Is the NZ Property Party Over?
In the year to September inflation hit 4.9%, the highest in a decade, and mortgage rates have risen rapidly. As a property investor it is natural to be concerned about the impact on property prices and yields…and ask is the property party over?
While the inflation rate has startled some investors, the real question is what are the drivers, and will it last?
- Shipping costs. By now we have probably all heard stories of the cost to freight a shipping container from Asia to NZ – rising from say $5k to $18k. That is certainly part of the inflation story. When Covid hit, my child hood friend who runs the shipping loan book for a US bank in Asia was suddenly under the pump…scrambling to deal with new builds that were being put on hold and the scrapping of older ships. As a result, tonnage in the industry was dramatically reduced. We know that ships are now being built again. But it takes 2 years to build a ship, and my shipping contact tells me that supply won’t materially change until 2023
- Increased demand for Durable Goods. No one predicted the massive surge in demand for durable goods, and thus the surge in demand for freight – see graphs below from Landfall Strategy. International and even domestic travel dropped off the edge of a cliff during lock downs. People had time on their hands, and the only way to get retail therapy was to sit online and let the fingers do the walking (for those younger than I guess 35, you won’t remember that Yellow Pages TV ad). Yes, the travel budget built up for many and its outlet was the new 65-inch flat screen, or fridge, or car (more on that below). Eventually international travel will open up again, and tourism will pick back up. That means the travel budget will stop getting stolen by durable goods purchases. What we don’t exactly know is when things will return to ‘normal’.
- Constrained labour market. Anthony Klotz predicted the Great Resignation, arguing that the pandemic will result in large numbers of people leaving their jobs as they emerge from lockdowns having had time to reflect on what they want out of life and the grind of 9-5 living. McKinsey call it the Great Attrition and report that 40% (see McKinsey graph below) of employees say they are somewhat likely to leave their jobs in the next 3-6 months, 29 million US workers have quit jobs since April 2021 and 36% of people quit their jobs without another job to go to. Add that to the mass layoffs that have happened around the globe and we end up with a severely constrained labour market.
What will these people do? Some analysts have suggested the model of working for one employee at a time will start to change, that workers will offer their services to multiple employers. That sounds like a consultant to me. Regardless, in my opinion we will certainly see changed working structures. The question is how long it will take for those who quit to re-engage with the workforce and ramp up.
In the meantime, employers are endeavouring to keep and attract staff through increased wages and more perks. McKinsey argue that employers aren’t getting it and need to offer ‘more’. In the meantime, increased wages will get passed through to goods and services.
- Where are the chips? Chips (crisps) never last long in our home with 3 teenagers. They burn through them. And that is exactly what is happening with semiconductor chips for the auto industry. Sometimes quite literally. Semiconductors are suddenly in short supply as a result of Covid, which has led to some firms stock piling, and all of which means that the auto industry can’t get enough chips to meet car demand. Urban myth has it that Audi NZ only imported 8 Audi vehicles in November. And guess what, that means prices go up.
So what? Well, a few things about the above stick out to us:
- The inflation factors are all distinctly global issues over which NZ has no influence. It doesn’t matter what our monetary policy is, we can’t force US workers to go back to work, we don’t have a ship building industry (Winston Peters will shake his head) and semiconductor manufacturing machines cost about USD50m each and a typical plant requires hundreds of them…who in NZ will build one of those? Even opening our borders will not mean the globe suddenly starts travelling internationally again…i.e. we don’t know how quickly durable goods purchasing patterns will return to historic norms, if at all or fully.
- There are key infrastructure issues to be resolved – infrastructure often takes years to address, not weeks.
- It is possible we have seen a permanent shift in working styles not seen since the industrial revolution. A confluence of events led Europe away from a largely agricultural based economy to an industrial based one. There is a lot of hype about block chain and how it will lead to the decentralisation of power to the worker. And good luck to any employer who tries to tell employees they must now work full time from the office going forward. Covid has shown us all, that meetings can work pretty well online, even if we don’t want to do everything remotely and want some time in the office. I don’t expect to see the labour force racing back to the status quo.
I think it is a brave person to suggest inflation will ease significantly in 2022. Our view is that in 2023, we may start to see it ease back as the above bottle necks are resolved.
Mortgage interest rates have risen pretty rapidly over the last few months. What are the drivers?
Banks Cost of Money up
Wholesale rates are up. The price of wholesale rates are driven by a combination of inputs – RBNZ has a good guide:
- The OCR is a driver, it went up 25 basis points in October and November, and now sits at 75 basis points after not having being lifted for years. The lift has largely been in response to CPI and perhaps to a lesser degree house price inflation…the RBNZ has stated it’s not their job to control the housing market.
- SWAP rates have also risen in response to inflation.
However, we note that there is only so much the RBNZ can do to control inflation with its blunt instrument; the OCR. They will surely understand that inflation is largely a supply side issue, and while they can theoretically discourage some consumer spending by taking money out of their pocket with higher interest bills, they can’t talk sternly to shipping companies, or the semiconductor manufacturers, or the US work force and tell them to sort their act out.
