What goes down must go up.
A year ago, I wrote about the fall and fall of interest rates and the impact on both borrowers and those living off interest earnings.
One year on and most pundits are forecasting that interest rates are at the bottom of the cycle and we may well see them rise, either later this years or early next year.
What will rising interest rates mean for those with debt, and particularly those with debt attached to investments in the Australian property market?
Investors need to be realistic about investing in apartments
Front page news last week saw yet another in a long line of OECD experts talk about the impending crash of the Australian housing market. OECD officials – writing in what is their first major review of Australia’s economy since 2014 – said the housing market may not “ease gently” and could develop into a “rout on prices and demand with significant macroeconomic implications”.
“A chief consequence would be a juddering shutdown in household consumption and a surge in mortgage defaults that would ricochet around the economy.” (1)
What overseas commentators fail to appreciate is the importance of not looking at the Australian housing market as a whole system: apartments and detached housing need to be evaluated separately.
A drive down any major road in any city in Australia will reveal an astonishing number of apartments under construction. We are building too many apartments in metropolitan areas along the eastern seaboard and not building enough detached housing to meet the demands of a growing population.
The Reserve Bank came out in early February with some statements on this matter (2). It reported that compared with previous housing cycles, a much larger proportion of recent activity has been in higher-density building. Apartments take longer to build than detached houses, which has contributed to an increase in the pipeline of work to be done. The average completion time for an apartment in 2016 was around six quarters, almost three times longer than for detached dwellings
While the large pipeline of residential building work is expected to support dwelling investment and employment over the next couple of years, there are risks associated with the high level of activity and the shift to higher-density buildings:
- Because much of the apartment construction is geographically concentrated, particularly in inner-city Sydney, Melbourne and Brisbane, there is an increased chance of localised oversupply resulting in downward pressure on local area prices.
- Because both approval lags and completion times are longer for apartments, developers might not be able to respond in time to price or other signals of waning demand, so an oversupply is more likely to build up.
If these risks materialise, there could be an increase in the proportion of newly completed apartments that fail to settle and a rise in the share of work yet to be commenced that is not undertaken.
The shift to higher-density construction has affected the RBAs ability to use the pipeline of work as a leading indicator of future dwelling investment. Because an approved apartment takes three times as long to complete as a detached house, the pipeline of work to be done provides information on dwelling investment much further into the future.
What the RBA is saying is: the longer lag between the decision to build a higher-density dwelling and its completion means that the impact on the housing market, including prices and vacancy rates, may be less predictable than in the past thus making it difficult to forecast if we have an over supply or not.
The message is clear: be cautious when investing in apartments and consider the inherent uncertainty about who will rent them and at what rental return and who will buy them when you are ready to divest.
A tightening credit market: What investors need to know
February 2017 saw Bankwest (a subsidiary of the Commonwealth Bank) restricting investment property loans and no longer taking negative gearing benefits into account when evaluating loan applications.
In other words, property investors are no longer able to include the tax benefits of negative gearing when calculating the loan serviceability.
Bankwest’s action is a result of a 10 per cent investor portfolio annual growth limit introduced in 2014 by the Australian Prudential Regulation Authority (APRA), in a bid to rein in frothy house prices in the capital cities.
APRA set the 10% growth target because they do not want growth in debt to exceed 10% per year because they are concerned about financial institutions carrying too much risk.
The tightening credit market will impact on investors in the following way:
- If an investor buys an apartment off the plan and there is a time lag before the apartment reaches completion, not only is the investor speculating that the apartment will be worth at least what they paid for it at the time of completion, they are also speculating that the bank will lend the money at that particular time at the right interest rate.
With interest rates at or near the bottom of the cycle, many investors look set to be disappointed
To sum up, when we buy something in the future, what we are doing is speculating – not only on what the value of the property may be in the future, but on the future interest rates, what the rental market will look like and the availability of credit.
Fundamentally, rising interest rates, the tightening of the credit markets and the inherent uncertainty in the investment property market means that if you speculate on a property investment three years from now, you are in fact speculating on a number of variables.
Risks generally pay off at the bottom of the market because the market only has one way to go: Up.
In this case, interest rates may go up and the apartment market may go up, fall or go sideways.
For those thinking about investing in the property market in a low interest rate environment, it is a time to exercise great caution. A choice must be made between taking some risk on the investment and your propensity to withstand these risks.
Yet, there will be opportunities for others who are prepared to bide their time. As always, debt is a double edged sword. When used wisely, it can significantly enhance your financial position and when used poorly, it can take years to recover lost ground.
In all cases your individual financial objectives, needs and circumstances need to be considered. Knowing the financial implications for each option – including doing nothing – is the key to navigating interest rates, debt and investing in the property market.
- The Reserve Bank of Australia STATEMENT ON MONETARY POLICY | FEBRUARY 2017 https://www.rba.gov.au/publications/smp/2017/feb/