The housing boom ends, signaling financial turbulence ahead

Australian property prices are falling at their fastest rate for five years, thus putting a definitive end to the debt-fueled housing boom. My concern is that this reversal has only just begun.

We’ve been warning investors of an imminent decline in the property market since the high-rise construction boom oversupplied apartments, and the Financial System Inquiry resulted in APRA capping growth of investor loans and limiting the proportion of interest-only new mortgages.

Property prices are now officially falling at their fastest rate in half a decade and $480 billion of interest-only mortgages remain due to migrate to much more expensive principal and interest (P&I) loans in the next five years.

For the financial hardship being imposed on many young home borrowers, a recent article tried to blame the banks. In that article, a former banker and founder of an online mortgage site observed that financially stressed millennials “are being forced to cut back on dining out…” because they had taken out mortgages without comparing products and rates, and without obtaining advice.

Generations before millennials were forced to cut back on a lot more than “dining out” to buy a house, raise the kids (which millennials aren’t having) and ‘get ahead’. Markets are indifferent to the age of those that pay a high price to lock in a low return.

Nobody should think they are immune to the vicissitudes of markets.

For anyone who has purchased a residential ‘investment’ property in the last few years – certainly since we began warning investors to stand back from oversupplied apartment investing – returns will be low simply because a high price was paid and net income is negative.

It’s a simple rule of investing: the higher the price you pay, the lower your return. A more nuanced rule for Australian property investors is: if the income yield is negative, your return can only come from a capital gain so you must be speculating on a ‘greater fool’ coming along to give you that capital gain. That is gambling, not investing.

Most recent investors in apartments have failed to generate a positive return. In one recently reported anecdote – which is not atypical and will become much more common – a one bedroom apartment in the Melbourne suburb of Richmond has failed to appreciate after being purchased off-the-plan eight years ago.

With Australia’s household debt-to-income at record highs, the majority of investors of course have borrowed to fund their purchase. They are now discovering that interest rates can go up. Many are also being moved onto significantly more expensive P&I loans as their original interest-only loans are refinanced upon maturity. So, the unwinding of the prior debt-fueled property boom is only just beginning.

Of course, high leverage by itself is not enough to cause a housing correction but a fast rising property market, fueled by rapidly rising debt are two of the preconditions of a financial crisis cited by Carmen M. Reinhart and Kenneth S. Rogoff in their book, This Time is Different – Eight Centuries of Financial Folly. 

When credit growth flattens out and turns negative, another nail is hammered into the coffin of financial stability and credit is currently tightening.

Many more stories of financial stress will emerge not only because less credit is being extended to would-be buyers who might rescue vendors in difficulty, but also because would-be buyers are less abundant through lack of desire to buy in a falling market.

As we have written about previously, capital losses on vanilla established-residential property investment is only one source of loss for investors. Some off-the-plan purchasers will also experience the failure of a developer unable to complete a development because other off-the-plan buyers have been unable to complete their purchase due to an insufficient deposit, rising mortgage rates or other unfavourable term changes.

The developer is forced to discount properties to move them on –  if they can sell them at all – simultaneously reducing area sales valuations and perpetuating the downward cycle.

ASIC data showing construction-related companies entering administration still remains low in absolute terms and lower than at the same time last year but the pattern of property price declines, reduced credit from banks and failed purchase completions, as well as rising input costs for developers, such as interest rates and contractor costs, indicates this number will rise.

Investors need to be confident that the developer of their off-the-plan purchase will remain in business after taking their deposit.

Meanwhile, banks are countering the expected increase in developer failures by reducing interest rates for new borrowers. While the strategy is essentially designed to maintain market share and grow credit in a falling market, the strategy also works to assist developers to find new customers. Of course, this behavior – luring new customers with attractive rates at the expense of existing customers – is precisely the kind of behaviour the Royal Commission is seeking to dissuade.

It is hoped by many that the regulators and banks can work in concert to ensure an orderly and, preferably, shallow decline; and that investors will be reminded that borrowing to invest has risks so that future speculative manias can be contained.

Hope, of course, springs eternal, but the hope of quick profit and the fear of missing out will always trump rational behavior. And millennials are not immune.