History also tells us that rising interest rates, do not on their own discourage the enthusiasm for the property market. Not while people are worried they are going to miss out on capital growth. The graph below shows interest rates increasing from Jun 03 to Mar 07 while house sales volumes remained strong. It wasn’t until the GFC hit and credit dried up that house sales volumes slowed – dramatically.
Since the GFC the RBNZ has introduced prudential measures such as the LVR limits enforced on banks. And now they have unofficially enforced a Debt to Income (DTI) measure on banks with a – “if you don’t do it on your own accord, we’ll do it for you.” Banks all measure DTI’s ‘slightly differently – but all use an assumed interest rate for servicing the loan at a level much higher than the prevailing mortgage rates. DTI’s are therefore making it much harder to get finance.
Also don’t forget about the capital adequacy rules that are starting to kick in, with banks needing to keep more capital on their balance sheets. It’s all about return on equity. What product lines produce the greatest return on equity after accounting for risk?
Perhaps what will slow down lending most is the nervousness of banks. We have anecdotal evidence that at the time of writing it is has suddenly become a lot harder for business and commercial property investors to obtain bank finance. Are credit departments very concerned about what may be yet to come and taking a wait and see approach? Allow some time for the government debt and lockdown to take its full effect and see what the impacts are. Speaking of which….
GDP, Government debt, Tax Hikes, More lockdowns
Perhaps the biggest uncertainty is whether we have really seen the worst of Covid; the impact of debt the government has taken on, likely, tax hikes to pay for it; the latest GDP slump of -3.7% (second worst since 1986); the end of wage subsidies. Let’s consider this:
- The latest GDP slump will of course be driven by the latest lockdown. But what are the flow on effects, especially given this is the second time around for a lot of Auckland businesses who are now faced with wage subsidies being discontinued. The media reports little about failing businesses, and to be fair Kiwis are pretty stoic, we prefer to bottle things up and deal with depression rather than tell our stories.
- The government has taken on a huge amount of debt to deal with Covid. There is now an interest bill to pay. How will we do that? GDP growth? We all hope for that, but the reality is that this is a labour government and labour governments like to hike taxes, and given the debt, probably will. That means taking money out of the economy, which is not a stimulant.
- Omicron…this government doesn’t hesitate to lock down. There is no clear plan to open the borders. Will Omicron result in more lockdowns and more GDP contraction?
- Surely the tourism sector is hanging on by a thread, campervan rental companies must be hurting. Tourism makes up roughly 6% of GDP and most of that comes from the international tourist. Some key facts (from Department of Stats) from the year ended March 2019 are:
- Tourists generated $3.8b of GST
- Tourists contributed $16.2 billion to GDP
- The indirect value added from industries supporting tourism was $11.2, 4% of GDP
- It’s worth considering the graph below just to fully appreciate what the closure of the borders to tourism means. Yes, some of that spend is replaced by Kiwis not heading offshore.
You might read this and think we are saying 2022 will result in economic carnage across the board. Nope. While it is a possibility, what we are mostly saying is that there are some pretty big burdens for this country to sort through. Opening the borders might wipe away a lot of pain relatively quickly, or there could be significant business failures in particular industries. We don’t know. What is most important is to be cognisant of what needs to be dealt with and the possible consequences if these issues are wallpapered over and spun as positives by the government, rather than being dealt with head on.
What is fascinating about the latest surge in property prices is that it has happened without an increase in population. House sales volumes are a good proxy for demand. Historically there has been a very close relationship between net migration and house sales volumes as can be seen from the graph below.
While net migration has basically gone to zero since the borders were closed, house sales volumes have remained relatively steady. If net migration is such a key driver, why then have sales continued unabated? Lots of reasons, people not travelling and therefore thinking about a house upgrade, Kiwis returning to escape Northern Hemisphere Covid madness, Kiwis offshore who can’t get back but want to get on with buying, non-Kiwi residents who are allowed to buy new from offshore.
Therefore, while interest rate increases will certainly prevent and/or discourage some from buying, opening the borders will generate housing demand, whether it be demand for rental properties or demand to purchase.
In this scenario, demand removed because of DTIs, LVR rules and interest rate hikes could well be replaced by growth in population when the borders finally open. The key factor here is the timing of allowing migration.
These Prices Feel Too High?
No property market commentary is complete without addressing the latest property trend.
In our experience, whenever we get well in to a property growth phase an army of analysts emerge telling us the prices are too high, and we will be in for a sharp correction. They look at affordability measures like price as a multiple of average income and get shocked at how high it is compared to say the 1960’s and run to the market with their insights and forecast a crash. I mean, look at the graph below – the latest surge in pricing looks pretty extreme, doesn’t it?
Housing affordability has been an issue forever. It has always been a struggle. In the 60’s there was generally one bread winner, one car, lots of home sewn clothes (the elastic broke in my home sewn shorts more than once at school), no cafes. It was a struggle to get into a simple 3 bed home on a small 1,100 s/m section. Now there is usually more than 1 income in a house, you can buy really great clothes from all over the world, you can eat out cheap if you want, and it is a real struggle to get into a small 200s/m section. Funny how things change but remain the same. It’s all relative.
