An SMSFs warning bell on apartments funding

The promise of high returns from developers is a high risk for investors.

Summary: Developers are offering huge interest rate returns to enable them to complete apartment buildings for - mostly - Chinese buyers. But mass non-settlement is a real risk.

Key take-out: If offshore buyers default, and attempts to market the apartment contracts to other overseas investors is not successful, then significant losses will be incurred by developers and their lenders. 

Key beneficiaries: General investors. Category: Strategy. 

It’s not often that I put out a specific warning to self-managed superannuation funds and other investors seeking very high yields from risky interest-bearing deposits.

All of us are being affected by the low yields in so many areas of the market. Inevitably it is forcing many people to take higher risks and, of course, that includes investing higher amounts in banks and other share securities than would otherwise be the case. But risk taking can go too far.

According to Credit Suisse, a great number of SMSFs are taking on mezzanine debt in the form of loans to apartment developers. Usually these loans are quasi-equity and carry interest rates of between 10 and 15 per cent.

Chinese buyer concern

It is always possible that the loans will be repaid in full with interest, but in a great many of them the risks being taken outweigh the rewards. One of the biggest areas of concern that I have in Australia is the fact that we are experiencing an inner-city eastern states apartment boom on the back of Chinese and other Asian buyers who have paid a 10 per cent deposit on apartments.

As a result of these deals, many billions of dollars in apartment developments have been started and will approach completion in the next two years. As I have explained before, the Chinese buyers at best can get another 20 per cent of the principal out of China but that is all they can manage.

The Australian banks have shut the door in their face, partly as a result of pressure from the Australian Prudential Regulation Authority and partly because they are scared of the market. Already Meriton’s Harry Triguboff alerts us that 50 per cent of the apartments bought by the Chinese are not settling on completion. Other reports indicate the rate is likely to be much higher.

Feverish efforts are being attempted to find other overseas buyers or funders. While an apartment is being built, another overseas buyer can buy the original 'off the plan' purchase. But once the apartment is completed it cannot be purchased by an overseas buyer so it must be sold to the locals. There is already in Melbourne a two-tier market, and that secondary market discount looks likely to increase unless the rescue efforts to sell these apartments to other overseas buyers is successful.

I think most local apartment buyers know the risks. But what is not understood is the multi-billion dollar financing liabilities that any mass non-settlement by the Chinese will create. The developers who started these projects gained their initial funding from the banks, but the banks limit their liability to about half of the total cost. So developers are offering huge interest rates to enable them to complete the buildings.

Other developers have purchased land and have permission to build the apartments, but are seeking extra funding. If the attempt to market the defaulting Chinese apartment contracts to other overseas investors is not successful, then significant losses are going to be incurred by developers. A large number will be wiped out and so will those who loaned money on high interest rate securities. I don’t believe it is worth the risk, even though the rewards are tempting.

If we have a weak Melbourne-Brisbane-Sydney apartment market caused by Chinese settlement difficulties, will it spread to the rest of the dwelling market? Most of the Chinese have bought in inner-city areas and it will affect apartments close to the Chinese demand areas, but as you move into highly sought after suburbs the impact will become less and it will be marginal in the outer suburbs. Adelaide and Perth will not be affected, but Perth has its own problems.

Commonwealth Bank

And talking about risk and reward on interest-bearing securities, as we all know the Commonwealth Bank has greatly reduced its term deposit interest rates after it increased them some two months ago after official interest rates were reduced. It was a public relations exercise because the rate rises were given as part of the reason for not passing on official rate interest rate falls to mortgage holders. I think the banks have a good set of reasons for not passing on all the official rate decreases, but the sharp increase in term deposit rates engineered by the CBA turned out to be part of a game.

Looking at the CBA term deposits, the plus-3 per cent two-year rate has been abandoned and only the 36 to 47-month rate of 3.2 per cent remains of the old higher rates. If you place your money on deposit for five years, the interest rate is between 2.75 and 2.85 per cent – well below the three to four-year rate. One-year term deposits are down to between 2.4 and 2.5 per cent. I think the politicians who questioned CBA chief executive Ian Narev should have been much tougher on this aspect of the bank's funding. But they didn’t seem to understand the significance of what had taken place.

Meanwhile, APRA has changed the deposit rule which means that in the future the banks will not need to raise as much local deposit money to satisfy the regulator's requirement. That means that in 2017, unless there is a big increase in demand for bank loans, there is less likely to be a war on deposit interest rates.

The money market is becoming less confident that there will be another official interest rate reduction in 2016, but I still think it is on the cards for early next year. If there is no interest rate reduction that might at least stabilise deposit rates at these very low levels. But even at very low levels I prefer a bank deposit to those high interest rates offered by property developers.

Renewables recant

In your emails following the weekend many of you gave me a hard time over my remarks on South Australian renewable energy. And you were justified.

When I saw the television images of the broken transmission towers it was clear that the state renewable energy policy had nothing to do with the power failure in the latest storms. I got that wrong. But that should not obscure the fact that if any state is going to increase its renewable energy content to very high levels on the basis of current technology then it needs a back-up should, for example, the wind not blow.

Whether that back-up is in its own state or a neighbouring state is less important, although if it is in a neighbouring state you need to make sure that the transmission is secure with alternatives in case of breakdown.