Investment value in the residential markets

From 2012-17 MP Funds Management provided investment funding for 20 or so residential projects The strong market fundamentals and the lack of competition, particularly between 2012-14 meant that we could charge a high compounding return on capital (usually between 18 – 25 percent) and our investment was underpinned by robust economics, an upswinging market and sound property fundamentals.

From 2016 we saw these favourable conditions replaced with a ‘toppy’ market: more capital participants had created competition and downward pressure on the pricing and investment returns that could be achieved.

So we switched sectors. Instead of investing as debt into construction funding, we started investing as equity into core-plus (yield plus a value-add) property assets, all of which have produced in excess of 20% IRR. 

At about the same time, some major American hedge funds started shorting the Australian banks as a result of our banks’ exposure to Australian residential mortgages. The international view was that our Australian residential market was becoming so ‘frothy’, that another GFC was looming and the bottom would fall out of the market, rendering those mortgage-backed securities held by our banks as assets on balance sheet worthless.

What the Americans misunderstood about our market was that Australian mortgages are personally guaranteed and you can’t just hand back the keys if times get tough like you can in the USA.

Nonetheless the shorts created a flurry of negative media attention and a PR headache for the Australian banks which coincided with an unprecedented influx of foreign capital into our residential markets – resulting in soaring demand and gross affordability issues at both an en-globo and end-product level.

What happened next is well known - the Royal Commission and subsequent tightening of government regulations via APRA, ultimately resulted in a market that sent it cooling just as fast as it had risen some years earlier.

Fast forward to our new post-COVID economy (potentially not-so-post yet considering the current Victorian outbreak) and headlines cite a reduction in property values and decline in rental values.

Read more on Australia’s falling house apartment values and rental yeilds here and here.

Not only are these latest figures driven by rising unemployment levels, but the total cessation of net migration due to our indefinite border restrictions, which will place significant downward pressure on demand for at least another 12 – 18 months.

So what’s the outlook then for the residential market?

The answer is it depends on how a few varying factors play out. However, in a market where visibility is difficult, I like to identify the facts and use those known facts as benchmarks to establish a view.

As with any market, the key balance is supply / demand. Understanding where there might be an lack of supply and a pocket of demand is where investment value will be achieved.

As I mentioned last week Australia has a population of 25.5 million and 60% of last year’s growth was as a result of net migration. To house the current population of 25.5 million people we have an aggregate 10.4 million dwellings or 2.4 people per dwelling.

Supply/demand fundamentals have of course been hit as a result of COVID and largely as a result of the immediate pause on in flow of migrants. Unemployment and softer business conditions also dampen both supply and demand.

However some comfort can be taken from the fact that the aggregate value of the 10.4 million dwellings equates to around $7.2 trillion. The aggregate mortgage value is around $1.8 trillion which, for the Australian Banks, leaves a buffer of unlevered equity of around $5.4 trillion and LVR in the order of 25%.

(*note there was a typo in last week’s numbers with respect to aggregate denomination value and LVR which should have been trillions)

Interestingly in January of 2020 there were c. 5000 surplus unsold brand-new apartments in Sydney metro, showcasing an oversupply and decline in the demand – possibly still as an overhang from APRA’s 2016 cooling measures and the drop off in Chinese buyer demand after 2014-16.

Despite the surplus Sydney metro apartment stock, because the market was showing strong enough demand for values to stay buoyant, debt providers – both major banks and non- bank lenders saw opportunity in providing lowly-geared loans on the residual apartment stock. Developers with unsold surplus completed stock were able to hold onto the apartments with these loans, and values in general were maintained as a result.

Given continued robust population growth and the gap in pipeline supply numbers, both house and apartment values were climbing to the March quarter 2020, with the mean price of residential dwellings rising $10,700 to $690,200, while the number of residential dwellings rose by 43,700 to 10,485,700.

Anomalies will present in various parts of the landscape, such as the downsizer market which will continue its strength as time marches on for those empty nesters who prefer high quality apartment living. As always during times of crisis there will be a flight to quality.

There will be those who have overleveraged in some way shape or form and been caught out by the sudden economic crisis, whether that be those who have lost their jobs, applied for margin loans with their home as security etc. Therein will lie the opportunity for an incoming buyer.

The government’s HomeBuilder package may stimulate the lower end of the market. However with banks being more stringent on employment income in vetting for mortgages and Victoria’s climbing highs of new daily COVID cases, home buyers in that lower price bracket may also find it challenging to take advantage of the package.

Australia’s overall reliance on immigration for both economic growth and new housing demand will mean a sharper decline in residential values in the short term. But then as doors re-open and government spending stimulates job growth via construction and infrastructure projects, we are likely to see a recovery over the longer term as those required in-flows of immigrants create a sharp housing demand.

The softer conditions now will mean a lack of supply when demand starts to rise, and prices will increase.

Like any market, understanding the size, the total value and the drivers is what enables better visibility and the ability to act quickly when a value anomaly emerges.

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