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Why buy a unit, villa, or townhouse instead of a freestanding house in 2022-2023?

Before answering this compelling question, we must look back over the past few years to understand what has happened in the Australian residential property market and what the immediate future holds for housing and the economy generally, as well as for our health and wealth.

Against a backdrop of war in Eastern Europe, the Reserve Bank of Australia has been grappling with the impact of rising costs of living, a severe energy crisis, and inflation which is now at 5.1% and expected to pass 6% soon enough, without falling back to the RBA’s preferred range of 2%-3% until mid to late 2024. Moreover, from an economic viewpoint, the RBA must also factor in the impact of “living with COVID” in mid-2022.

This is not to mention the constant heartaches inflicted by fires, floods and the pandemic, over the past three years and their economic implications.

So, the sixty-four-dollar question is: how will these events impact everyday Australians? What will be the effect on interest rates, property prices, and the general economy?

The RBA Governor’s message to mortgage holders on 10 March 2022 signalled the start of more sobering announcements than previous statements. “Mortgage Holders should start preparing for interest rate increases.” In my view, prior to this statement, borrowers had been unwittingly lulled into a false sense of security by the RBA, that historically low-interest rates would be with us until at least late 2024.

The first-rate rise, of course, occurred on Tuesday 3 May 2022 for 0.25%, taking the official cash rate to 0.35%. That was the first upward adjustment in the official cash rate since November 2010. That’s nearly 12 years!

The so-called expert predictions are for additional increases in the official cash rate totalling 2.5% between now and Christmas next year. That would be 2.75% in total. In 2024, the experts say, there may be further increases of up to 1% which would be 3.75% in total, if the experts are proven correct.

From all the current data available, I would expect at least four additional interest rate increases this year alone, with more to follow in 2023. My further view is that 2024 is too far away to predict with any certainty.

My summary then, is that the cash rate will increase (including the May increase of 0.25%) by 2.00%, in total, over the next 18 months. If that occurred the cash rate would peak at 2.10% in December 2023.

Even the most optimistic property pundits understand that rate hikes will challenge future price appreciation and signal an inflexion point leading to property prices falling. Moreover, these anticipated rate increases will have broader ramifications on other asset prices and the wider economy.

The Federal Government and the RBA have been walking a precarious tightrope as they gradually taper pandemic economic support and raise interest rates, while not beating the economy into a recession.

Despite these significant economic challenges, especially the inevitable withdrawal of cheap mortgage money, Australia is once again better-equipped than its international peers in dealing with these challenges, with Australia’s mineral-rich economy being a benefactor of high energy prices. This competitive advantage in minerals also acts as an inflation hedge in a world of rising prices. In addition, having immigration as part of our export mix effectively cushions the economy and limits labour constraints, while improving our national GDP figures and fending off stagflation fears.

I guess the million-dollar-question (or more like, the $1.6 million question in Sydney and the $1.1 million question in Melbourne) is.

1. How far will property prices fall over the next 18 months?

2. Will those falls be consistent across houses and units?

3. Will some property types actually rise?

As Albert Einstein once said, “If you want to know the future, you need to look into the past”.

On March 6, 2019, the RBA Governor presented at the AFR business summit. As can be seen in the graph below, the benefit of hindsight lays out the foundation and justifications for future rate reductions for the sole reason of increasing property prices.

Looking at the benefits of property price appreciation, a 10% increase in property prices would increase consumer spending by circa 1.5% (Keynesian Wealth effect) to give the economy some additional stimulus.

It is essential to note that this was all happening while property prices took an 18% hit in 2018. That was not due to a lack of demand; rather it was induced by APRA’s intervention combined with the Banking Royal Commission which restricted bank finance and the flow of capital to buy property.

It was not too long after these events that interest rates began to decrease from the then 1.5% official cash rate, with the RBA Governor uttering one the most important quotes in regard to property prices. He believed that property prices could go up as high as 30% without being a risk to the general economy.

