A growing body of evidence and opinion suggests that the residential property market has plateaued and may be due for a fall, leaving investors to consider the alternatives for gaining property exposure.
According to the latest CoreLogic report on residential prices, out last week, the average price of a Sydney dwelling was unchanged in April and Melbourne values were up just 0.5 per cent.
Tim Lawless, CoreLogic’s head of research, says: “The two hottest housing markets in the nation have shown signs of slowing. The index for the combined capital rose just 0.1 per cent in April, the lowest month-on-month rise in capital city dwelling values since December 2015.”
The softer results in the two largest capital cities follow dramatic capital gains recorded over the second half of 2016 and the first three months of this year.
Lawless says: “We need to be cautious in calling a peak in the market after only one month of soft results.”
However, investment bank Citi has called the top, saying house prices could fall by as much as seven per cent over the next year.
In a report issued last week, Citi says: “Given the stretched house price valuations in Sydney and Melbourne, some correction would seem likely as supply continues to catch up with demand. The largest price falls would be in high-rise, inner city apartments in Brisbane and Melbourne, given their greater potential for oversupply.”
On top of that, mortgage insurer Genworth Mortgage Insurance Australia reported last week that it saw a sharp increase in loan defaults in the first three months of the year.
The combination of factors leading to a bearish outlook for residential property includes high household debt levels, an oversupply of apartments in some markets, low wage growth, slowing immigration numbers and regulatory intervention in the mortgage market.
In March the APRA directed lenders to limit interest-only loans to no more than 30 per cent of new residential mortgage lending (they are currently around 40 per cent).
The regulator considers interest-only loans more risky than principal and interest mortgages for a couple of reasons: the borrower is exposed to the full value of the loan if rates rise; and there is less incentive to continue paying a mortgage in difficult circumstances when none of the principal has been repaid.
APRA’s latest move follows an instruction it gave to lenders at the end of 2014 to limit growth in new investor loans to 10 per cent a year.
Lawless says: “In a city like Sydney, where more than 50 per cent of new mortgage demand has been from investors, a tighter lending environment for investment purposes has the potential to impact housing demand more than other cities.”
When consulting group Deloitte asked a panel of mortgage industry leaders what sort of growth in loan origination they expected in 2017, 50 per cent said settlement volumes would fall and 20 per cent said there would be no growth.
The survey was taken in December, before APRA’s latest regulatory move.
Craig Swanger, senior economist at fixed interest broker FIIG, says: “By 2006 the impact of the Howard Government’s increased migration program, which was subsequently supported by the Rudd and Abbott governments, started to impact population growth.
“Rents rose steeply as the shortage of dwellings across Australia reached record highs and the 2009 recession only served to slow construction, leading to further price increases.
“By 2012 construction had picked up and rapidly reduced shortages and by 2015 construction exceeded demand for the first time since 1999.
Swanger says there should be a net surplus of housing for the next three years at least. Population growth has slowed since the end of the mining boom.
“The increase in supply coupled with lower population growth needs to be carefully monitored by investors, as it will lead to more price volatility,” he says.
Call to switch to managed funds
In such an environment, property investors need to consider the alternatives. There is a case to consider the commercial property market.
Real estate investment trusts have been a top-performing asset class in recent years. According to Morningstar, REITs produced an average return of 18.5 per cent a year over the five years to December, second only to international equities. Last year REITs were up 13.2 per cent.
Chris Bedingfield, the principal and portfolio manager of Quay Global Investors says the best residential property returns are behind investors in the current cycle.
“Our philosophy in real estate is that long term value reflects replacement cost. When you think about the residential market you have about 140,000 new dwellings built in Australia each year.
“Since interest rates went down we have seen the market go on a run, with prices moving well ahead of replacement cost.
“So now there is an incentive to deliver new stock. We are up to about 240,000 new dwellings a year at the moment and approvals are still at record levels.”
Quay Global launched its first fund, the Quay Global Real Estate Fund, in 2014. It has around half of its holdings in the United States, 17 per cent in Australia and 14 per cent in the United Kingdom.
Bedingfield says the global market offers opportunities that are not available in Australia, such as the “manufactured housing” market – affordable housing built with pre-fabricated materials, sold on long-term leases.
Another is the healthcare market. He says the trend overseas is for property investors to own the hospitals and lease them to operator.
Steven Bennett, the head of direct property at Charter Hall, says net yields in the residential market are around 2.5 per cent. “It is a bet on capital growth,” he says.
“One of the greatest challenges for investors, particularly trustees of self-managed super funds, is creating an investment portfolio with the right balance of growth and defensive characteristics.
“Sydney and Melbourne residential markets had annual rental growth of 2.2 per cent and 1.4 per cent respectively in 2016. Cash flows from commercial property are typically positive and often exceed six per cent after all costs.
“Lease terms are significantly longer for commercial property than for residential property. The leases are often to high-quality corporate and government tenants. This aids in providing security of income to investors.”
While the future of the residential market remains uncertain, risk-averse investors can find plenty of property markets alternatives.