Dwelling commencement – the risk to Australia’s GDP

This is the message from RiskWise Property Research and Development Finance Partners (DFP), a major financier for developers, which jointly have assessed a number of key risk indicators in relation to residential dwelling commencements.

Their conclusions are dire with projections, particularly for units, far worse than initially predicted.

RiskWise CEO Doron Peleg said key risk indicators that provided six-to-12 month lead in to dwelling commencements were not included in the available data which showed a major risk of stronger reductions than expected.

“This means there is a high risk that the broader economy and GDP growth will be materially impacted,” Mr Peleg said.

These risk indicators include failure to meet pre-sales and sales targets by developers; lower sale volume and less focus by some property marketers on units in areas that are harder to sell; very low developer confidence, based on this year’s DFP Market Sentiment Survey; more conservative approaches and thorough risk-management practices by developers; very low risk appetite and conservative risk-management practices by lenders; lending restrictions and ‘black list’ areas by lenders for both residential lending and construction loans; the ‘pipeline’ of available funds shrinking; significantly lower LVR (i.e. higher deposit) for property developments and very high rate of pre-sales as a condition to proceed to commencements; and difficulties getting finance from alternative financiers.

Mr Peleg said the current reduction in dwelling approvals and, particularly dwellings that proceed to commencements, were only part of the problem, with some key indicators showing that the risk, at least in the next six-to-12 months could be significantly higher. He said the three-month aggregate of dwelling approvals for the current period of 51,406 was the lowest since August 2014, which was 50,588. This is in contrast to its peak which was 60,345 in June 2016.

“In order to better understand the process that results in actual dwelling commencements in the next 12 months and beyond, we need to assess the position of the developers, property marketers, buyers and lenders,” he said.

“Many developers typically have a few projects at different stages – those that need to meet pre-sale requirements; those that need to be fully sold; and those that need to be settled.

“In the current market conditions, with many areas having high levels of stock (there are 255,333 units in the pipeline in the next 24 months in Australia equating to 9.8 per cent of current stock), many developers are struggling to meet at least one of these targets.

“Also, based on a report from property advisory group Urbis, only 46 apartments were sold in Sydney in the three months to September. This represented only 13 per cent of the market, which shows how soft it is. The story was similar in Melbourne which saw new apartment sales sitting at just 330 units, only 17 per cent of stock.”

The HIA New Home Sales report this month shows the number of sales during the three months to October are down by 10 per cent compared with the same time last year. It states: “In the market for established homes the credit squeeze has been reflected in a material drop intransaction volumes and falling prices. In the new home market we are seeing fewer new builds goingahead.”

In addition, the number of new homes approved for construction in the month of October 2018, dropped by 1.5 per cent from the previous month and 13.2 per cent from October 2017.

Following the ABS release in relation to the total homes approved for construction in October 2018, HIA Economist Diwa Hopkins said: “A downturn in new home building has long been anticipated. The current credit squeeze however risks the pace and magnitude of the decline developing into something faster and greater than expected. This would result in a greater drag on the wider economy”.

Mr Peleg said this had a flow-on effect on developers’ cash flow and profitability and, more importantly, on their business strategy, risk-management practices and ability to demonstrate their success to potential lenders. This was particularly the case where developers had a large number of unsold or unsettled units in high-risk areas, such as Inner-Brisbane.

According to the DFP Market Sentiment Survey, there was a significant deterioration in developer sentiment with the overall optimism level of developers declining from 80 per cent in 2017 to 63 per cent in 2018. In NSW it dropped from 84 per cent to 65 per cent and in Victoria 82 per cent to 62 per cent.

Mr Peleg said lending restrictions, the findings of the Banking Royal Commission, an increased scrutiny of residential property loan applications and restrictions on foreign investors had led to a significant reduction in investor activity and changed the market landscape and consumer sentiment.

This had a direct flow-on effect on investor demand and, consequently, on developer sentiment.

Developers stated as the retail banks pushed investors with interest-only loans off their portfolio or had them convert to principal and interest, it was not a good time to develop and they expected to see further reductions in commencements.

With many borrowers unable to meet the new requirements it would further dampen the market.

And, Mr Peleg said, there was more gloomy news from property marketers.

“Some property marketers who in the past were easily able to shift a large number of off-the-plan units in high-risk areas with a large concentration of new units, are struggling to do so now, and despite significant marketing and sales efforts it often results in a small number of transactions,” he said.

“Therefore, some property marketers in many areas have shifted the focus from off-the-plan units, and instead are targeting house-and-land packages which are easier to sell.”

Bill Nikolouzakis, the newly appointed CEO of listed company iBuyNew, said he had certainly seen a change in the type of dwellings investors were enquiring about and purchasing over the past six-to-12 months.

“House-and-land packages and townhouses have become much more popular while the larger inner-city apartment developments have received significantly lower enquiry from this buyer type,” Mr Nikolouzakis said.

“With reduced borrowing capacities and the Sydney and Melbourne markets coming off the boil, investors are erring on the side of caution and reverting back to landed properties at the lower price points.

“The owner-occupier segment, however, is much more dependent on local markets – with Sydney slowing in terms of enquiry for inner-city apartments while Melbourne downsizers have re-entered the market with a renewed push towards luxury apartments in blue-chip suburbs.”

He said with selection still plentiful, it was the highest-quality projects that attracted the vast majority of buyers and those perceived to be lower quality in those same locations were slow to sell.

Getting finance from the major Banks, however, is the biggest problem now according to DFP director Matt Royal.

In addition, the major lenders, who provide both residential lending to home buyers as well as construction loans to developers, ‘black list’ many areas and, assuming their risk-assessment process is applied consistently across the bank, it means that these areas are also subject to very tight credit standards for construction loans.

Mr Royal said in addition all of the major bank lenders had set a lower LVR, i.e. higher equity from the developer as a non-negotiable condition to apply for finance.

Importantly, both major lenders and others required a high rate of pre-sales, in many cases of 90 per cent of the dwellings in the project, in order to commence construction.

He said the banks higher presales and equity requirements had encouraged strong non-bank credit growth which required lower presales and lower levels of equity.

APRA’S latest report (for the period ended on 30 June 2018) on ADI’s property exposures has indicated that there is a material reduction in the category ‘land development / subdivisions’. This category, jointly with ‘other residential’, is specifically associated with actual residential property development loans which net out retail loans.

Land development loans have declined year on year by 14 per cent from their most recent peak in March 2017. While medium to high-density development loans are not showing a significant decline, it is likely that following the reported period there have been stronger reductions also in the category ‘other residential’.

Based on the DFP survey, for 2017 and 2018, the common major issues for developers were shown to be bank financing and buyer inability to finance. The biggest change was in obtaining alternative financing, only a minor issue in 2017, but a major one in 2018.

Mr Royal said these results were unsurprising due to lending restrictions and more conservative lending standards in the residential property sector.

What developers need to do:

# First, focus on developments that carry a lower level of risk, for example house-and-land packages in areas that enjoy strong demand, particularly by owner-occupiers.

# Have a solid risk-management plan to address a longer time to sell and potential discounts.

# Work with well-regarded marketers and assess the marketing costs and the commission at a very initial stage of the feasibility assessment. The commission rate is a very good key risk indicator. Generally, the higher the commission the greater the risks to meet pre-sales and sales targets, as well as the settlement risk. Projects that require high commission indicate that there is only low demand despite strong marketing and sales efforts in Australia and very often overseas. However, projects that require only small commissions indicate that the project is relatively easy to sell due to strong demand.

# Explore unconventional and creative finance options, for example, joint ventures and finance from a number of non-bank lenders, as opposed to only one lender.