There's not enough bang in the residential construction boom

Although the boom in housing construction appears to have legs, it won't be enough to carry the rest of the economy.

Building approvals declined in December but the residential construction boom appears likely to be more persistent than previously thought. Nevertheless, residential construction activity accounts for only a small share of the Australian economy and this boom won’t change that.

Building approvals fell by 3.3 per cent in December, beating market expectations, to be 8.8 per cent higher over the year. Approvals continue to be held up by the volatile units sector and there’s good reason to believe that approvals will ease over the remainder of the year.

On a trend basis, approvals surged to a new record high in December. What’s impressive about this is that it came after a brief period when approvals began to decline. That’s not unprecedented -- it has occurred a couple of times in the 25 years (see graph below) -- but it was certainly a surprise and indicates that the residential construction boom may last longer than previously expected.

But the residential construction story has also become a tale of two sectors. On one hand, we have approvals for housing -- historically less volatile -- which have eased since early last year. On the other hand, we have approvals for units, which fluctuate wildly from month-to-month but remain around their highest level on record.

Approvals for units fell by 7.9 per cent in December but this followed growth of almost 55 per cent over the previous two months. Moderation was expected in December -- in fact the market had priced in a larger fall -- but the very nature of the segment makes it difficult to predict.

One observation from the data is that approvals for units are increasingly being held up by abnormally large and unsustainable results at the state level. This month it was New South Wales (where units rose by 52 per cent), and in October and November it was Victoria (up 67 per cent and 38 per cent, respectively).

Growth of this nature typically reflects a few large apartment projects but there is a clear limit to how many of these projects can be undertaken at any one time. The concentration of such projects in Sydney and Melbourne may also be cause for concern -- what will fill the gap when these projects dry up?

Big projects could be announced in Queensland -- where apartments are roughly as popular as they are in Victoria -- but both South Australia and Western Australia continue to be dominated by housing approvals.

We should also remember that this data relates to approvals and not completions or construction and some projects may not go ahead. Construction in Western Australia or Queensland might be the most at risk -- given the current state of their resource sector -- but increasingly there appears to be risks of an overbuild in Victoria.

Recent research by Prosper Australia, for example, found that over a quarter of properties in the Docklands sit idle. Furthermore, 12.7 per cent of properties in Carlton South and 11 per cent of properties in West Melbourne are vacant.

Those numbers, particularly in the Docklands, could surge further over the next couple of years as more supply comes online and is purchased by investors who are interested in capital gains and not particularly fussed by earning low rental yields.

Finally, it’s also worth putting the current construction boom into perspective. While approvals are obviously elevated, the upswing has not been as significant as during past construction booms.

Until recently, the current boom appeared to be similar in scope and nature to the 2010-11 expansion. Now it appears to have similar characteristics to the double-peaked boom in the early 2000s. This episode won’t be as persistent or as lucrative as that earlier boom and should peak at around 3.5 per cent of real GDP (up from 3 per cent in the September quarter). It may peak higher if economic growth is weaker than anticipated.

There are obvious risks associated with the current construction boom -- particularly in the volatile apartments sector -- but the pick-up in approvals is proving to be more persistent than initially indicated. That’s a good result for the Australian economy -- the longer the construction boom persists, the better -- but we shouldn’t lose perspective about how small residential construction is by comparison with the Australian economy.