The flattening Sydney property market – four reasons why this time could be different

April 11th, 2018

Driven by high credit and population growth, Sydney’s property market has been on an almost uninterrupted upwards trajectory for well over a decade.

During that period, it has proven remarkably resilient to various shocks which, in order of significance, have included:

  • The global financial crisis (GFC) of 2008
  • A crack down on foreign buyers: in June 2017, New South Wales doubled foreign investors stamp duty to 8 percent
  • Macro-prudential regulations against banks, introduced in March 2017 by the country’s banking regulator Australian Prudential Regulation Authority (APRA), which capped interest-only lending to 30 percent of new loans

This week, Shane Oliver, chief economist for AMP Capital, announced that median property prices in Sydney were expected to drop by $1000 a week.

According to property analytics group CoreLogic, home values this year are down 1.9 percent in Sydney. During the week up to 8 April 2017, 775 homes went to auction in Sydney (67.1 percent were sold) – a large drop from the number of properties that went to auction during the same time period last year (1,436 homes with 77.7 percent sold).

Signs of a correction in Sydney’s residential property market (in contrast to its industrial and other commercial property markets), include “prices contracting slightly from the September quarter, properties being listed for longer prior to sale, and fewer reported interest in open homes,” says Blake Buchanan, an executive at international brokers Specialist Finance Group. “Other factors are that the regulators have made it harder and more expensive to borrow money for certain segments, particularly international and investment.”

A correction is one thing, a national property crash another. Why should now be any different? Doesn’t history suggest that the Sydney property market is bullet proof?

No.

In December last year, hedge fund Watermark Funds Management warned that Australia has similar conditions to markets which experienced a severe crash following the GFC, including the United States and United Kingdom. These include inflated prices, a flagging economy and high household debt. (Australia’s household debt to income ratio is now just under 200 percent, making it one of the highest in the developed world; total household liabilities number $2.466 trillion, according to the Australian Bureau of Statistics).

A sudden hike in interest rates, combined with a decrease in credit availability, might push Australia over the edge.

Buyer’s agent Curtis Associates has pinpointed four factors with implications that are unique to Sydney and which could add pressure to an already flattening property market. Individually, or worse combined, they have the potential to be the shock that makes the difference this time round.

Infrastructure woes

New South Wales has committed a record $80 billion spend on infrastructure over the next four years. Projects in the pipeline include the controversial 33-kilometre $16.8 billion WestConnex toll road and the multi-billion Sydney Metro, the largest urban rail project in Australia’s history.

Yet not everyone is happy: one poll conducted in The Sydney Morning Herald showed that “almost half of voters do not think NSW’s multi billion-dollar investment in transport will improve their commute.”

That raises the question: what happens if a cash-strapped population refuses to pay tolls? Or if the Sydney Metro is a dud  because it is riven with planning flaws as discussed in our last CurtisCall special report.

WestConnex, due to open in 2023, is still years away from completion – with ballooning costs. Indeed, the City of Sydney Council has estimated that the cost of building the WestConnex and its connecting roads combined will be more than $45 billion and has more recently raised concerns that the competition posed by the Sydney Metro may weaken the business case for WestConnex.

In order to fund this the government announced plans last year to sell a 51 percent stake in WestConnex. Problems will arise if there are no buyers or, once completed, if the motorway is under utilised. Another threat to the popularity of toll roads is a growing appreciation of possible health risks posed by particulates pumped out of unfiltered ventilation stacks and tunnel portals, as discussed by buyer’s agent Curtis Associates here.

One stark example of the cost of over-estimating usage is Brisbane’s Clem7 tunnel, which went bust in 2011 (investors who purchased shares in the tunnel won a $121 million payout from traffic forecaster AECOM and owner operator RiverCity Motorway in 2016.)

So why does this matter for property?

