There has been a lot of media around the findings of the recent royal commission and how the banks have now made it significantly harder to apply for a loan. Another change, that was mandated prior to the royal commission, is set to place a much greater importance on keeping your credit file squeaky clean.
Most people who apply for a loan, from a mortgage to a credit card, accept that the lender will perform a credit check on them. Whilst these credit checks have always played a significant role in whether the application was accepted or declined the data that was historically available was limited to three items:
The date of the last credit enquiry for the applicant.
The name of the credit provider that made the inquiry, e.g. ANZ bank
If there were any credit defaults or bankruptcy registered against the applicant. A credit default includes a repayment in arrears for a period of 60 days or more.
The lender would then rely on the applicant to include the balances and structure of any outstanding loans in their application and back them up with the relevant statements.
On 2 November 2017 the government announced it would legislate for a mandatory Comprehensive Credit Reporting (CCR) regime to come into effect by 1 July 2018. So by 1 October 2018 the four major banks were required to report that 50% of their credit data, including home loans, credit cards, car leases, etc. are shared with a credit bureau and made available to other industry participants. By 1 October 2019 this figure will grow to include 100% of all credit data.
Whilst the government’s mandate only applies to the four major banks, to gain access to the data a lender must also be a participant so it’s expected the smaller lenders will follow.
What does this mean?
Under the new reporting regime, the number of data points contained in a credit file would be significantly increased. In addition to the three listed above, the information available to lenders would include far more detail around the balance and limit of any loans you have outstanding or closed, the type and structure of those loans and their month by month payment history for the previous two years.
All these factors will then be considered to produce a credit score for the applicant of between 0 and 1000. Clearly this will provide lenders access to a lot more data, enabling them to better assess a borrower’s true credit position and hence their ability to repay a loan.
How will this affect me when applying for a loan?
As more Comprehensive Credit Reporting (CCR) information becomes available, it should drive competition and result in lenders offering a better deal based on your unique credit circumstances. In short you could be rewarded for a good credit score with a lower interest rate or punished for a bad one. The race will be on to best utilize this level of data and introduces the possibility of nimble fintech start-ups to enter the marketplace.
It may also result in a reduction in the documents you need to provide the lender with your application. If a lender can view your current balances and repayment history, then there may not be a need to provide this information in the form of paper statements.
Whichever way you look at it, the change will place far more importance on maintaining a clean credit file and will ultimately result in a more competitive risk adjusted lending market.
It’s natural that a parent would like to be able to help their kids out financially, especially if it’s to get a foot on the property ladder when even that first step can seem so out of reach these days. But you need to think carefully before you hand over a couple of hundred thousand dollars because if things go pear shaped a big chunk of that money could disappear.
Let’s imagine you give your child $100,000 to put towards buying a $1 million house, then not long after your child meets a partner and they move in together. If they end up marrying or the relationship becomes de facto, which according to the Family Law Court is after at least two years, but the relationship falls apart, your child’s ex can make a claim for a financial settlement. It’s possible your kid’s ex could get half the house, including half the money you gave your own child.
And if it’s your son and there’s a child involved the financial settlement can be a long way from 50/50. Within a few years of a very generous gesture, a big chunk of the money could well have gone.
It is apparently possible that a Family Court Judge will make an allowance where the relationship didn’t last very long and they conclude the spouse doesn’t really deserve to share in the money the parents gave. But that is far from certain.
There are two things you can do. First, rather than gift the money to your child, lend it to them. The value of the loan will be excluded from financial settlement proceedings. You want to make sure the deal is characterised as a loan from the outset and the smartest way to do that is going to the trouble of getting formal loan documentation drawn up by a lawyer so if there’s a dispute the courts will be left in no doubt what the arrangement is.
You can even lodge a mortgage against the property, with specific clauses requiring that any partner must enter an agreement with respect to the money.
