Category: Property Market

Rental Stress is growing, and more property investors are underwater when it comes to covering their mortgage costs on an ongoing basis, so what are the implications for property investment as mortgage rates continue to rise? Welcome to the Property Imperative Weekly to 29^th July 2017.

We start with our research on property investment, which was published this week. We look at this from two perspectives, first from the point of view of those renting, and second, from the perspective of those who are property investors.

Whilst there is considerable discussion about mortgage stress, rental distress hardly gets a mention yet there are more households in rental stress than in mortgage stress according to our analysis. We know their financial confidence on average is lower. First, we need to define rental stress. Whilst some will use a “30% of income to pay the rent” as a benchmark, we do not think it is an adequate measure – 30% is too arbitrary!

So we look at net cash flow. If households, once they pay their rent, tax and other outgoings have close to nothing left, or a small deficit, at the end of the month, they fall into our mild stressed category. Those with a severe cash deficit at the end of the month, are in severe stress.

We start by looking at the causes of rental stress. Using data from our surveys, we find that costs of living, under employment and flat incomes are the main causes.

More than half of renters in NSW are in rental stress (on our definition), and the highest proportion of any state here are in severe rental stress. The proportion of households in stress fades away as we look across the other states and territories. But the three most populous states have the highest rental stress levels.

Looking across our segments, we see that older households are more under stress, and a significant proportion are in severe stress.  Whilst wealthy seniors may hold some savings, stressed seniors do not. Many are reliant on Government support.

Greater Sydney and the Central Coast have the highest representation of stressed renters as a proportion of all households renting.

Looking across our geographic zones (a series of concentric rings around our main urban hubs) we see significant levels of stress in the urban centres, as well as on the urban fringe. The former is being created by high rents – especially in the newly constructed high-rise blocks being thrown up across the eastern states, often occupied by young affluent households; whilst in the urban fringe, it is more about depressed incomes. We see stress rolling out into the regions, but is less apparent in the more rural and remote areas.

All this highlights the issues renters have due to the combination of flat incomes, and rising costs, despite only small rises in rents.

Now, if we look at the other side of the coin, our research shows more investors have a net cash-flow problem, thanks to that flat rental income, whilst mortgage rates continue to rise.

The CPI data released this week by the ABS showed that overall inflation remains low.

But within the series there is a striking contrast. The Housing Group category of data rose 0.3 per cent for the quarter, and 2.4 per cent for the year to June 2017 but rent rose only 0.2 per cent for the quarter, and 0.6 per cent for the year.

It is worth reflecting on this in the light of the out of cycle rate hikes which property investors are experiencing, as the banks improve their margins using the alibi of regulatory tightening. In fact recent hikes being applied not just to new mortgages but to the entire book deliver a significant “bonus” to the banks.

First, let’s be clear rental rates have more to do with income that property prices, and the fact that rental rates have hardly grown reflects the stagnation in wages. Vacancy rates are also rising.

Second, the fact is a greater proportion of property investors are now underwater on a net rental cash flow basis. But the situation varies by state.  VIC and NSW have on average negative net returns. The net rental calculation is before any tax offsets.

Investors seem ok with negative cash-flow returns because in many cases they just offset the losses against tax, and comfort themselves with the thought that the capital value of the property is still rising (in most eastern states at least).

However, the divergent movement of mortgage rates and net rental returns are a leading indicator of trouble ahead, especially if capital growth reverses.

Given flat incomes, we think rentals will not grow much at all for some time, and remember more new properties are coming on stream, so vacancy rates are likely to continue to rise!

So in summary, we think more rental property will be vacant so holding rentals low (despite being expensive for many potential tenants) whilst investment costs will go on rising. As a result, we expect to see weaker demand for investment property, and should capital values start to fall, more owners will try and sell. In fact we think many property investors are in for a rude awaking, sufficient to tip the overall market lower, despite recent quite strong auction clearances.

More broadly the HIA reported that housing affordability declined further in the past quarter,  largely due to a rise in the median dwelling price of 9.1% per cent to a record high of $540,200. They say, NSW was the most significant negative influence on this result with affordability in Sydney now declining past a critical level (Sydney, – 0.7% and the rest of NSW, – 2.2 per cent). Acquiring and servicing a mortgage on a house in Sydney now requires more than two standard Sydney incomes. Sydney is the only market to have achieved this outcome in the 15-year history of their report. Affordability in Melbourne improved marginally in the quarter but remains 6.0 per cent less affordable than this time last year. Of the capitals where affordability worsened, the biggest deterioration was in Perth (-1.3 per cent).

