Australia has not had a recession over more than 25 years. There is significant leverage built into the system and we feel a run away housing market and subsequent decline poses one of the greatest risk to the economy.
This post is designed as a pre made prep book on potential trades that can take advantage of decline in house prices. While timing is just as important as entry price in any trade. The goal of the play book is to prepare ahead of time and when the situation does rise, the ground work has been done.
Option number 1: Short Banks
One of the most straightforward way of shorting Australian housing is to short Australian Banks. Australian residential mortgages are predominately held on bank balance sheet. Any decline in house prices will have a magnified impact on bank earning and impairment charges. Bad debt charges are almost at record lows in the recent bank earning cycle. The headwind of increase bad debt charges will limit forward earning growth.
Bank earnings are pro cyclical which rises faster than the broader market when the times are good. During periods of stress, especially real estate related. The inherent leverage of the banks will erode capital and hence shareholder value.
Book values of banks during broader real economy weakness is not to be trusted.
The trick to for this trade to work is to limit the pain of the large bank dividends. High dividends presents a significant negative carry while waiting for the trade to work. Hence we are reluctant to short the banks until we see confirmation of weakness in housing prices, deterioration of employment indicators and cliff fall in consumer confidence.
We are not too eager to short until confirmation or strong confident as weakness will persist until when everyone the worse will happen.
Option number 2: Short Australian Dollar
The Australian banking sector is severely concentrated between the big 4. Any wider weakness in the real estate sector means that the whole system would be infected by increasing bad debt. The best way to take advantage of systemic risk as result of bursting of the property bubble is short the Australian dollar.
Issues of negative carry from the first option is limited when real economy distress is widespread. RBA will cut rates which will add fuel on to the fire.
Any government initiative in stabilising the system is equivalent of risk transfer from the private sector to the public sector. Arguably short term positive, long term negative. If government let the crises run through the system with minimal intervention it will result in AUD collapse.
Option number 3: Short specific names
Share price of developers like Lend Lease and CIMIC will not escape any slowdown unscathed. Although if you can get borrow, focus on smaller residential developers which are not as diversified as the first two.
Discretionary retailers can also be a good opportunity to express this view. JB Hi Fi, Metcash for its hardware sector exposure and consumer oriented financials.
One name we are keenly keeping an eye out is REA Group. REA Group owns Realestate.com.au which is a listing site for Australian residential properties. REA is essentially a secondary derivative play on the housing market. Its earnings are based on the overall health and volume of the residential market.
A number of factors makes shorting REA group one of the best way to short the property market.
The pure exposure to Australian real estate sale volume is the primary thesis for shorting REA. REA earns fees when sellers list their property on the market. Previous earnings were driven by increase in penetration of interest listing and growth in the sale volume which both factors will slow down going forward.
One lesson we learned and follow is not shorting a company based on high valuation. In REA’s case, it provide support but not a primary driver of our thesis. It is more attractive in shorting REA verses the likes of the Australia banks given the high carry cost bank dividends. The high franked dividend payments means that there will be significant cost in holding the short position. REA dividends yield is not material given the high share price valuation.
The market has priced in the stock a level where earning growth is expected to continue at the current rate. We question the rate of growth under a weaker housing market environment. The comparable sites it owns in Europe and parts of Asia does provide a strong growth story. However as avid growth investor, we see these parts of the business to be immaterial to earnings for at least 3 to 5 years down the track.
Last year REA earning per share was $1.50 with consensus street expectations of $2. At $50 this is still 25x forward 2017 earnings. If weaker market volumes flows through to stock earnings in the 2nd half of the year. There is a lot more downside to the stock.
The second thesis is the quality of the earnings of REA.
Chart above shows the 1st half revenue by segment. 24% of the underlying earnings segment are from media and developers and coincidently it grew 24% year on year.
These are revenue based on new products or developments coming online. Real estate is a cyclical business and given the part of the cycle where we are today. The elevated level of housing approvals nationally make us feel that this part of the business will not grow as fast going forward.
Interesting to see how this pans out given the weak bank share prices. Market has latched on the idea that housing provide significant risk to the retail banking business. If a potential weakness flows through to the broader conscience, then the next question is who is next. Our pick is REA.