Is the housing market ready for a "two wave hold down"?

Today I'm joined by Pete Wargent who is a property analyst to discuss what is going on with Australia's property market at the moment.

Here's Pete Wargent, property analyst.

Pete, it feels like or looks like every bit of the property and real estate markets are falling, prices, auction clearances, construction approvals, everything is on the way down.  Is that what it looks like to you?

Yeah, I think if you look at the national level figures yes approvals have passed the peak and the prices are sliding.  I think Sydney and Melbourne are obviously the focus of most reporting and Sydney in particular the median price now over 12 months is down 5.5% or so mainly driven by the upper price deciles.  I guess the question that people are asking is how long does the downturn run for and I think if you look back over the five decades or so of reliable figures Sydney downturns have typically lasted one to two years but in some cases it’s taken three or four years to get back to previous peaks.  The fundamentals for Sydney’s economy are very strong so the latest unemployment read was under 4.1%, still got very powerful population growth at about 100,000 per annum and as you mentioned the number of inner city apartments under construction that’s now more than halved after that great glut that we saw about 12 months ago.  In some respects fundamentals are good but clearly there is access to credit that’s been the driver and tighter lending standards.

Yes, it seems to me this time that there are two competing differences with the normal cycle that you cite over the past five decades.  One difference is what you mentioned, the population growth which is clearly higher now than it’s ever been in the past, but the other difference is the amount of credit that’s out there, the amount of debt that we have, 190% household debt to income, and also the impact of the Royal Commission and that on the credit market which is kind of tightening things up and also the APRA control.  How do you see those two competing differences playing out?

Yeah, I think it’s an interesting thing.  APRA’s APG 223 is a practice guide, I think that’s been to some extent that’s really a chemical change for the housing market.  Serviceability now for new borrowers will be stress tested at at least 7% regardless of what happens to mortgage rates.  There’s a lot more scrutiny now on loan to income ratios so that’s going to impact particularly portfolio investors and there’s obviously a lot less high LVR lending than there was before the financial crisis.  So what APRA has basically introduced over the last year or two we’ve seen higher mortgage rates for investors and interest only loans in particular, and I think this is not really impacting home buyers quite so much on serviceability side but for investors in particular much harder to get access to credit now.

But the other thing is do you think that the amount of debt out there will make this a more serious downturn in price?

I think this is the interesting question.  You mentioned the debt to income ratio.  I’ve done quite a lot of work on this and in fact with the BIS I attended the UBS conference in London, the European conference where we debated this very topic.  As you said the gross level of household debt in Australia is very high compared to what we’ve previously seen, I think 190% of household disposable income.  The net debt is much lower than that because of something that’s almost quite unique to Australia.  A lot of people have been using mortgage offsets and other forms of buffers and something that’s just changed relatively recently now is we’re seeing this great big stock of interest only loans, people are now switching across, they’re either being forced or they’re voluntarily switching across to paying down their debt.  We’ve now got about 70% of borrowers that are actually paying down their debt so that’s a change from what we’ve seen.  I think that’s sucking some of the energy out of the market.  I think a lot will depend on how this interest only reset plays out and whether the pressure on borrowers to limit the interest only lending continues because at the moment the flow of new interest only loans is extremely low compared to where it was, about 15% of new loans down from 45% at the peak in 2015.  If the appetite for interest only lending remains as it is I guess as long as that goes on there’s going to be a lot of downward pressure on the market and I think, as I said, the energy being sucked away.

I suppose the problem is that the reason there’s been greater downward pressure on the market is if people were forced or wanted to sell the property in order to avoid having to pay down their debt because they can’t and so more and more stock comes onto the market which of course pushes the prices down.

Yeah, for sure.  I think that’s what everybody has been watching very closely.  Interesting thing to me when you look at the figures that get released is it’s hard to get a read in real time because the data lags so much but if you look at the stock of interest only loans outstanding at the peak we had about $600 million worth or about 39% of housing debt which is extremely high in international terms and obviously the policy makers and regulators are pretty uncomfortable with that but the interesting thing to me is just how quickly that stock of IO loans has come down.  I think now that we’re in mid-August you’d probably estimate that that figure is probably down to close to 30% already but probably heading lower in the second half of 2018.  It’s interesting just to consider how long is that downward pressure going to continue, at what point will the regulators be happy that what they intended to do has been achieved because if you look at those interest only loans outstanding now there’s a ratio, that’s below the average since about 2004.  How much longer are they going to push that, it’s very hard to say.

Another piece of data that I saw recently which surprised me was the declining number of listings coming onto the market.  I thought that as the market falls more and more people are putting their house on the market which is causing the problem in a way but in fact listings are in decline.  What does that tell you?

I think people generally have very short memories and I expect a lot of people in Sydney may have sold in the previous downturn, particularly the post 2004 downturn and then they found it very difficult to get back in.  I suspect if downturn becomes more sustained then that might actually change a few views.  I think at the moment there’s a lot of hope of prices resuming that upward trajectory.  I think the thing to me is that at the moment we’re in a bit of a holding pattern and I think the regulators are happy, policy makers are happy just to see prices easing but we’ve got an election coming up in potentially less than 12 months and I think that could be a real game changer because the Labor Party seems to be ahead in most polls, particularly the news polls and they’ve got some very significant proposed changes to how the housing market is taxed.  In the next 12 months I expect we’ll just see more of the same but what happens beyond the election that’s a whole other question.

As I understand their policy it’s to change negative gearing to only new houses, not existing ones, but existing ones would be grandfathered so that wouldn’t necessarily lead to a lot more stock coming onto the market, people having to sell their existing properties because of the tax changes but do you think it – I suppose it might put a cap on potential increases of existing houses beyond that.

