Pete Wargent blogspot

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

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Sunday, 27 December 2015

Construction boom to peak in 2016

Construction boom to peak

A quick break from the cricket to nut out a blog post!

In 2015 average capital city property prices once again outperformed regional property markets, with lot values in the capital cities again rising strongly

The result of the drip-fed or constrained supply of shovel ready land is an interesting dichotomy, whereby detached "cookie cutter" housing is built largely on the city fringes - where greenfield land is plentiful but facilities and transport options are sparse - while infill developments are becoming dominated by high density or high rise apartments.

Units above marginal replacement cost

With prohibitive land remediation costs on brownfield and previously developed sites, it has taken record low interest rates, rising apartment prices, and a ready and willing market of offshore buyers to get consents rising, but in 2015 rise they did, and to unprecedented highs.

Splitting out building approvals by property type in the chart below shows that this cyclical boom has been dominated by high rise apartments (rather than houses, terraces, townhouses, or low-rise developments), although ultimately these will only be built where it is felt that the market is willing and able to absorb the new stock.

With APRA having effectively tightened deposit requirements, building materials and labour costs inflation rising as the residential construction industry hits its full capacity, and Chinese authorities reportedly clamping down upon capital flight, rolling annual dwellings starts appear likely to peak imminently, at around 213,000 or about 10 per cent below the record number of approvals. 

The above graphic underscores that those seeking outperforming property in 2016 would do well to steer clear of the glut of new high rise supply, instead seeking out supply-constrained suburbs and scarce property types which are in high demand from owner-occupiers.

Stock overhang

Ostensibly the relative number of lone and two-person households is poised to increase, but in reality many of these high density developments are targeted specifically at investors, and relatively few owner-occupiers have a preference for living on the 10th floor of a block.

Experiences and historical evidence from overseas suggest that new supply is not always effective in slowing price growth while credit is still expanding at a solid clip, particularly in larger cities where new supply represents only a fraction of the total dwelling stock. What a glut of supply can do, however, exacerbate downturns. 

On the other hand markets and property types which are undersupplied can bounce back more quickly from a downturn, which goes some of the way to explaining why London house prices are now at record highs, only a few short years after the harshest recession in decades.

Would-be property buyers should be aware of the difference between advisers that are acting with their best interests at heart (typically charging a transparently disclosed fee for service), and salesmen pushing a product, typically a newly built property (earning a percentage fee for a punchy commission). 

Housing ladder broken?

In a model housing market where transactions tend to work in a chain, a surge in housing starts should be met with a correspondingly strong rise in the number of owner-occupier transactions.

While this link has not been severed entirely in Australia, the rise and rise of the property investor has certainly muddied the waters, and punitive stamp duties are also acting as a discouragement to market mobility. In short, as shown by the chart below, while housing starts are at their highest ever level, but the number of owner-occupier transactions remains well below the levels seen previously.

The notion of the traditional housing ladder still holds true to some extent in capital city areas where demand is at its strongest, but in many regional locations for a number of reasons the rungs of the housing ladder have effectively been sawn off. 

On average first homebuyers are buying later than they once did, some opt to rent and buy an investment property instead of a place of residence (perhaps understandably, given today's more flexible labour market), and countless others have failed to gain the requisite capital growth in order to trade up.

Of course, some regional markets have performed well, particularly a number of those within a reasonably close radius of the largest capital cities. Some others have been hurt by the resources downturn.

Median price statistics can sometimes be skewed higher at this stage in the construction cycle by new builds, but listening to the stories of market participants suggests that this cycle has been underwhelming in most parts outside the self-sustaining jobs markets that are Sydney and Melbourne.

Different proposition

It is worth considering momentarily how the property ownership proposition has shifted over recent decades. Two decades ago in 1995, mortgage rates were still high (although not as high as they had been), so too were rental yields, and on average inflation and capital growth expectations were generally higher.

Today mortgage rates, inflation expecations, and rental yields are all considerably lower, while dual income households in particular have compensated by taking on greater levels of debt, meaning that serviceability costs may potentially remain more onerous for longer (especially given lower inflation and wages growth). Granted, this is a stylised example, but it raises some interesting questions. 

In today's capital cities an average income typically does not buy an average house. As such new entrants to the market today face the prospect of an arduous task in wearing down a higher level of mortgage debt, whereas once high inflation, capital growth, and wages growth did much of the heavy lifting for homeowners, even if serviceability was periodically harsh.

It is not all bad news, however, with the cost of money very cheap homeowners are building mortgage buffers and forging on ahead on repayments, while Fitch's latest index showed 90-plus-day arrears at record lows of just 0.41 per cent.

Moreover, despite what you intuitively might think, the internal rate of return on property as an investment may not be lower, even with lower rates of capital growth - in years gone by capital growth had to be considerably higher just to keep pace with inflation.

The wrap

As macroprudential measures bite it seems likely that the apartment construction boom will pass its peak through the year ahead. The latest housing finance data suggests that banks are pushing lending at the owner-occupier segment of the market hard in order to make up for the decline in investor lending.

This may work over the short term as existing owners play musical chairs for a while, but if housing credit growth is to be sustained at 5 year highs then at some point the first homebuyer segment of the market will need to start buying. I discussed this in a little more detail here