The second approach is to have your child’s new partner sign what’s referred to under family law as a “Binding Financial Agreement”, pretty much the equivalent of what is popularly referred to as a ‘prenup’. Your child’s partner would have to acknowledge the money you’ve given and agree that it’s not to form part of any financial settlement in the event of divorce or separation. This is much easier if the money is used for something readily identifiable, like a house deposit, but it can get more complex if it’s intermingled with other money.
Again, the wording of such an agreement has to be quite specific and certain protocols have to be met, like having the signatures witnessed by a lawyer or Justice of the Peace, so it’s pretty much a necessity to use a lawyer.
It’s worth bearing in mind that it’s not just a relationship breakdown where the money you gave can end up in someone else’s hands, if your child goes bankrupt their creditors can end up with it too. Here again, having the money tied up in a formalised loan should protect it.
There are two other considerations: if you’re receiving a government pension, under the so-called ‘$10,000 rule’, Centrelink will look at gifts and transfers exceeding $10,000 per year, or $30,000 over five years, when calculating whether you qualify under the assets test. This includes paying school fees.
Secondly, if your child is taking out a loan to buy the property a lender is likely to want to know if the deposit is being part-funded by someone other than the borrower, and it would be a really bad idea to fudge things in an effort to make it easier for your kid to get the loan.
Helping your child out financially should be a heart-warming experience, taking a few precautions can help stop it turning into a gut-wrenching one.
Most people don’t apply for a home loan many times in their life. Even if you’re just renovating or refinancing, it may have been 3–10 years since you last applied for a home loan and there have been a lot of changes in the lending market over that period so that what used to be a relatively straight forward application process can now be a frustrating, and potentially costly, experience.
What has caused the changes in the market?
In 2014 the Reserve Bank got concerned about the sharp rise in house prices and requested APRA, the government watchdog for the banks, to tighten the ‘prudential’ lending regulations and hopefully slow the market, so APRA limited the banks to a maximum of 10% growth in investor lending over a 12-month period.
To meet these new requirements the banks raised interest rates on investment loans in some cases by as much as 1% almost overnight, as well as significantly tightening their loan application assessment policies. Chart one shows the impact that this has had on the growth rate of investor lending.
Chart1: Investor lending slowed sharply after APRA tightened regulations
Source: JP Morgan
Then in April 2017 APRA introduced additional macro-prudential measures which capped interest-only lending at 30% of all new loans issued. Around six months after that was introduced, home prices in Australia’s major east-coast housing markets began to decline. Chart two shows the significant fall in year on year house prices in Sydney and Melbourne particularly.
Chart 2: Melbourne and Sydney home prices started to decline after APRA restricted interest-only loans
Source: JP Morgan
Throughout this period APRA has also been working closely with banks to develop stricter underwriting standards for both investor and owner-occupied loans. This tightening, combined with the public shaming at the Royal Commission into Financial Misconduct, has forced banks to take note.
How has this affected the lending process?
There is no doubt the regulatory changes have been introduced to make sure our financial system remains unquestionably strong, however, for anyone intending to apply for a home loan there are consequences you should be aware of.
1. More paperwork – In the past lenders have been able to accept that what you entered on your application was correct, but today they will require you to verify much more of your financial situation with documentary evidence in the form of bank statements. Often the submission of one statement leads to further requests which can be frustrating for all involved.
2. More questions – Banks are required by their regulators to keep evidence explaining why they assessed your application in a certain way. While something may seem obvious to you as the borrower, the banks may request an explanation in writing to ensure they have documentary evidence.
3. Living expenses – Currently banks ask that you estimate your living expenses and then take the higher of your estimate or the Household Expenditure Method (HEM). HEM is a national standard based on a few things, including where the borrower lives and the number of dependent children, and then assumes a basic standard of living. History has shown borrowers generally have a surprisingly vague understanding of their monthly living expenses and tend to underestimate this figure, and banks are now starting to require more evidence in the form of transaction or credit card statements to prove actual expenditure, rather than simply taking an estimate. A review of the HEM model is also underway.