Australia missed out on the worst of the GFC largely due to the mining boom, leading to a period of strong household consumption growth. As the mining boom dies down – and more households now start saving – “infrastructure spending has effectively supported the economy,” Martin North, Principal of Digital Financial Analytics told Curtis Associates saying “what has not happened, we haven’t seen a private business investment spike. Essentially business investment is not firing and has not been firing for a long time and I’m not sure it will fire anytime soon.”

In other words, if infrastructure goes belly up, so does the economy.

“There are a number of projects in the pipeline at the moment,” adds Mr North. “And the government is clearly both at a state and federal level putting money in to kick start the economic outcomes. But these are big projects that tend to overrun and become more costly. The big question is whether they’ll get the returns they expect. If [infrastructure] stresses happen the government will be under huge pressure.”

A change in State government in 2019

Next March New South Wales will hold its State elections – leading to a very real possibility of a change in State government as the Liberal/National Coalition, currently led by Premier Gladys Berejiklian, attempts to win a third four-year term.

If Labor enters office this could have serious consequences for infrastructure plans.

Victoria is a case in point. When Premier Daniel Andrews took office in 2014 he unceremoniously cancelled Melbourne’s East West Link toll road, dubbing it a “dog of a project”, in a move that cost the government $1 billion.

“Victoria may be an interesting analogy – when there was a change of government some of the big projects got re-scoped and stopped,” comments Mr North. “There is often a difference of priorities [between political parties] in those big projects. To be honest the opposition hasn’t been clear about what it might do. It doesn’t bode well for big projects.”

Opposition leader Luke Foley attempted some clarity on 6 April 2018, declaring: “We will deliver Metro West years earlier than the Liberals because we won’t build a northern beaches mega tunnel nor will we proceed with the pointless conversion of the Bankstown line.”

“Consumer and business confidence plays a huge part of our economy. I think a change at the next state election would not be good considering the current state of NSW finances, the significant investment now and into future planned developments particularly around infrastructure,” says Mr Buchanan. “A change would be a disruption to these.”

Banking Royal Commission

A number of less than flattering revelations have come out of the banking Royal Commission this year. Practices exposed include so called “liar loans” issued on false information and systematic reckless and imprudent lending from banks.

Round one of the Commission “was more severe than we anticipated, with irresponsible lending a key finding of its investigations,” UBS writes in a report on the Australian banking sector, released on 5 April 2018.

Such revelations may lead to plummeting house prices as lending is tightened – which, in itself, could lead to serious repercussions for the national economy (roughly two-thirds of all money lent by Australian banks are home loans adding up to $1.7 trillion).

“We believe the Royal Commission is likely to recommend a higher level of due diligence is required for banks to comply with the Responsible Lending Laws,” UBS reports. “In particular banks may need to undertake a detailed assessment of each customer’s living expenses rather than relying on the HEM benchmark, while overstated income will require greater validation.”

As such UBS estimates this may lead to customers’ borrowing limits falling by as much as 35 percent as “a sharp reduction in housing finance and credit growth looks more likely.”

Duped into borrowing too much – with wages now stalling at just 2 percent growth nationally – many homeowners could get caught out. In the same way the GFC unraveled from a specific micro market in the US (sub prime, low income), in Sydney’s residential property market it could be the highly geared more affluent upper end who would be in serious trouble if rates went up even one percent. In the commercial property market many loans are up for renewal and those borrowers may also be in for a rude shock.

And because Sydney has the highest prices of any Australian city, buyers will feel the impact of interest rate rises more than buyers in other urban centres.

The upshot of the Commission is less credit availability.

“Lots of households are sitting on what we call unsuitable loans. Effectively the banks made loans they should never have made,” says Mr. North. “That could lead to all sorts of litigation and costs for the banks. As a result profitability will be degraded significantly and they’ll have to start putting interest rates up to deal with that.”

“We are already seeing borrowing power down 20 percent,” he continues. “In the worst case scenario credit will be less available, households will have to pay more for that credit. Home prices are connected to credit growth – if credit availability shrinks, home prices will fall. That has significant impact on households and their confidence and ability to spend – look at Ireland. Home prices killed the economy for a generation.”