If we apply ‘relative’ to the above graph, then the latest price surge may not be as extreme as it first looks. If we stopped the graph at April 2007, as we have done in the graph below, then all of a sudden the property boom leading up to the GFC looks extreme relative to history, yet in the first graph it looks quite benign. What this demonstrates is the risk of analysing median house prices in nominal dollar terms. If we analysed it in % growth terms it would show a very different and less alarming story. If we rolled this graph forward another 10 years to 2031, the growth in the last few years is likely to look quite benign as well.
What is really interesting is that the worst financial crisis, the GFC, which they are now calling the Great Recession is in plain sight for all to see in this graph – look at the dip in 2007. I bet most readers didn’t even notice it because the eye is naturally attracted to the more dramatic recent surge in pricing. Yet at the time it was earth shattering – investors around the globe told me economies would never be the same and this would change things forever. Yet here we are more than a decade on and people continue to want to buy property and banks have continued to lend on it.
Not for a minute are we suggesting prices will keep going up, they could cool off. Already we know that sales volumes are beginning to ease and that is likely to result in price growth slowing. Besides, this graph tells to expect a softening about now.
What I know is that how we ‘do’ property will keep changing, and at the same time there looks to be at least one fundamental property principle: property prices go up over the long term. Yes, plenty of caveats about location and type of building. At the end of the day what the above graph tells me is if you had bought 10 properties in 1992 at the median house price with 100% leverage you’d have over $8m of equity to your name today. What is that as an IRR, or ROI, or NPV? Whatever measure you use, it’s still $8m of equity.
As always at Erskine Owen we do not aim to predict what will happen with property prices in the short term. Our main focus is to remain well invested for the long term and be prepared for likely outcomes.
- Inflation is unlikely to unwind in 2022 – but may begin to ease through 2023. But let’s not forget this is a largely global issue and birthed out of what are basically infrastructure issues, over which the RBNZ has little or no control.
- There is strong evidence that interest rates could continue to increase through 2022 in response to inflation, in part due to possible future OCR rises, but more largely driven by the cost of capital from offshore. That said, there could be opposing downward pressures with the RBNZ not wanting interest rates to get too far ahead of other markets and thus attracting unwanted demand for the NZD.
- Demand for property is being artificially constrained by restricting availability of credit through LVR restrictions, DTIs, and general scaremongering from the RBNZ and possibly banks. Interest rate increases are a real deterrent in a short term sense. But we keep in mind that as the population increases, the overall demand for property will continue to grow. Something eventually has to give; else we end up with overcrowding and a stalled economy.
- At some point the borders will open and that will result in a rapid return to healthy net migration. That in turn increases demand for housing.
- Don’t rule out a significant economic downturn as the full impact of lockdown flows through with government debt needing to be paid for, and the end of wages subsidies. And while we pray it won’t happen – Omicron lockdowns.
What therefore should we be prepared for?
- If inflation continues to climb expect
- Interest rates may keep going up
- property finance may remains as hard, if not harder to obtain
- If interest rates continue to climb…
- Make sure you have enough funds to service the debt. If you are on an interest only loan, check when the interest only period ends and make sure you can service the principle repayments as well. If not…act now to refinance to another bank. You may not qualify with the current bank under DTI measures.
- Lock in interest rates sooner rather than later
- If you are dubious as to whether you can meet commitments…think sooner rather than later about other solutions. It might feel like hard work to deal with it now…but it is a lot easier than doing it when the bank is on your back.
- Get pre-approved to purchase. There could be some people who hit the wall and need to exit quickly. Land is often the first to soften up since there is no income on it.
- If finance remains hard to get, or get even harder
- If you have a pre-approval, check that you can get it extended now
- If you are wanting to buy next year and need finance, start now on your approval since it might only get harder.
Anything can happen. In 2020 everyone was saying it was very hard to see how interest rates would head back up dramatically. In fact the RBNZ was telling banks to prepare for negative interest rates. In Jan 2020 there was concern about coronavirus, then it hit and during the first lock down the OCR dropped further. What no one saw was supply chain challenges, inflation, and rising interest rates. What it tells us is to expect the unexpected.
We draw 2 main conclusions
- Protect your cashflow. If you can’t service debt – everything else is irrelevant and you can get into a downward cycle. Better to be prepared for a storm and it misses, than to think you’ll work it out as you go.
- Once that is done – get ready for a variety of possible scenarios:
- Prices to go up because inflation will drive up rents which in turn will drive up property prices, or
- Economic recession with some industries hit particularly hard resulting in distressed commercial property sales. Be on the look out for good buying opportunities with property owners needing to offload.
- An economic boom, as borders open and the majority get on with 2nd, 3rd jabs and Covid becomes ‘normal’ or
- A combination of a), b) and c). Conceivably some property could go up in value because of inflation, but at the same time coupled with interest rate rises, rising taxes, business failures, may create ‘forced’ sales. Some industries may flourish, while others may be scarred.
Expect the unexpected. Expect a bumpy ride. Protect your cashflow and be positioned if you can, for opportunities not seen in a while.