4. Inflexible – Each bank has a list of criteria that need to be met to gain loan approval and these are documented in the bank’s lending policy. Banks have been instructed by APRA to strictly adhere to these policies and make very few exceptions. As a result we have seen an increasing number of declined applications for circumstances that may seem like common sense to the borrower, but unfortunately do not meet the specific requirements of the lender’s policy guide. Each bank’s policy guide is different, and it pays to speak to someone who has knowledge of these subtleties.
5. Principal and Interest (P&I) repayment – with such a regulatory emphasis on investment and interest only loans, it doesn’t take much to realise that much of the recent lending growth has come in the form of P&I repayment. Depending on your personal circumstances and lending objectives, you may consider paying principle and interest (P&I) instead of choosing an interest only loan.
These are just a few examples in which applying for a home loan has become significantly more difficult in recent times, but they highlight the importance of speaking to a professional to ensure you have the right structure and preapproval before you make an offer on a property. Where appropriate, we can also help you to apply with a non-bank lender that is not affected by APRA’s restrictions.
Our asset allocation consultant, Tim Farrelly, has done a deep dive on what he sees as the drivers behind Australian residential property. Applying his usual analytical bent his conclusion is that falling interest rates over the past 30 years have been the primary driver of rising property values, but now those rates have probably bottomed. We think you’ll find it reasonably easy to follow and given how topical the subject is we thought it well worth publishing.
“If returns came out of history books, then librarians would be the richest folks around”
-Warren Buffett
Residential property has been a wonderful investment for millions of Australians over the past 30 years and longer.
So much so, that investors know that, despite minor short-term slow-downs, residential property will always show excellent capital gains in the long term. They know this because it always has been this way in the past. Their parents bought their first house for four thousand pounds and it’s now worth over a million dollars. Every house they have ever bought has made money. And, better still, everyone they know has made money on residential property. Not most people – everybody. Investing in residential property makes you rich. It’s an historical fact!
Well, almost. Unless they have been very unlucky, past investors in residential property have done well and that is an historical fact. As is shown in Figure 1, capital growth has been exceptional for a long period of time.
However, as Warren Buffett also noted, past returns and future returns are quite different things.
This Editorial looks to understand past returns from residential property and then to use that understanding as a basis for forecasting future returns. To understand where the price rises came from, it helps to be able to break apart the role of fundamental factors, such as growth in rents, from market factors, such as how much the market is prepared to pay for a dollar of rent.
In essence, this approach says that the price of a property is determined by net rents multiplied by the amount the market is prepared to pay for each dollar of rent. We call this the Rent Multiple. If we have a property that produces $10,000 per year in net rent and the market is prepared to pay $40 for each dollar of rent, that property is worth $400,000. For the property to increase in value, either net rents must increase or the Rent Multiple must increase – or some combination of the two.
Let’s look at an example using the property described above. If, over the course of a year, rents rose 3% and the Rent Multiple rose by 5%, the house price would rise by 8%. This is the increase in rents (3%) plus the increase in the Rent Multiple (5%) as shown in Figure 2.
Where this approach becomes very useful is in understanding the contribution of each factor to past growth in property prices. As can be seen in Figure 3, increases in rents have been very much the junior partner in this exercise. Prices have risen much, much faster than rents. That is to say that the increases in prices have not been backed up by increases in the fundamental earning power of property. What has driven the major part of the price increases is a huge increase in the Rent Multiple.
As outlined earlier, the Rent Multiple is the amount buyers are prepared to pay for each dollar of rent. The Rent Multiple is the inverse of the yield on a property. The yield is calculated by dividing net rents by the property value, whereas the Rent Multiple is the value divided by the net rent. As can be seen in Figure 4 (overpage), a soaring Rent Multiple means tumbling yields.
Clearly, the major driver of increasing housing prices in Sydney and Melbourne has been the huge expansion of the Rent Multiple. In the case of Sydney houses, the Rent Multiple has risen from around 15 times rents in the 1980s to a massive 65 times rents today – even after a period of softer prices. Other capitals have experienced similar increases.
