Is Sydney property market in a bubble? Sydney known for its beaches, food and weather. A quality of life that is on par with New York, London, Hong Kong and parts of Canada have also one of the most expensive residential real estate market in the world.
As with any bubble, the original fundamentals which drove the value of the asset is there but the market takes it a step further and turbo charges the price outside the realm of reality that we would consider the asset class in a bubble territory.
We have gathered some interesting charts to highlight the excess in the market and potentially what a housing bubble looks like. After all we have plenty of historical and ongoing examples of excess real estate markets which act as indicator if there is a Sydney Housing Bubble.
Our conclusion is that the Sydney housing market fit into the pattern seen in previous housing bubbles around the word where the run up in prices are now in excessive territory. We are cautious on our property market forecast and the slow down in Sydney house price growth will have wider implication across the economy when the price corrects investor excesses. The upside is that even in a depressed scenario our property forecast sees Sydney residential market will still outperform other markets such as Melbourne and Brisbane.
What causes a property bubble?
There are signs that a property bubble is brewing in Sydney caused by a number of factors. Investment bubbles are commonly described when the market become overzealous in anticipating higher future asset value and willing to pay any price to get their hands on the property today. This result in runway asset values because the buyer hopes to offload the asset at an even higher price in the future. The key driver of property bubble is fear of missing out and the greed of hoping continual price increases going forever.
Note it is important to know that future price is an assumption only. A bubble bursts when the materialized reality does not work out to what the speculator thought it would with original buyers holding onto over valued asset.
Sydney House and Apartment Price Growth Slowing
The chart is courtesy of Knight Frank Research which shows the pace of house and apartment prices in Sydney price increases on a 12 month rolling basis. This means the bar at each respective period is the housing increase over the last 12 months. Everyone pay attention to price changes because unlike commercial property investments where investors focus on the income. Most of the return from investing in residential properties are from capital gains.
Sydney residential prices saw 18 month of strong price growth since December 2014. Annual increase in house prices slowed considerably since mid 2016 which can be attributed to a number of factors listed below including stricter bank lending criteria and onslaught of apartment supply hitting the market in 2018.
Coincidentally the run up in housing value were step inline with the collapse of the last mining boom. This had a direct factor in pushing up house values or support prices across the Eastern seaboard. During the mining boom, the strong Western Australian economy supported the interstate migration inflows which the last 2 years has seen a reversal. As people move back from WA, the pace population growth pushed up demand for residential property. The Reserve Bank of Australia also helped when they had interest rates cut to generational record low.
Bank lending – boom ends in a whimper instead of a bang
Real estate is a leveraged asset class. It is a primary driver of middle class wealth in a number of countries not because real estate returns are better than equities or bonds. It is also one of the few only avenues where every day investors can purchase assets using enormous financial leverage. For example using a typical Sydney House market median value of $1 million, if you use 90% borrowed funds or $900k mortgage with $100k down payment means that the equity in the asset is leveraged 10:1 leverage. You are buying an asset that is valued 10 times your equity input.
If you use a “Conservative” deposit rate of 20%, this is still 5:1 leverage. Leverage can be used in equity investing with margin loan but it is uncommon to be above 50% of 2:1 leverage ratio. Commercial real estate will be hard pressed to use anything above 50% loan to asset ratio as well.
To offset, common wisdom is that illiquid nature of the investment is in their favor since price falls are only realized when the asset is sold. This is only true for owner occupiers. For investors any fall in asset values couple with the use of leverage means in some instances it may require additional equity. If prices fall more than your equity and with no additional capital input, the banks will pull the plug.
Australian residential property lending is driven by banks. With little or no securitization market since the GFC. The banks are in the drivers seat in the market in lending funds for residential real estate. Australia Prudential Regulation Authority (APRA) has been proactive in limiting the animal spirits of the banking sector in funding for residential real estate, especially residential investment loans.
A critical driver of housing bubbles in history was the ease of access to credit by speculators. Crucial ingredients include low lending standards and numerous banks chasing clients like what we saw in the US subprime crises.
By this standard with strong anecdote evidence of more stringent credit flows, absurd stories still exist still exist for investors that hold multiple properties across the Sydney house market. However they are the exception rather than the norm.
Going forward we anticipate slower credit growth which will put a lid on further price appreciation in the Sydney housing market. However it is already too late for some segments of the market where house prices are already inflated due to prior loose lending standards. We are not day 1 into the excess housing market but near the peak as the last few years, money has been flowing into the market non stop.
Supply and Demand – watch out for the cliff
It is well known historical supply has lagged demand in Sydney. The limited supply we would argue is one of the main drivers of market price appreciation in the Sydney houses.
However we are cautious that current supply will outpace demand in the near future and that it will take the market considerable time to digest upcoming supply. This would put pressure on future housing price increases going forward. 2018 is expected to be a big year for Sydney.
Although history never repeat it self, it does rhyme. One component keen watchers of the housing market should follow is the inflow of foreign capital into Australian property market. The area we are most concerned with the inflow of foreign capital is the funding of new apartment construction. The government has responded to this by increasing property stamp duty on foreign owners as well as higher land tax. This has take some wind out of the market.
The weak Aussie dollar has exacerbated the issue, as historically low exchange rate makes purchasing local asset cheaper from foreigner investor’s currency perspctive.
As we have noted in the past, the inflow of foreign money can create distortion due to regulatory constraints. Foreign investors can only invest in new housing stock. They are one of the largest providers of funding for residential construction in Australia, particularly gateway cities such as Sydney and Melbourne.