Exodus of foreign students

For years Australia’s universities have been propped up, and paid for, by Chinese and other international students. This year, however, for the first time visas issued to Chinese students have dropped, according to Austrade.

There are a number of reasons for this. Chinese tertiary education is itself improving, meaning more students are willing to stay at home, and controversies about Chinese government interference in Australia has shaken confidence in the sector.

As the Australian Financial Review reported on 6 April 2018, the RBA is also closely monitoring any possible devaluation of the yuan which, if that occurred, would hurt its overseas students.

Of most impact, however, are Malcolm Turnbull’s 457 visa changes, which went into play in April last year – making it harder for foreign students to transfer from a student to work visa.

As The Sydney Morning Herald reports “part of the attraction of our universities for some foreign students has been the ability to turn a student visa into a temporary work visa and that, in turn, into permanent residency.”

Yet, with the carrot of permanent residency removed, “457 visa applications for the six month period [to the September quarter] were down by 34 per cent on the previous corresponding period. Within that, student visa transitions dived by 50 per cent,” writes The Sydney Morning Herald. 

For property, that’s bad news. Despite attempts to cap foreign investment – including limiting sales for foreign buyers to fifty percent of all new apartment blocks – Asian, and in particular Chinese, investment in Sydney has long bolstered the market (last year, foreign buyers purchased a quarter of all new houses in New South Wales). Much of that investment, in particular in the inner-city market, is from parents whose children are enrolled at universities. Or parents who see a future for their children in Australia.

“The number of foreign buyers is definitely going down; those in student related categories have dropped considerably,” says Mr. North. “It’s going to reduce [property] demand further.”

“It has been harder and harder in the last few years to lend to 457 holders and for the last 12 months at least, this has been off the table where there is not a permanent resident associated with the loan,” adds Mr. Buchanan. “Combining that with sanctions imposed … [on] international borrowers for the last 18 months and new stamp duty tariffs applicable from July 1 2017 this has had some time to play out but we have not seen significant adverse results as yet.”

“Some of these affected purchases are still yet to land but the four percent tax was introduced in June 2016 and applicable from July 2018. There is no doubt that this plays a part in a correction.”

What next?

Mr North states that 956,000 out of 3.2 million occupied borrowers in Australia are already in mortgage stress – or close to 30 percent of borrowers.

“That’s been rising consistently over the last three years, despite the fact that interest rates are low,” he says. “If we think that incomes are going to recover anytime soon and interest rates will stay low, the household sector may muddle through somehow. It seems to me we have a lot of evidence that [interest rates] will rise – and even a small rise will have a profound impact on mortgages being paid.”

As such Mr North predicts house prices will fall between 15 percent to as much as a 40 percent – the former arguably a correction, the latter a crash.

“I think 2019-2020 is going to be the crunch year,” he says. “We are in the equivalent to the year 2006 in the US. We have no Plan B, we have no growth strategy other than trying to persuade households to spend more and other than trying to spend more on infrastructure, and neither are sustainable.”

On the other hand, Mr Buchanan believes that Sydney’s property market “will survive through more than most other cities due to demand, infrastructure and a matured market.”

“Yes the Chinese investment changes are having an impact, yes the changes in policy for mum and dad investors will have an effect, yes the Royal Commission into banking will shed some light on issues held in that sector but it will assist competition also, yes a change in government will have an impact,” he says.

Added to this “the international markets are having their own challenges which [do] have flow on adverse effects in our economy.” Yet, despite this Mr Buchanan believes that “a projected ten percent decline in dwelling values over two years after prices doubling over a ten year period [is an] acceptable and normal cycle of an asset.”

Ultimately, how the pieces of the puzzle will come together and what that means for Sydney property is hard to predict.

As Mr North says, “Part of the difficulty with predicting a crash is it’s like trying to bake a pie. It’s got lots of individual ingredients. But until you put them all together you’re not sure how it’s going to turn out.”