Housing fears built on weak foundations

Suddenly the debate about residential property is turning on the notion that yields in the market are falling. But are they really? After seeing a rash of headlines in recent days warning that ‘rental yields’ are falling I remain very unconvinced. Yes there is weakness in some sectors of the apartment market, especially Melbourne. But for most investors, most of the time, investment in the housing market makes a lot of sense.

At the heart of the issue is allegedly a huge boost in supply, especially in the apartment space. Now if this is occurring, then that could be a problem for investors. You know the drill – lower yields and a supply glut all lessens the attractiveness of property as an investment. Investors may increasingly decide it’s not worth it. I don’t think investors need to be too concerned, however.

That’s not to say that rental yields aren’t falling. They are. But I think some of the concerns expressed may be a tad premature. Take a look at table 1 below.

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As you can see from the table, I don’t think there is too much in it. Rental yields are down marginally at best. Having said that, and while I think it’s very premature to be worried by what are in reality statistically insignificant falls in rent yields – especially with home values soaring – it’s a valid point that we should continue to expect rental yields to fall.  The issue for investors is whether this turns out to be a malign fall driven by a supply glut – which would be a worry – or something much more benign. That is, driven by continued strong interest in property, continued strong investor interest and price growth.

On the supply side of things, there is a clear uptrend here. Completions are up 7% over the year to the March quarter, reflecting a 22% increase in apartments and a 0.2% fall in houses completions.

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Chart 1 shows the situation over a longer time period. As you can see from the chart, house completions have actually declined over the last few years and remain below average. Adjusting for population growth, housing construction is actually very weak. So we can safely rule out any risk of a glut in that space, I think. Also see my previous article, Housing glut doesn’t stack up.

All the action is occurring in the apartment space, but I’m not sure that looking at a national average there’s a glut just yet. Fair to say that chart 2 shows one might be developing though. Apartments under construction (but not yet completed) are up nearly 18% for the year, and the chart says it all. That’s a record high at nearly 100,000 units under construction.  That’s a serious amount of supply coming on board.

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Chart 3 gives a bit more detail as to what’s’ driving this surge. You can see from the chart that the uptick is across most states. Yet it’s only really in Victoria we’re we seeing any sign of a possible imbalance developing. Looking at the remaining states, the rebound either comes after a period of weakness – such as in NSW and Queensland and WA – and isn’t too different from recent averages.

In Victoria the situation is clearly different. By itself, unit construction in Victoria accounts for 54% of the annual lift in apartment construction nationwide. Construction there is at a record high, and well above any average. That’s the only indication I can see that a glut has developed – but only in that state – and even then, it’s not equivocal.

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Any examination of a supply excess is incomplete without reference to population growth. A glut implies construction growth above and beyond what population needs would demand. I have to confess, I don’t think that’s occurring. The reason for that is because the ratio of construction underway, or even completions, to population growth is actually slightly below average.  That is construction relative to population growth is not historically high.

There are clearly flaws with using such a simple ratio that I should point out. It’s not a definitive indication that a glut is not developing and that construction is not above and beyond what population growth would demand. It doesn’t take into account apartment size etc. or the demographics behind population change. Not to mention changes in consumer preferences – multiple housing, household size and the like. It is an indication though, and it is still useful alongside other key indicators.

So, for instance, vacancy rates are still comparatively low. In Melbourne, SQM Research notes that vacancy rates are still around 2.6%. That hasn’t changed materially for many years and is below rates of 3-4% seen in 2005.  The other major cities too enjoy low vacancy rates – and rising ones in some cases: 1.4%in Darwin, 1.5% in Adelaide, 2.3% in Brisbane, 1.7% in Hobart, 1.8% in Sydney and 2.5% in Perth. These are not indicative of a glut.

Similarly, auction clearance rates remain elevated. Just over the last weekend (August 23) auction clearance rates nationally were at 67%, with particular strength in Melbourne 64%, which is well above lows of 40-50% seen in early 2012. Sydney was 76%. Lower rates were recorded in the other major cities – Canberra and Perth, in particular, with rates of only 47% and 39%. Although, then again, there is no issue of a supply glut in those cities.

The bottom line is that I don’t think there is any sign yet of a supply-demand imbalance. Victoria is the only state where there is any risk of that developing at this stage and, even then, the evidence is weak. With that in mind, price still remains the best guide as to the supply-demand imbalance – and price gains remain strong in Sydney, Melbourne, and Brisbane. Less so in the other major centres.  There is clearly demand there, and houses and apartments are being bought – with owner occupiers still the largest segment of the market. Concerns have been expressed that this demand is also constrained, with Fairfax again leading the charge suggesting that the excess of house prices to disposable income will lead to only modest house price growth.

I think this view has some merit, although only at much higher interest rates. In the meantime, debt servicing is at decade lows. This means that households are not as constrained by debt as some think. So there is no reason to believe that at low interest rates and decade low debt servicing that house price growth will only grow in in line with disposable incomes.

If you are cautious or risk averse, then take care if purchasing an apartment in Melbourne, although at this stage, and while construction has surged, there is still no sign that this is above population growth. Otherwise, market conditions elsewhere remain very attractive for property investment – especially for detached housing.