Newspaper headlines like “House prices continue to tumble nationally” are now everywhere. While we have been worried about the potential for a housing correction for a long time, what was theoretical has become actual. Prices are down and it’s no longer the fringe doom-sayers that are predicting further falls. It could get a lot uglier. Or it could be mild. As with many other big risks, it pays to prepare, not predict.
For a start many property owners think prices go only one way. And they had been right. National residential property prices have risen a little over 7% per year over the last 30 years. Sydney and Melbourne have risen even faster; Sydney property prices were up 74% in the five years to June 2017.
Leverage has also helped, making the return on the homeowner’s equity much higher. And in the rush to buy property, owners have been taking on more debt: household debt to income has climbed to an astonishing 190% from 160% five years ago. Fortunes have been made by owner-occupiers, investors and developers.
But, as you’ll find on any disclaimer: past performance is not an indicator of future performance. And things have changed.
Higher prices finally brought in new supply. Apartment construction approvals doubled in the five years to 2016 and are still elevated. Those apartments have been coming onto the market over the past year. Vacancy rates in Sydney are the highest in 13 years and rents are down.
The debt grenade
Then the pin was pulled on the debt grenade. The Royal Commission showed that banks have been basing their lending assumptions on unrealistic customer living expenses. Loans are now harder to get. And the amount of credit being provided has been reduced meaningfully. In a recent UBS podcast, their banking analyst Jonathan Mott explained why this is so important:
“House prices are not driven by the demand and supply of housing and population growth. Maybe on a 20-year time frame they are. House prices are determined by the demand and supply of credit availability. When you take your hand down at the auction is when you run out of money. And if the banks aren’t lending you as much as they did 12 months ago, well your hand comes down a couple of hundred grand lower”.
High debt-to-income and interest-only borrowers, mostly investors, are in the most trouble. They are squeezed by higher borrowing costs, more principal repayments, and fewer opportunities to refinance.
And then there’s the big one. That psychological X factor. Will buyers sacrifice avocado on toast to own a home? Does the comfort of owning a home outweigh the freedom of being mortgage free? Will the emotional attachment to home ownership fade? While hard to pinpoint, this factor will dictate whether a 10% to 15% correction becomes something far more significant.
ANZ (ANZ) and Commonwealth Bank (CBA) have now both pegged their forecasts on a peak to trough 10% fall. With a couple of hundred billion dollars of mortgages on their books there are plenty of reasons for them to be artificially optimistic. More bearish predictions have property prices falling 30% to 40%, more likely in the hot markets of Sydney and Melbourne. Disaster. But let’s keep it in perspective. A fall of 40% in Sydney would take prices back to mid-2013. That’s not exactly ancient history.
What happens next?
We are not predicting disaster or salvation. Instead we are trying to be prepared with a portfolio of stocks that can deal with a bad outcome. So what happens to listed businesses if property prices fall sharply from here?
Starting with the big banks. It’s a tale of higher compliance costs, lower credit growth and higher bad debts. Increased compliance cost the Commonwealth Bank another $400m last year. Credit growth has slowed, mostly due to property investors stepping back from the market. Bad debts are still at very low levels, but with arrears increasing it might not be long before mortgages start to go bad.
Mortgage brokers are next. New lending has slowed. And attracting and retaining brokers has become more difficult. Mortgage Choice (MOC) has recently started paying more to its brokers to stem departures. It’s a tough space and one that would be most affected if the worst occurs. REA Group (REA) and Domain (DHG) are already seeing lower listings while still trading at high earnings multiples. This is a dangerous combination. Forager’s exposure to banks, mortgage brokers and property portals is zero.
But those are just the most obvious effects. It would spill over from there and investors should not underestimate how important the residential property asset class is to Australia.
For a start lower house prices would mean lower consumer confidence. Those comfortable buying a $5,000 couch from Nick Scali (NCK) when their house price rose by $100,000 last year might shudder to do the same when they are looking at a $100,000 loss.
A loss of consumer confidence would see Harvey Norman (HVN) sell fewer $5,000 4K TVs too. And a tightening budget could mean fewer overseas trips: watch out Flight Centre (FLT) and Webjet (WEB).
And what about one of the biggest discretionary purchases: a new car? Well new vehicle sales last month were down 5.5% from last year. If house prices keep falling it won’t get any better for AP Eagers (APE) or Automotive Holdings (AHG). Salary packaging and novated lease companies like Eclipx (ECX) would also be in trouble. Forager’s exposure to these two sectors is also zero.
And what about credit?
It could also mean less access to credit for smaller companies, as banks start being more cautious across all loans. Small business lenders like Silverchef (SIV) and Axsesstoday (AXL) are already in trouble with higher arrears in their own lending books. Less access to credit and tough times for their customers could make life for these companies, and other highly leveraged businesses, even harder.
Here we do have some exposure. Thorn (TGA) would suffer if credit was withdrawn from its equipment finance division, although its consumer division could be one of a small number of beneficiaries. CSG (CSV) would also struggle collecting payments from its small business clients. Others, like MMA Offshore (MRM) carry debt, but are less susceptible to domestic issues.
There are also negative implications for the Australian dollar. Portfolio companies earning money in foreign currencies, like Macmahon (MAH), Matrix (MCE) or Enero (EGG), could actually be better off. In fact, we would argue foreign currency diversification is probably the best protection you can buy.
There are plenty of reasons to think that the future for residential property in Australia is not going to be rosy. But just how bad it gets is hard to quantify. As we do with other big risks, it’s less about predicting the outcome, and more about being prepared if the worst does happen.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.