The first six months of 2015 has seen commentators offer conflicting views as to whether there is a ‘housing bubble’ being experienced in certain areas of the Australian residential property market. Their focus has been on Sydney, and to a lesser extent, Melbourne.
At two ends of the spectrum, commentary has reflected that:
- we are experiencing a housing bubble which, when it bursts, will have dire consequences for the property market and the economy generally
- while there is increased pressure on prices in certain sectors of the market, the underlying trends of supply against demand are in balance and the market equilibrium will balance out over time, and together with the underlying fundamentals of the economy, will prevent any such bubble occurring.
The Reserve Bank of Australia (RBA) and Australian Prudential Regulatory Authority (APRA) are taking active steps to diffuse any risk of an over-heated property market in Australia and the collateral damage to the economy if that occurred. They are placing pressure on financiers to re-assess and reinforce their credit policies to prevent excessive lending on a highly geared basis to borrowers, especially in the investment market such that if there was a market correction that the borrowers would not suffer adversely.
Why the rise?
There are a combination of forces which have contributed to the increased demand by purchasers of housing stock, which has caused the recent sustained increase in housing prices. The big four forces include:
- fixed house interest rates for 30 years
- a substantial increased level and appetite for foreign purchasers mostly from China, Malaysia and Singapore
- the apparent lack of supply to market demand for housing stock
- an increased appetite for investors to move into investing in housing stock due to foreseeable capital growth, which off sets falling property rentals.
Who is to blame?
Australian housing financiers are competing head on with each other to lend money to the housing sector. This is mainly due to the lower risk weighting, given to housing lending and the lack of appetite from the business sector to borrow.
The RBA has played a part by cutting interest rates in an attempt to reduce the value of the Australian dollar and stimulate the slowing Australian economy.
One of the unintentional consequences of the RBA’s action in lowering interest rates is that it in turn reduces borrowing costs and hence greater competition on the housing market reacting to increased prices.
How do we take control?
Given the current review of the Australian Taxation System, particularly with respect to discussions around the proposed increase in GST and to broaden the tax base to assist the Government offset the lack of revenue derived from the mining sector, two pertinent taxation changes have been proposed.
There has been a renewed push to reduce or restrict the extent to which negative gearing for investment properties can be utilised by investors.
While negative gearing has its benefits, it also increases the appetite of investors to potentially over-leverage to borrow more money for property investment lured by the potential tax benefits.
It had been proposed that the benefit of negative gearing was advantageous as it brought on line more housing stock when supply of housing did not meet the demand. While this was the case up until recently, the pendulum has now shifted whereby investors are moving out of traditional methods of investment and moving into the housing market which gains the momentum and the price increases currently being experienced, even though supply of rental properties has reduced rental returns.
SELF-MANAGED SUPER FUNDS (SMSFS)
APRA has been quite vocal in its desire to wind back the extent to which SMSFs are able to borrow to acquire residential property.
In 2009 when the borrowing rules were relaxed, it appeared to be a good idea at that time to give SMSFs flexibility in their investment options to buy property. However, on figures currently available, SMSFs have leveraged up to acquire property has artificially increased competition in the market.
As a consequence, it has been indicated that some of the major Australian banks are winding back, if not ceased lending to SMSFs in high leveraged property acquisitions mainly due to the fact that the rules require that these loans are non-recourse as against the directors of the Superannuation Fund Trustee (which in itself was a benefit for the scheme).
The present Government has indicated that it does not have a mandate and therefore is not willing to make extensive changes to the taxation system within the current term of Government, so these changes may be some time off.
The RBA and APRA have been vocal in the press requesting that financial institutions be cautious against over-exuberant lending practices and to focus more strictly on maintaining proper credit guidelines and policies.
As a consequence, several of the major Australian banks have reportedly reduced their gearing ratios for investor loans from 80 to 70 percent and are also introducing rules to stress test the borrower’s ability to service loans at a 7 percent interest rate as distinct from the current 4 to 5 percent rates currently on offer. This will work to ensure that the borrower’s financial capacity is available to meet increased servicing costs once interest rates eventually rise again, which is anticipated to occur in the reasonably near future.
Further, the Reserve Bank of Australia is requiring all the Australian Banks to further increase their capital adequacy ratios to ensure that they have greater available cash assets to meet a market correction.
Another important factor to be borne in mind is that the ratio of household income to debt, has increased to 153 percent which is now one of the highest rates of leverage in the world. While the property market remains strong, this may not be a terminal problem.
If there is a correction in the market, then the extent to which property prices continue to increase will cease and in certain areas, property values may fall, which could place highly leveraged purchases, particularly investors, in a negative equity territory.
Coupled with a slow economy which is forecast to remain flat for the foreseeable future and a relatively high level of employment growth, the consequences of a market correction could be compounded.
Can we learn from the Kiwis?
Given the similar heightened demand in the New Zealand property market, the Reserve Bank of New Zealand has introduced a ceiling on loan to value ratios which financial institutions must adhere to. The intention was to prevent excessive leverage which artificially increases demand and heightens the risk of major default. Anecdotally, this approach seems to have slowed the rate of increase of value of properties.
Consequences of an over-heated market
Regulatory officials are hoping that by placing greater pressure on financial institutions to be more stringent in their lending guidelines, including restrictions on the extent to which institutions will lend to foreign purchasers, it can orchestrate a lessening in the demand sufficient to ensure that the current status of the market continues to grow, but not at the rates currently being experienced, thereby avoiding the bubble being burst.
If the market becomes overheated and a correction occurs, then a situation similar to the housing market crash of the late ‘80s could occur. Coupled with a recession in the economy, increases the unemployment rate and loss of property values, all combine into the perfect storm, which will create a lot of collateral damage to the whole economy especially to those investors who are highly leveraged and secondly to the banks who will have to make ever-increasing provisions to cover losses due to their excessive exposure to housing stock.
Proceed with caution
Given the interaction of all these market forces and the careful intervention by the regulatory authorities, more sensible and stringent adherence to lending guidelines by the financiers then hopefully, an over-heated property market leading to a substantial correction can be averted, which will mean that the economy will not suffer a major setback.