Yeah, I think that’s it.  It’s more a prospective thing.  I think as you said, for existing investors there’s not really that much impact except to the extent that their resale market is reduced but I think the thing with negative gearing is that it has always been reliant to a great extent on prices going up and if the prices slide or don’t look like they’re going to continue increasing that’s when people start saying okay, well maybe I should be looking at other asset classes and just winding back that exposure to residential property which in Australia has been pretty high.

Prices are already sliding, aren’t they?

That’s right and how long does it go on for.  I recently co-authored a pretty detailed report on expected outcomes with a group called Risk Wise and I think in that scenario where the ALP wins you’d say that the NPV of an investment property is going to decline and yes, investors are only part of the market but one of the things that their model has shown is that particularly over the past dozen years or so investors are really driving housing market sentiment now, they’re such a big chunk of the market that if you reduce the flow of new investors into the market that has a knock on impact to the owner occupier segment and there’s a very strong correlation now between investor activity and auction clearance rates and price action.  I think the modelling showed potentially quite a different outcome around the country, we looked at all the different SA4 regions across Australia but nationally you would expect to see an impact on prices if that policy goes ahead.

Is that work available that you did?

It is, yeah.  Risk Wise Property Research or review, that’s the name of the company that actually produced the report.  So it’s a very detailed modelling so they looked across 86 SA4 regions, they looked by dwelling type and it’s as complex model with a lot of in-depth data that isn’t necessarily all publicly available so some of it came via CoreLogic.  It did show that while the impact will be varied across the country it would still be an adverse outcome for prices but of course the point of the policy is supposed to be multi-generational, it’s not looking necessarily in the first year or two.

What’s your reflection on the impact of population and to what extent that will cushion the decline?

I think to some extent Australia has always been seen in recent decades as a popular place to live.  I think the key thing that’s really played out since the mining boom peaked in 2012 is just the sheer concentration really on just three parts of Australia, Greater Sydney, Melbourne and southeast Queensland, that’s really just accounting for almost all of the net population growth now.  That naturally does create a lot of demand for particularly well-located land but even medium density properties to some extent and that’s something that is quite different from some of the other housing markets that have experienced worse downturns, particularly the States is often the quoted example.  But the second-tier cities in the US you’ve got plenty of choice but in Australia the population growth has become very focussed just on those three areas.  I think one of the things you would say about population growth is that it tends to be pro-cyclical so when the economy is absolutely booming as it was through the early to middle years of the mining boom then population growth tends to follow it up.  If we saw a sharp recession then population growth isn’t much of a backstop but at the moment the economy seems to be meandering along reasonably well so from the demand side there’s still plenty of immigration to keep pressure on prices.

Summing up, Pete, what do you think now we’re looking at over the next couple of years in the property market?

I think I’ve been staying up on the Sunshine Coast for the last couple of weeks, I’ll use a surfing analogy for you.  Like most Anglo Aussies I’m a pretty ordinary swimmer but the one thing I always fear in the surf is that two wave hold down and I think that could be what’s coming for the housing market.  I think we’ll see prices continue to slide over the next year, I think we haven’t yet seen the full impact of those tighter lending standards but if we go into a scenario with an election and big change to how investment property is taxed then it will just create further uncertainty. 

I think it should be said that Treasurer Morrison has already created something of a two tier market because he’s enacted changes to division 40 plant and equipment depreciation as well as eliminating travel expenses but what Bowen and Shorten are proposing is really a two tier market on steroids because you’re essentially proposing a completely different tax treatment for new and established properties which will create complexity and uncertainty.  I think the key point that seems to get lost in the debate is that it will make investing in new property much more riskier, a far greater risk of loss because your resale market to other investors the backside is going to fall out of it.

Assuming the polls continue as they are I would say we’d probably see another 12 months of declines and then probably another year or two beyond that, that would be my base case but a lot can change, as you know, in politics.

Okay, that means you’re saying that if the Labor Party wins.  The thing I hadn’t focussed on which you’ve highlighted is the impact of the resale market which means that buying a new property is also affected by the thing as well, by the changes to negative gearing as well, even though it continues.

Yeah, that’s right.  That’s why I was so impressed with the modelling done by Risk Wise and why I actually put my name to the report because as you said ultimately the NPV of any investment has to take into account to some extent the cash flow but also if you’re expecting to sell for a profit or a loss at the end of the investment and if the property you buy that’s brand new, which is what the policy is intended to encourage, people to invest more in new property, but if their resale market is being greatly diminished or if a second user of a property is going to see that NPV is much lower well it actually makes new property pretty unattractive too.  To me I’m not really a fan of buying new property myself anyway because the price is premium but it’s been popular with non-resident investors, superfunds, there’s a good deal of spruiking of new property and various property groups but I think people need to be aware of that resale risk particularly for the investor style property by which generally I mean inner city apartment type stock that’s really built with investors in mind.  The second hand demand for that type of property is going to be stripped away.

What did you call it, a double wave dump or something?

Two wave hold down.

A two wave hold down.

Yeah, I wouldn’t place any great reliance on my surfing terminology but that’s really what I think, particularly for Sydney the downturns have only really lasted for most actual downturns have been one to two years on average.  We will probably see that but then we could see a second wave, I think, of at least uncertainty and quite likely I would think falling prices further.  There are other different moving parts, as you said, there are other things that could happen to counteract that but this is why the housing market is so interesting to people, it’s that wondering what happens next.

Indeed.  That was great talking to you, Peter, thanks.

Pleasure, Alan.

That was Pete Wargent, property analyst.