Recent apartment construction, especially in middle ring of Sydney causes some concern. This is an area where gap value will be the widest as number of projects will become marginal in the secondary market once the froth is gone.
Sydney Apartment Approvals
Previously it was standard practice for developers to pre sell a housing project up to 80% before the bank will release the funds for construction. However foreign entrance in the market means construction can commence with limited pre sale or directly in the oversea markets. The goal is to sell the projects in foreign markets where Australia residential apartment contain a “safe haven” premium.
The problem arises when construction supply becomes out of step with apartment demand which we forecast will occur in the medium just as we are seeing in Brisbane Fortitude Valley and Melbourne CBD. Then it is up to the market to correct it self. Increase upcoming supply coupled with potential settlement risk and pullback in residential investment lending means that Sydney prices will be increasingly coming under pressure.
House Price to Income Multiple
Similar to price to earning ratio used for stocks, housing can be valued in a similar fashion as multiple of either rental income or household income. In this instance, the house value to median income is a measurement of housing affordability while rental income is a measurement of value.
Median House Price to Income multiple for Sydney shows that prices is on par with some of the most expensive real estate markets in the world. Hong Kong is by it self completely off the charts.
How did the prices get to where it is today? The chart below shows the trend in house prices in multiple terms over the last 35 years. The increase in Sydney housing prices is really a story of multiple expansion. The issue with multiple expansion is that it is a finite driver of value. When multiple gets to a level where it can be no longer sustained, it will revert to the mean.
Sydney real estate prices always contained a premium relative to the rest of Australia. However the current premium is high even by historical standards.
If you take a typical residential property yield of 3% – 5% then inverse that. Then you get a real picture on the valuation of real estate in Sydney. Under the scenario of 5% yield implies earning multiple of 20 times. Equivalently, for a stock to be priced at 20 times p/e ratio there need to be a great story to justify the future growth.
The current high prices are supported by record low interest rates. The mistake is for investors to overpay assuming the low rates are here to stay. If an asset is purchased at today’s level the low income yield is effectively locked in. Upward movement in rates would wipe out any cashflow growth unless rental income grows substantially from current levels.
Note it is difficult to lock in long term rates under standard mortgage products. Typical lock in is a 5 years at most with 10 year money not very cost effective.
Affordability indicator shows that the current market is stretched and multiple expansion cannot go on forever. Asset owners are banking on income growth to justify the current high prices.
Sydney Rental Income and Vacancy
Chart below shows the capital city vacancy and rental growth rates. Logically, as vacancy increases rental growth slows. Increase level of supply coming to market driven by safe haven money will put pressure on future rental growth rate going forward.
As previous price increases are driven by multiple expansion as result of strong investment flow. If the price to income multiple of property becomes too high then the primary driver of value will be income growth.
Key question in the same investors mind now are:
1) If income is not growing or even falls, would the underlying asset be worth the same? How much to an extent is future income growth priced into the price paid today.
2) What is the future price expectation if rental income (or return on asset) is falling?
3) Given no growth in income, is the current yield on investment worth the risk?
Typical 3 – 5% gross yield on Sydney residential property does not look enticing with no growth in rental. This is coupled with 4% interest on borrowed funds.
The chart shows what the rental market looks like when the market vacancy rises. Currently Perth residential prices is in slump where natural demand has fallen away after the end of the mining boom. Even as commodity prices has recovered, miners are still not investing in new mines. The rising vacancy rates has reduced apartment rents by almost 25%. It is estimated average price has fallen 10% but this is market average and it would be worse it the fringe markets.
Sydney Property Market Forecast
Given the above factors we consider the future for Sydney residential market to be bleak. The prices are in excess territory while supply is coming online to meet artificial demand. Any slow down will be prolonged as it take time for the market to absorb the supply and head towards to more natural levels. This means that future price growth will not repeat the past performance. A severe downturn in residential market will flow onto broader economy with job losses outside of real estate, the tricky part of forecasting is getting the timing right.
Only because there is no hard landing scenario does not mean it will not be painful for residential investors, especially mom and pop investors. Australia has not had a recession for more than 25 years. The leverage built into the system is larger than most expect and any minor shakeout will have far and wide consequences across economic sectors outside the real estate industry.
Just like the collapse of the Japanese housing bubble and recent US experience. US consumer sentiment dropped significantly. We would expect any slow down to be the same in Sydney. Additionally, we are cautious on the discretionary sectors.
From investment financing perspective standard mortgage products are full recourse rather than limited recourse seen in the US residential lending market. People cannot just walk away from under water mortgages. Interest payments, albeit lower in a downturn scenario will still have to be paid. Discretionary spending will be the first to be cut. We remember during the GFC where spending at the Pub and eating out literally collapsed overnight. Business spending take time to be cut due to forward planing and contractual obligations. Consumer spending can be stopped overnight.
The silver lining is that Sydney is considered a core market. The best assets will still do better than secondary markets.
Investment Implications as result of property weakness
A weak housing market will have wider implications across the Australian economy and the equity markets. Cyclical stocks for specialty retailers and even to an extent the consumer staples will be hit due to immediate decrease in revenue magnified by strong operating leverage in the business models. Financial institutions will not escape unscathed. We feel the degree of severity will not be realized until bad debt charges upward spikes from current levels.
We would be keeping an eye of the Commercial Real Estate markets. Asset values have been supported by secondary stock leaving the market. Strong residential market means that the highest and best use of B grade office buildings is tearing it down and convert to residential apartment. This has support prices on otherwise terrible assets in already weak markets.
A slowdown in Sydney property market means that office and industrial sites would be price naturally on a standalone value which could result in pull back in some listed property trusts.