Despite the fact the US Federal Reserve held their cash rate this week, signalling a slower rise in interest rates in America, Westpac lifted a range of their fixed term investor loans, with for example their 2-year fixed rising 31 basis points.  Bank West said  they would impose a 25 basis point increase for interest-only investor home loans; and a 35 basis points increase for interest-only owner-occupier home loans. They did offer small reductions to some owner occupied principal and interest borrowers. We are seeing a small flurry of rate cuts for some new borrowers ANZ for example is offering a 31 basis point drop for new two-year fixed residential investment loan for customers paying principal and interest (P&I), falling from 4.34 per cent per annum (p.a.) to 4.03 per cent p.a.

The round of mortgage rate repricing which we have been tracking for the past few weeks, with investor loan portfolios being strongly repriced, and owner occupied loans less impacted, has created a significant well of opportunity for banks to selectively offer attractor rates to principal and interest borrowers. In addition, funding costs are now lower, and the yield curve is less strongly indicating future increases, thanks to changes in the US financial markets and news that the ECB will continue its bond buying programme. But many existing borrowers are saddled with higher rates.  We expect to see a flurry of selective, targetted offers, aimed at acquiring new business and supporting loan portfolio growth.

Wages growth in Australia will remain muted for some time to come yet and RBA Governor Philip Lowe said that if some of the long standing links between income growth and monetary policy are not working as they did, more monetary stimulus may encourage investors to borrow to buy assets, which poses a medium-term risk to financial stability. In comments after the speech, he also made the point that surging asset prices has led to a growth in inequality across Australia.

We think the policy chickens are coming home to roost.  We have seen a significant decline in home ownership in recent years, from 69.5 per cent in 2002, to 67 per cent at the 2011 census, and to 65.5 per cent last year. This is a direct result of RBA policy, and the household debt bubble, which has pumped property prices way too high.

As a result, many younger Australians are being forced to rent, or take out very large mortgages. This debt burden will suck up much of their disposable income for the next 20-30 years, and will leave them exposed to future rate hikes. In a low interest rate environment, the capital owed does not depreciate as fast, so the burden is longer and heavier.  This has a knock-on effect on their ability to save for retirement, so their entire life may well be debt laden.

On the other hand, households holding property have enjoyed significant paper gains. Whether they keep them will be determined by future property prices, but there are more reasons to think prices will fall than rise.

A generation of poor myopic property driven policy will have significant negative long-term impact on the economy and lays at the heart of the inequality across the country, which was subject to much discussion this week. Prices may not drop much in the short term, but we believe they will correct eventually. The longer that takes, the bigger the fall ultimately will be.

And that’s the Property Imperative Week to 29^th July 2017. Do subscribe to get our latest updates, and check back again next week. Thanks for watching.

How much will mortgage rates rise, and when? Welcome to the latest edition of the Property Imperative Weekly, our digest of important finance and property news.

Today we are looking back over the week to 22 July 2017. Banks, Mortgage Rates and Household Finances were all in the spotlight.

We start with APRA’s announcement that they will require banks to lift their capital ratios over the next few years, to ensure they are, to quote the Financial System Inquiry “Unquestionably Strong”. APRA focussed on the CET1 ratio, and they chose to take a long-term, through-the-cycle approach, rather than tying capital ratios to the top quartile of international banks.

Major banks will be required to hold an additional 150 basis points by 2020, whilst those on the standard capital approach, typically, smaller banks, will need a 50 basis point lift. In fact, most regional banks are already operating well above the target minimums, and the majors have been lifting their capital already, with some like ANZ likely to be at the required levels, whilst others, like CBA will need to bulk up, either using dividend re-investment plans, or by issuing more capital.  It does tilt the playing field slightly towards the smaller guys, but those who are investing big to migrate to the advanced IRB capital method will be a bit miffed.

APRA did not address the question raised by the Basel Committee and the new international framework still in the works, which is likely to raise internal-ratings based risk weights for investor mortgages and mortgages with high loan-to-value ratios. This change would further add to Australian banks’ capital needs.

Two points to make on all this. First, APRA has come out with a relatively small lift and below the expectations of many analysts, which is one reason why the bank stocks rose this week. It had all been well signalled. Second, APRA says the net impact will be around 10 basis points on income, and they flag this may be recovered from borrowers or from reduced dividends. If all of this was applied to mortgage portfolios, we think an uplift of 20 basis points or more would be needed. In practice there are so many moving parts in the banks treasury operations, we will never be able to isolate the impact of a single factor. But it does put more pressure, not less, on future mortgage rates

Also this week, the RBA released the minutes of their July meeting. It contained on interesting discussion on what the neutral interest rate in Australia at the moment. The “neutral” official cash rate they estimate is 3.5 per cent – a full 200 basis points above where the cash rate is now. This has two implications, first the current settings are stimulatory, and second, it was taken by many as hinting that rates will rise in the months ahead. The media spoke about a 2% rise in mortgage rates, coming soon.