From an institutional investor’s perspective, Sydney residential property is outrageously expensive. By way of comparison, commercial property trades at around 13 to 20 times rents and shares trade at about 16 times after-tax profits. As a result, institutional investors rarely invest in residential property.
Why is residential property so expensive?
farrelly’s believes it is because prices are set by those looking for somewhere to live rather than conventional investment metrics. Owners of residential property are, of course, largely owner occupiers, with a fair number of private investors. Both behave very differently to institutional investors who look at the earnings power of an investment and the potential for growth in earnings. In trying to make sense of residential property prices, it helps to think about how residential buyers and sellers go about deciding what to pay or accept for a property. From there, we will propose a theory of how prices might behave and then, finally, look at the data and see if our theory translates into the real world.
How home buyers decide what to pay for a property
How much do home buyers pay when looking for a house? The answer? Whatever they can afford.
Home buyers, after their first day of house hunting, invariably return deflated. “Is our dream home really that far out of our range? I can’t believe how little we get for our money.” After that first day, the buyers’ strategy becomes clear – work out the maximum they can possibly borrow and then go looking for the least worst place they can buy for that amount of money. Concepts like yields or the Rent Multiple just don’t come into it. They just want their own home to live in and in which to raise a family. So what do they spend? Whatever the bank will lend them.
The banks will assess a loan on the ability of the borrower to pay the interest. They compare the amount of the borrowers’ weekly income that can be spent on interest payments with the interest payments required on the amount borrowed. So, if the borrowers’ earnings rise, or if bank interest rates fall, the banks will lend more to a given borrower. Similarly, when interest rates rise, banks will lend less for each dollar of income. Borrowers want to maximize the amount they have to spend on their property and the banks are only too happy to lend it to them.
When interest rates fall substantially, buyers all over Australia simultaneously find they can borrow, say, 20% more to buy a fixed number of houses. You would expect that, in this environment, prices should rise by around 20%. And, more or less, this is what actually happens, if not immediately.
Note that this only works if the supply of houses is relatively stable. If the supply of houses responded rapidly to changing prices, bank lending would no longer drive prices to the extent suggested here. In Australia, we have some nine million dwellings growing at around a little over 1% per annum – and that is with a building boom underway.
Now, home buyers don’t automatically pay more for a given property just because they have had a pay rise and can borrow more. In practice, they study the market for a while, work out what is the going rate for houses in a particular area, and then go looking for a bargain, or at least something that seems reasonable. Sellers go through a similar exercise. They find out what other houses in the street have sold for and hope to get a price a little bit better than that.
The impact of thousands of such buyers, all making similar assessments, will gradually move prices up when average weekly earnings rise, or if interest rates fall. In the long term, prices should rise in line with the amount the banks are prepared to lend.
How investors decide what to pay
Because home owners aren’t the only buyers in the market we need to investigate the market impact of investors, who, as we have discussed, are rarely institutions who worry about income and how fast that income grows.
Private investors are more concerned with the amount of capital appreciation that may be achieved over a period of time, without being too concerned where that appreciation might come from. For a private investor, a bargain is a property that is cheaper than the house next door, even if both are ridiculously expensive from the viewpoint of an institutional investor.
Private investors believe that residential property will increase in value. Their experience, and the experience of just about everyone they know, is that property prices rise in the long term. So their process for investment turns out to be much the same as home owners. They work how much they can borrow and find a property at a half decent price compared to other properties in the area. And the banks’ attitude to them is much the same – how much interest can you pay and can they pay a deposit?
Affordability: theory and practice
Our proposal is that in the long-run, prices are set by home loan affordability which can be best thought of as how much the bank will lend to the average buyer. In effect, we do something close to the calculation a bank makes before deciding on a loan. The bank will start with the amount a borrower earns, work out what is left over after living expenses and therefore available to be used to pay interest, and then divide by the interest rate payable to arrive at an affordable value, or the amount the bank will lend.
If this works in practice, then we should see long-term prices following a path that is similar to that of the Affordable Value calculation. We should see prices rising as average earnings rise and as home loan interest rates fall. In the short-term, prices may move away from the theoretical Affordable Value – depending on the amount of buyers and sellers active in the market – but prices should come back over time.