Remember, this was during a time where most property economists believed property prices would fall between 20%-30%! My predication was a modest fall of 2%-3%. I was wrong but much closer to the mark then falls of up to 30%!

Indeed, since the RBA Governor made that statement, property prices have increased by nearly 30% nationally over an 18-month period to February 2022.

Interestingly, the most effective property modelling conducted in Australia has been commissioned by the RBA itself – most notably a joint paper by Trent Saunders and Peter Tulip entitled, “A model of the Australian Housing Market.”

The paper outlined the key drivers to property prices and with no surprise, it reaffirmed the RBA’s property price prediction that with a 1.5% drop-in interest rates, property prices would rise by up to 30%.

Accordingly on the flip side, it would be easy to conclude, with the RBA’s admission that interest rates could go up beyond 1.5% over the next 18 months (including the May rise of 0.25%), that the property gains of the past few years would be easily reversed. That would be a rational conclusion that property prices would fall back to the levels seen in 2018, when the cash rate was at 1.5%. However, the reverse is not automatically true in this case.

The model also outlined other contributing factors such as, changes to incomes, unemployment, population growth, housing stock, and rental vacancy. Upon looking closely at all these elements, I believe that despite rising interest rates placing downward pressure on property prices, all other factors are positive for the property market and this will, I believe, limit the downside.

As inflation expectations are increasing, wage inflation will increase from its present May 2022 level of 5.1% to perhaps 6%. The other significant metrics to note are that unemployment was at a record low of 4% in April 2022 and expected to fall to 3.8%, and immigration will increase even more significantly than pre-COVID levels. As well, we still are not building enough dwellings (houses, units, villas, and townhouses) to meet demand, and so rental vacancies, are now lower than pre COVID level at around 1%.

It is my view that property prices will fall as the cash rate increases by up to another 1.50% over the next 12-18 months. Importantly, I believe falls will be modest – between 8% to 12% due to the other abovementioned factors moving in favourable directions.

Interestingly, property prices have fallen in February, March and April 2022, in Sydney and Melbourne by around 0.5% in total, but in almost all other capital cities, prices have increased by an average of 2.25% over that 3-month period.

If the Reserve Bank needs to raise rates above 2% over the next 24 months, we may be looking at a credit crunch with more severe property declines, therefore we believe that the RBA will be more cautious than the financial markets are anticipating.

The RBA is well aware that one of the most significant factors as to why the property market grew by 30% in the 18 months until January 2022, was the availability of cheap money which allowed first home buyers, who would otherwise have been locked out of the market, to buy their first home and to borrow significantly more then would have otherwise been the case.

That said, Banks and other home loan lenders have been assessing borrowers’ capacity to pay their mortgage repayments based on a 5% mortgage rate, as it was always expected that interest rates would rise, the further we moved away from the impacts of COVID-19. Accordingly, any suggestion of wholesale mortgagee sales and property prices plunging, is just nonsense.

Moreover, existing homeowners who were looking to upgrade were also able to buy a bigger property with a bigger price tag because of their increased borrowing capacity. Homeowners, during this heightened period of property activity were keen to fix their mortgage rate for up to 4 years at sub-2%pa!

The normal ratio of fixed to variable rate loans moved from 20:80 to 40:60. The RBA will be very cognizant not to increase cash rates too much too quickly as that would have a significant impact on mortgage borrowers, who from an historical viewpoint, have borrowed too much for too little cost.

In my view, the brakes should have been put on the historical low cash rate of 0.1% in about July 2021. If that happened, we would not be in the current predicament. The RBA, in my view, have moved 6 months too late.

The other factor that is causing great mischief is the reckless reporting by the media that property prices will crash by 20% to 30% and this is causing instability in confidence and therefore affecting normal market conditions. The RBA is also very conscious of this fact.

It is useful to examine property prices on an aggregate level. That said, it is also essential to look more closely at a micro-level; where I envisage a divergence in property prices across different geographical regions, different property classes, and specific trends that impact property.

Regional Property.

