepreneurs can secure business loans;

ii) - Personal lending products: rising dwelling prices increase the value of housing equity available for entrepreneurs to draw down on by using housing related loan products such as home equity loans; and

iii) - Personal guarantees: rising dwelling prices increase the value of personal guarantees since this is a function of the value of the guarantor’s assets, including residential property.

In particular the paper found that a rise in dwelling prices increases the net wealth of homeowners which may encourage them to take on more risk, just as I referred to above - including starting a business - independently of any change in their borrowing capacity.

Lenders assess the capacity of borrowers

Lenders are said in alliterative terminology to evaluate the “four Cs” of borrowers: character, capacity, collateral and capital.

Of course there are alternative avenues for young entrepreneurs starting a business to access finance, with equity rather than debt financing often more appropriate for start-ups given their elevated risk profile.

Traditionally is is said that small businesses are financed by "friends, fools and family" as I analysed previously here.

Lenders today acknowledge the intertwined nature of the entrepreneur’s business and personal finances - they actively seek to analyse the finances of their small business customers on a consolidated basis - and this is particularly the case for sole-traders and family businesses.

Other credit products

It is also possible for entrepreneurs use personal credit products such as home loans and credit cards for small business purposes.

Lenders have noted that a share of their home loans to self-employed borrowers and home equity loans for “investment purposes” might be used in part to finance small business expansion.

This might, noted the study, in part be due to a lack of knowledge or awareness of small business lending products and the tax benefits they can provide.

The tax shield (h/t Modigliani & Miller)

One of the key financial benefits of small business loan products relative to personal loans might be the capacity to treat the interest paid as tax deductible within the business, in turn reducing its tax liability.

However, the benefit of interest deductibility is only of relevance for small businesses that actually face such a tax liability.

The RBA's draft paper cited data from the Australian Taxation Office (ATO) has indicated that in the 2012 financial year only 44 percent of "micro companies" and 69 percent of small companies actually paid any tax at all.

Start-up businesses in particular may take some time to become profitable, therefore negating the potential benefits of interest deductibility for tax return purposes.

Property loans are cheaper

Another reason why entrepreneurs may prefer to draw on their home loan is that the interest rate tends to be lower than for business loans which are secured against residential property.

Small business rates are typically higher than home loan rates, with the spread having widened materially through the global financial crisis.

The results of the study indicated that the probability of starting a business is significantly positively correlated with the dollar value of home equity - in short, an increase in home equity is associated with the probability of starting a business.

Prior analysis had already found a positive correlation between housing equity and the probability of starting a business.

The new research also implied that new entrepreneurs actually make use of their housing equity to access finance, with the positive correlation between entry rates and housing prices is solely due to small companies.

Noted the paper: the positive association between the level of housing prices and the small company entry rate is more than twice as large as it is for all companies.

The wrap

While lenders have emphasised that the provision of collateral is not sufficient of itself to justify lending to a start-up without due evidence of serviceability, it nevertheless increases the likelihood of lending.

The study also found supporting evidence of a positive correlation between housing prices and entrepreneurship.

In the draft paper's own words, it found :

...a clear and robust positive correlation between the level of housing prices and the share of new companies measured across postcodes”.

The correlation was only apparent for small firms, and it was found to be broad-based across industries.

Naturally, I've already had several dozen snarky Tweets about this mightily unpopular conclusion this morning.

Lest it is not blindingly obvious from the title of the draft paper, I didn't actually carry out the research - it was carried out by the Deputy Head of the Economic Analysis Department at the Reserve with two other henchmen!

Therefore, please direct further zings accordingly.