Back in early 2017, when property markets were booming, we warned Professional Planner readers that the boom was unsustainable and property prices would decline. You might recall our list of property doyens who were selling. Today, property prices are falling and our thesis is playing out as expected.
The issue now is determining whether investors should turn to local or global factors when establishing the drivers of short and medium-term reasons for expecting a benign decline or even a return to positive growth.
There is little doubt that local conditions and sentiment are important factors when considering the outlook for property, but it is vital that investors appreciate the property boom experienced since the GFC was a global phenomenon and that current falls are synchronised across global cities, too. That suggests global influences might be more important in determining the prospects for property – and its related sectors – than regional or community effects.
According to CoreLogic, a preliminary major capitals clearance rate of 56.7 per cent was registered on the last weekend of June 2018. But this number is the result of comparing properties that sold to those that didn’t, from the 1251 results that were submitted to CoreLogic, not from the 1669 properties that went under the hammer.
Back in 2014, some of the seeds of today’s property sell-off were being sown.
David Murray’s Financial System Inquiry eventually produced a regulatory response from the Australian Prudential Regulation Authority that changed bank mortgage risk weights such that they simply couldn’t lend as much for mortgages for each dollar of equity they held. Banks were also ultimately required to rein in lending on an interest-only basis and they were forced to limit the growth in their investor loan book, eventually forcing many interest only borrowers onto principal-and-interest products, increasing repayment obligations, particularly for those who have used rising property equity to buy additional properties without an increase in income to service higher repayments.
Then, at the same time that apartment supply was heading towards a glut, banks began curtailing the suburbs to which they would lend.
Meanwhile, changes to foreign investor regulations have caused applications to the Foreign Investor Review Board to fall by 65 per cent in 2017 from over $70 billion to less than $26 billion.
Finally, the Hayne royal commission uncovered uncompliant lending procedures that went beyond ‘lax’, and prompted federal treasurer Scott Morrison to threaten ‘jail time’ for bankers who failed to rein in procedures that put convenience ahead of the law. The effect was to reduce lending volumes and loan-to-value ratios, while simultaneously increasing the time required to process a loan as banks more rigorously assess borrowers’ income and living expenses.
Clearly, the risks of a credit crunch are raised and with property prices already falling, the possibility of a death spiral increases if falling prices produce negative equity, which is the single biggest determinant of defaults. And thus far we have left out any mention of rising bank funding costs, which could bring an increase in mortgage interest rates, nor have we mentioned the implications of mandatory Comprehensive Credit Reporting from July 1.
GLOBAL CREDIT WOES
The simple fact is that the root cause of current property ills is that credit is harder to obtain. What is perhaps surprising is that the change in credit conditions is being experienced globally.
We have heard anecdotes of more than 30 per cent of mortgage applications being rejected, compared with just 5 per cent a year ago. And those that can get a loan are unable to borrow as much as last year. Some stories suggest borrowing capacity has been reduced by 30 per cent.
APRA’s monthly banking data, released on June 29, credit conditions are having an impact. With one exception, all major banks have reduced their investor property lending. Housing investor credit growth slowed to the lowest level on record.
But while domestic factors are interesting, they serve to accentuate a trend that has a global birthplace.
The US Fed wants rates ‘normalised’ by the end of the decade and the market has been aware of this objective for some time, and appears now to realise the day is fast approaching. The market shift in sentiment is a reminder of the old adage that ‘rising rates aren’t a problem until they are’. Investors now realise that the pace of US economic recovery will not give the Fed an opportunity to press the pause button on its higher rate policy.
Hedge fund impresario and DoubleLine Capital founder Jeffrey Gundlach noted, “Here we are doing something that almost seems like a suicide mission… increasing the size of the deficit while we’re raising interest rates.”
INFLUENCES ON LOCAL RETURNS
If short-term rates rise faster than long-term rates, the yield curve first flattens and then inverts. An inverted yield curve usually portends a recession.
Financial markets often provide more reliable indications of the economic outlook than consensus economics. Australian bank shares are already off circa 20 per cent from historical highs and even the venerable US-based Wells Fargo has traded down 24 per cent from most recent highs. Banks are operating in a tougher environment almost everywhere in the world and while US growth is strong, it’s not as robust elsewhere.
In such circumstances, it is difficult to see how property prices can rise, even if domestic factors are supportive, which they aren’t.
Domestic property investors, and those in retail and property-related stocks, should be aware of several influences likely to affect domestic returns. The first is that in a globally connected world where securities are comparable, if not fungible, international credit conditions will determine the direction for asset prices more than in the past. Secondly, when price changes are synchronised globally, it suggests the influences are global rather than local. Finally, investors should be aware that in any market dislocation, the variance of returns declines. In other words, the baby tends to be thrown out with the bath water. If the US sneezes, we all catch a cold.
Hedge fund billionaire Ray Dalio recently summarised the situation: “2019 is setting up to be a dangerous year, as the fiscal stimulus rolls off while the impact of the Fed’s tightening will be peaking,” and “…since asset markets lead the economy, for investors, the danger is already here.”
There is no question that factors like immigration, tax incentives and affordability have an impact on property prices locally. But synchronised changes in property globally are a virtually certain indication that global factors need to be considered in any evaluation of a property strategy. As domestic and global equity managers, we are avoiding companies with direct and indirect exposure to real-estate prices and activity. We think you would be wise to investigate whether such an approach is equally sensible for you
Roger Montgomery is chairman and chief investment officer of his own investment firm, Montgomery Investment Management.
