For all the volatility across investment classes globally, the Australian property market has held up ok so far. In an environment where every asset class is being impacted negatively by rising interest rates, Australian property seems to be an obvious next victim. Especially residential property, which is expensive on almost any measure. Residential property has fallen around 5-10% from its highs in most capital cities but with interest rates rising fast, many believe a sharp fall is on the cards. I think this is highly likely as I wrote in May this year, I expect 20% plus fall. But I also think there are some unusual nuances to consider this time around as a legacy of trends stemming from both the GFC and Covid.
The impact of rising interest rates goes far beyond simply property prices. It effects a wide range of subsectors with problems often evolving as new home construction slows and bad debts rise. Concerns around the number of people, especially those under 40, who have borrowed millions and are maxed out already naturally leads to concerns around what happens if they can no longer afford the repayments. What does this mean for the banks and the economy more broadly? There are several aspects to this market that I think we need to be mindful of as this process takes hold and flows through the economy through 2023 and 2024.
Bank strength
Ordinarily rising defaults and bad debts could become a dire financial situation, especially for the banking system. However, since the GFC, the crisis in property markets globally lead to rules that ensured the banks have much higher capital requirements in place. As a result, banks have a significantly stronger capital base and although its likely bad debts will increase with rising interest rates, they will see increasing net interest margins too. For all the problems in the world, the banking system in Australia is well capitalised and in quite good shape.
Housing & construction data
There are lessons for Australia from US data. In the US, new mortgages have fallen dramatically. Mortgage interest rates going up so quickly (from 3% to around 7% in less than 12 months) means not only has this depressed the number of people who want to buy or build, but it has also reduced their borrowing capacity. People can’t afford to buy or build even if they want to. New housing starts in the US have dropped substantially too. We are still in the early stages of this flowing through the industry but from home builders, contractors, mortgage brokers, equipment sales, building supplies – there are a vast array of jobs that are underpinned by the construction industry. We are starting to see this here in Australia too with the recent profit downgrades from James Hardie and others on the front line.
Interest rate impact
When it comes to mortgage interest rates, a key difference between the US and Australia to be mindful of is that in Australia most mortgages are variable rate, so the increases deliver immediate pain to homeowners and consumers. In the US it’s a different story as a significantly higher portion of mortgage holders have fixed rate loans for 15 or 30 years so there is far less immediate overall impact and in turn less concern around repayments. This may mean that lower interest rates are required in Australia compared to the US to have a similar result.
Bank of mum and dad
The rise of the ‘bank of mum and dad’ is a unique phenomenon that I think adds a layer of protection for the banks and the banking system across some of their most ‘at risk’ borrowers. Post GFC, the banks have been willing to lend very high amounts but have protected themselves by ensuring parents either go guarantor or provide additional property as security. We won’t find out until things get bad just how much of a factor this is. However, many families have provided security to banks to fund property purchases that will be in the firing line should their adult children start to struggle under the weight of higher mortgage repayments. The risk of default may well result in that risk being effectively transferred from the banks to the parents. It means less forced selling in such a situation and a more orderly property market than we might have otherwise seen in the event of a substantial correction.
Landlords will start closing down businesses
There are many companies who during covid were unable to meet their rent. In many cases, landlords enabled these businesses to pay what they could but at the same time, the landlords accrued the amount owed. Many businesses are getting closer to that day of reckoning where they have to face the reality that they are not able to repay the back rent owed. Subject to their relationship with the landlords and their landlord’s assessment of their efforts to pay and future prospects, expect this to result in many businesses having their doors locked in 2023.
Working from home
Perhaps the biggest legacy of covid is nothing to do with our health, it is about the way we live. Working from home is another trend that dramatically accelerated during covid. Certainly, it is here to stay and it’s also the future of work in many respects. I see it as the precursor to work in the metaverse in the decades ahead. But I do see this changing in the short to medium term as the power dynamic shifts between employees and employers in the next 12-24 months. Many employees love it, many employers prefer staff back in the office. Some have found a balance. But once unemployment rises during 2023 and jobs become scarcer and promotions more competitive, many employees will find themselves reverting to being back in the office. This will support the ailing CBD office sector.
Summary
Overall, I believe property prices will continue to fall significantly here in Australia in the new year. While at this stage it may not result in the catastrophe of forced selling and loan defaults, the impact of rapidly rising interest rates on property and construction and the associated industries will begin to fully impact the entire economy in 2023 and beyond. There will be numerous opportunities to buy stock in companies in these sectors as markets find a bottom during the year. But before we get to that point, we need to see some of the economic pain flow through to earnings and more companies reflect the downgrades in their 2023 earnings forecasts that are yet to be made.
General Advice Disclaimer: This information is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different, and you should seek advice from an investment adviser who can consider if the strategies and products are right for you. Historical performance is often not a reliable indicator of future performance. You should not rely solely on historical performance to make investment decisions.