Figure 5 compares actual median house prices around Australia with farrelly’s estimate of Affordable Value in different states. The results fit the theory well. As expected, in the short-term, prices seem to take a while to respond to changes in affordability and at times get driven beyond the levels one would expect if they were set by affordability alone. But in the long run, prices seem to follow the path set by changes in affordability.
Looking ahead
If affordability continues to be a key driver of residential property prices, then the major drivers of prices will be wage growth and interest rates, both of which depend to a large part on inflation.
Inflation
Forecasting inflation is a subject in itself. For the purpose of this report, we will assume that the RBA and RBNZ continue to have moderate inflation as one of their primary targets and continue to do an excellent job of keeping it there. Our estimate is for inflation to remain in the 2% to 3% per annum range, averaging 2.25% per annum, in Australia and 2.0% per annum in New Zealand. However, it is possible that inflation could be higher or lower than the targets and so we will also look at the impact of higher or lower inflation as well as our base forecast.
How fast can wages grow?
The data for average weekly earnings growth compared to inflation is shown below in Figure 6. What we see is that wages move broadly in line with inflation, generally with some scope for real growth, usually reflecting productivity increases.
Currently, real wages growth in Australia is very slow, reflecting the sluggish Australian economy. As the economy gradually improves, we see that picking up, but not too much. We expect average income growth at around inflation plus 0.75% per annum in the next decade in Australia.
Interest rates
In the long run, interest rates tend to be driven by many factors, but the key one is inflation, or expected inflation. It is our expectation that interest rates will increase modestly over the next decade to, say, 3.0% or 3.5%. Rates may even go higher. What they will not do is go much lower. Nonetheless, we can test the impact of a range of different interest rate environments on Affordable Values.
Affordability through to 2027 under different scenarios
We can test the impact on affordability of our base case and for a number of different scenarios. Nonetheless, given we need either high wages growth or falling interest rates to drive affordability, even without looking at the numbers, we can quickly see that growth in affordability is likely to be much slower than in the past. The various scenarios in Figure 7 make assumptions about what real wages growth and interest rates would be under different inflation scenarios. And, while the 1.5% to 4.5% range of inflation scenarios may seem narrow, moving outside those scenarios doesn’t change the remarkable conclusion from this review that almost regardless of what scenario we look at, the rate of growth of housing affordability is likely to be extremely low going forward.
This suggests that capital growth is likely to be around 2.5% per annum or less for the next decade, which, when added to the extremely modest rental yields on offer, suggests very modest pickings for residential property investors over the next decade, as is summarised in Figure 8.
While the analysis here is focused on the Australian market, anecdotally the same logic largely applies for the New Zealand market although farrelly’s lacks the data to back-test the affordability model in NZ. As can be seen here, the outlook for the Auckland residential property market looks much the same as that of Melbourne and Sydney, and for all the same reasons.
What could go wrong with this forecast?
Forecasts are based on assumptions, many of which could prove to be wide of the mark. In this case, there are many factors that could lower residential property returns below even these modest forecasts.
What could make returns even lower than forecast?
Foreign investors become net sellers – this is possible, particularly if the markets show signs of weakness. In property markets like Hong Kong, investors are notoriously fickle. However, anecdotally, much of the foreign buying in Australia and New Zealand has been for lifestyle rather than investment purposes.
Local investors become fearful, take flight and dump property – again, this is possible, but unlikely. There is a very strong underlying belief in property as a sound investment. It would take a long time to break that belief.
Changes to the capital gains tax treatment or deductibility of interest expenses— again, this is possible, but unlikely to have too much impact. It may slow new investors entering the market but any changes would in all likelihood be grandfathered and so would not effect existing investors.
Massive overbuilding – there have been signs of this in some suburbs of Sydney, Melbourne and Brisbane and, if building activity keeps going at current rates, that certainly would lower returns. However, building approvals are slowing and so the long-term impact should be modest.