Perhaps one of the biggest surprises that has emerged during the pandemic has been the stellar performance by the regional property market, inspired by the combination of low-interest rates and COVID encouraging cohorts moving towards the tree and sea lifestyle changes, despite the backdrop of zero net migration.

For those who can afford a second home, this change can be sustained; however, the reality is that the work-from-home phenomenon will eventually run its course, and health, education, and work options are much more plentiful in the cities, meaning that some people will move back to the cities thereby reversing some of this trend in the coming 24 months.

Sydney, Melbourne and Brisbane

With Queensland being the star outperformer on the internal migration front (7,035 net migration just in Q4 2021), and with Brisbane being the most affordable city on the eastern seaboard, we believe the rise in Queensland property prices in percentage terms will outperform those of NSW and Victoria, but importantly not in dollar terms.

This is because Queensland, especially Brisbane, has the ability to quickly deliver sufficient supply to meet demand; credit for this can be given to Queensland having a much quicker planning process and less constrained with land, allowing developers to meet market demand quickly keep prices affordable.

COVID’s Impact

During the height of the COVID pandemic, with historical low interest rates and easy access to cheap money, households spent money on property due to pent up demand due to lockdowns. Importantly, we also saved money ($235 billion) as well. With the benefit of hindsight, it is no surprise now that the property market, share market, and other asset classes have done exceptionally well.

Very importantly, during COVID, particularly at the height of the lockdowns, units were seen as less attractive than freestanding houses because being locked down in a unit was much harder than being locked down in a larger freestanding house with outdoor recreational space. Accordingly, the average increase in unit prices was 20% and not 30% as was experienced with conventional housing.

Units Versus Houses

The price gap between “units” (units, villas, and townhouses) verses freestanding houses has never been wider. As affordability becomes more realistic, we believe units will be the feasible alternative. There is a significant shortage of larger unit apartments suitable for young families and empty nesters.

Property developers are focusing their attention on creating a more suitable product catered for this market, which lead to a psychological shift in property preferences away from freestanding houses in the future.

So, to answer the previously posed questions.

1. How far will property prices fall over the next 18 months?

A. 8%-12% for houses

2. Will those falls be consistent across houses and units?

A. No. existing units, which did not go up as much as houses may see a flattening of the price curve followed by falls of between 4%-8%, as demand for this more affordable type of housing increases.

3. Will some property types actually rise?

A. In the short term, new unit stock should have some increases in prices over existing stock – perhaps up to 3%-5%.

For first home buyers, units.

1. Provide better value for owner occupiers to be able re-enter the market; and
2. Government support for approved applicants for new purchases up to $800,000.

For empty nesters, units.

1. Allow downsizing to a more manageable property;
2. With no capital gains tax on the sale of an existing owner occupier property; and
3. The release of surplus “house equity” for retirement living.

For investors, units

1. Allow a lower entry level value than freestanding property;
2. Will provide good rental returns (which have increased by 10.8% in the last 6 months);
3. Plus negative gearing;
4. Plus depreciation benefits; and
5. Long term capital growth.

While Australians have one of the highest rates of home ownership in the world, housing affordability in our capital cities is among the least affordable in the world. Thus, getting in at the ground floor by purchasing a unit, villa, or townhouse and holding onto it through the next property cycle makes good long-term financial sense.

John (JT) Thomas

This opinion piece is provided by John (JT) Thomas, a 46-year veteran of the financial services industry and since 1987 a specialist in commercial mortgage funds. Considered by many to be the father of the modern commercial mortgage fund sector, JT helped establish and then managed – for 17 years – what became the largest and most successful commercial mortgage fund in Australia – The Howard Mortgage Trust – with assets exceeding $3 billion. Under JT’s stewardship, investors never lost one cent of their investments and indeed, investors always received competitive monthly returns. JT was also Chair of the $40 billion mortgage trust industry sector working group.

JT has been proudly involved with Princeton for eight years and sits on both the Princeton Credit Committee and the Princeton Compliance Committee as well as being an advisor to the Princeton Board.

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