We have been highlighting for some time now the current cash rate will rise at some point and the RBA language certainly reduces the likelihood of a further cut.  How soon a rise will hit though is uncertain, with Malcolm Turnbull on one hand warning households that they should prepare for higher rates, whilst on the other, later in the week, Deputy Governor Guy Debelle seemed to be hosing down expectations of a rise anytime soon.  He also indicated that the neutral cash rate is probably lower now than in the past, despite a trend towards rising rates elsewhere.

All of this may be confusing, but our perspective is the next move to the cash rate will be up, not down, and it could come anytime in the next few months, especially if inflation rises, and the growth in employment, as reported this week continues. What this means is that households do need to start planning for higher future rates, and we know from our mortgage stress work that around a quarter of mortgage holders have no wriggle room. Personal insolvencies have risen in the past year.

Whilst the current round of bank led mortgage repricing may have abated – there were no significant hikes for the first time for weeks – we do not think this is the end of rate lifts.

We think there are three groups of households who should be taking great care just now.

There are some amazing offers around for first time buyers, and lenders are falling over each other to try and attract them. This is because banks need new loans to fund their growth. But these buyers should beware. They are buying in at the top of the market, when rates are low. Banks have tightened their underwriting standards, but still they are too lax. Just because the bank says you can afford a loan does not mean it is the right thing to do. Any purchaser should run the numbers on a mortgage rate 3% (yes 3%) higher than the current rates on offer. If you can still afford the repayments, then go ahead. If not, and remember incomes are not growing very fast – best delay.

Second, there are people with mortgages in financial difficulty now. Well over 24% of households do not have sufficient cash-flow to pay the mortgage and other household expenses. The temptation is to use the credit card to fill the gap – but this is expensive, and only a short term fix. Households in strife need to build a budget (less than half have one) so they know what they are spending, and start to cut back. Talk to your lender also, as they have an obligation to assist in cases of hardship. And be very careful about refinancing your way out of trouble, it so often does not work.

Third there are property investors who are seeing rental incomes and mortgage repayments moving in opposite directions. As a result, despite tax breaks, investment property looks a less good deal. Of course recent capital gains are there – and some savvy investors are selling down to lock in capital value – but be careful now. New property investors are in for a shock as mortgage rates rise further. And multiple investors, are most at risk. Should property values decline, then this will mark the real turning point; but we think the investment property party may be over.

Cutting to the chase, mortgage rates will continue to rise, but the speed of such increases is hard to predict.

Next, the noise about mortgage broker commissions continued with consumer groups reinforcing their view that brokers are conflicted and current commission structures mean consumers are not getting the best outcomes, whilst industry associations continue to rubbish the criticism, and argue that brokers help to propagate competition in the mortgage market, and mortgage rates would be higher without brokers.

We think the right route is to reinforce disclosure. If brokers were to fully disclose their commissions, consumers could make a more informed choice. Some may choose to go with brokers who charge an advice fee, others may run with those offering the current “free” advice in return for payments from lenders. Mortgage brokers do actually offer a valuable service and should be remunerated for their efforts, but conflicts of interest which beset the current arrangements according to ASIC must be addressed. We are not sure the current industry led committee approach will get to the right outcome.

Finally, we published our latest household surveys which shows that whilst there are segmental movements in play, overall demand for property remains intact, despite rising mortgage interest rates and concerns about stalling income growth.

Results from our latest 52,000 survey show that first time buyers are being encouraged by the more generous first home owner grants on offer in several states. On the other hand, the relative benefit of home purchase relative to renting has reduced.

 

The biggest changes in the barriers first time buyers are experiencing relate to the availability of finance, whilst concerns about future interest rate rises, and rising costs of living reduced a little compared with our May results. Overall first time buyer demand is up.

Turning to property investors, the barriers to purchase are changing with a rise in those concerned about rising mortgage interest rates and availability of finance. The reasons to transact have shifted, with a significant rise in those saying they were driven by tax benefits (both negative gearing and capital gains) whilst there was a fall in those looking to appreciating property prices and low finance rates. Overall, investor demand is down a bit.

Another important group are those refinancing. After a strong swing in 2016 to get a better loan rate, there has been a rise in those seeking to reduce their monthly repayments.

So plotting the change of transaction intention over the next 12 months, we see a significant fall in both portfolio and solo property investors, but a rise in first time buyer purchasers expecting to transact.

Finally, we see that in relative terms, there is a fall in the proportion of property investors expecting to see home prices rising in the next 12 months, whilst first time buyers are a little more positive, and there has been little change in expectation across our other segments.

Putting all this together, we think demand for finance, and for property will remain quite strong, and on this read, it is unlikely home prices will fall much at all in the major eastern state markets. Other states are more at risk of a fall, which once again underscores the diversity in the market across Australia.  As a result, lenders will still be able to write more business, though the mix is changing. But affordability will remain a challenge.