Even tighter regulatory controls on bank lending practices – this has already been happening to some extent and has been incorporated into this analysis. Further tightening of lending standards will further lower capital growth.
Recession – this could hurt returns in the short term and medium term, as recessions tend to move the actual value below Affordable Value for a while. On the other hand, recessions tend not to impact affordability in the long term.
Much higher interest rates – these would have little impact on nominal returns but could be devestating for highly geared investors. This is quite unlikely as central banks will be very cautious about lifting rates too far too fast.
Legislation aimed at improving housing affordability by reducing housing prices – this is a real possibility but the impact will be targeted to slow capital growth rather than reduce prices substantially. This is a political tightrope – don’t expect too much from our politicians!
Transaction costs – the cost of buying and selling a house normally comes close to 8% to 10%, enough to reduce returns by 1% per annum on a 10-year investment. This will apply to all new investors considering a residential property investment
What could go right?
Because these forecasts are somewhat pessimistic, instead of worrying about how the returns might be much lower than forecast, it is possibly more useful to worry about whether and how returns might be much more attractive than expected.
farrelly’s sees two main catalysts:
The foreign investment floodgates open – this is possible, but unlikely. The New Zealand government has been on the housing affordability case for some time, with limited success it would seem. Now, even Australian politicians have woken up to the idea that this is a major issue for a large part of the population. Restricting the impact of foreign investors on affordability is too easy a win. If increased foreign capital flows was a factor that was really driving property prices, expect it to be shut down quickly.
The politicians attack the affordability issue by making it easier to buy property – this is low hanging fruit. First time home buyer grants, allowing banks to ease lending criteria, allowing superannuation savings to be used to buy a first home – all just make the affordability issue worse. Again, this seems unlikely as most politicians seemed to have worked this out. But it is ripe for the populists.
Now is not a great time to be investing in residential property
Low returns, high transaction costs, and the threat of rising borrowing costs all make Residential Property a dubious proposition at this time, despite magnificent past performance.
Lower interest rates are almost certain to fire up a housing market and property developers will make out like bandits as they rush to bring on new projects to meet the fueled up demand. This certainly appears to have happened here in Australia where a record number of unit approvals have now rolled into commencements. One look at this chart from UBS Asset Management shows why this may be spelling trouble: whenever you see a chart go all but vertical you have to stop and wonder, particularly when you’re talking about the supply of dwellings, since there are only so many people to buy them and live in them.
One analyst estimates there is about 12 month’s oversupply of new dwellings, which is hardly surprising given, as the chart shows, there are more than four times the number of apartments being built now than in 2000. Of those being built, 88% are in Queensland, New South Wales and Victoria, leading to assertions of an apartment glut. For example, there were 2,700 apartments a year added to the Melbourne CBD over the past 14 years. Right now, however, there are 19,640 apartments under construction in the City of Melbourne, with an additional 18,800 approved for development.
If the property market does cool down it’s quite possible apartments will be the catalyst. By the end of June there had been 96,000 completed apartments settled in the previous 12 months and there were 92,000 pre-purchased apartments due to be settled. One problem though is the banking regulator, APRA, firstly instructed the banks to reduce their investment lending activity overall, so they have been lowering the amount they will lend against apartments and some lenders have listed specific postcodes they are avoiding altogether and, secondly, pressured the banks to reduce their lending to non-residents. The decline in funding availability means some buyers are having to resort to non-bank lenders, which comes at a cost.
Also, while it’s unclear how many apartments have been purchased by Chinese buyers, Meriton in Sydney is reporting that following the Chinese government’s crackdown on capital leaving the country they are seeing off the plan buyers walking away from their 10% deposits, which hasn’t happened before.
If an apartment is bought as an investment and is to be rented out, the estimated yield in Melbourne is now 3%. Once you deduct costs the net yield is about half that, so 1.5%, which is lower than a government guaranteed term deposit. That means the only possible justification to purchase a Melbourne rental property is expected capital gain. If supply is about to rise markedly, that expectation will look increasingly like speculation.
