This is the maths facing the recent buyers of off-the-plan inner-city high-rises. There’s a lesson here…
I’ve been flying some red flags over inner-city high-rise developments for a while now. So far the market has been trundling along ok, but things could perhaps turn quickly.
So what would that scenario look like?
The key trigger to watch for takes the form of ‘settlement risk’. Settlement risk captures the things that can happen between commitment and delivery of apartment stock.
Let’s run through some numbers so you can see what I mean.
Imagine someone purchased a $500,000 unit ‘off the plan’ with a $50,000 deposit – say a year or so ago when the banks were happy to lend 90% of the value. They were probably thinking that by the time settlement is due, in like three years, that unit might have appreciated 10% or more (which is pretty reasonable over 3 years).
That would mean that their equity would have gone from $50,000 to $100,000. Happy days. Hopefully, rents and returns have been increasing as well.
And if you bought a property at almost any time in the past 20 years, this was the scenario you were looking at.
But things have changed.
First up, banks are no longer happy to lend 90%, especially on new construction in the inner city. They’ve started covering their arses a bit. So say the buyer’s bank now wants 80% of the valuation. They’ve got to come up with an extra $50K.
I could probably come up with $50K rummaging around in my cars, but not everyone has $50K just lying around.
But we’re also talking 80% of the valuation, and maybe the valuation has changed. Maybe the bank no longer thinks the property is worth $500K.
How likely is that?
Well, according to the Australian Financial Review, a study of nearly 2000 off-the-plan properties in Melbourne valued by WBP Property Group between 2014 and 2015 found that half are now worth less than their original purchase price.
According to the study, the average loss was about $40,000, or about a 10%, from their original purchase cost. Most of the properties studied were purchased between late 2009 to late 2015.
Only 1% of properties surveyed were deemed to be worth more than their original purchase price, with the remaining 49% now valued at the same price they were originally purchased at.
We’ve had an absolute truckload of high-rise construction coming on line in recent times. Check out the chart on 4+ storey building approvals.
That means there’s a lot of similar stock on the market, more sellers than buyers, and it seems that this has been depressing prices.
So a 10% fall in the valuation is not impossible, particularly if the banks start getting pushy about it.
So now our buyer’s bank says they’re only willing to lend 80% of $450K (=360K), but our buyer is down for the full $500. And so the buyer needs to somehow come up with the rest.
The loan of $360K + the original deposit of $50K = $410, so our buyer is $90K short.
Even I’d have to start going through my coat pockets to come up with that much.
So what can they do? They could walk away and lose their deposit, or they could try argue their way out of the contract, but both aren’t exactly appealing options. It’s a messy business.
They could try to sell the apartment, but the market has moved against them, and they’d be selling at a loss.
Say they sell and realise the $450K. Say that’s works out at about $400K after transaction costs. They pay off the loan of $360K and have $40K left over.
But they’ve sunk $140K of their own savings into the deal ($50K deposit, + additional $90K), so this deal has turned $140K into $40K.
And that’s not including any rental losses along the way.
Even if they decided to hold, if the rental market is soft, they might not be getting anywhere near the kind of returns they were expecting. Vacancies are high, which means greater holding costs and less scope to get a decent return.
And maybe their bank decided to increase rates as well. This has happened. So the gap between the rental income and the repayments widens. Most people still think negative gearing is a good idea, but there’s a limit to how negative anyone can go.
This is all a sad story for the buyer concerned, but there’s a macro-story here too. What happens if a lot of buyers find themselves in the same boat?
And what happens if they all decide they’re better off just to cut and run. Suddenly we’ve got even more stock on the market, prices are falling faster and realised losses are rising.
People could get crushed in the rush to the exits.
And this contagion could spread to the developers who now have no buyers for their stock, and the banks that funded the development.
And then chicken-virus would be in every school and kindergarten.
Ok, I’m painting the worst-case scenario here, but the point is, it’s not too hard to see it happening.
And given we had a tonne of development in 2015, we could be starting to see the effects of this in 2017-2018. It will be something to watch for.
Some folks (like the RBA) are relaxed about it, given how many apartments are being bought by foreigners. But with Chinese capital controls kicking in, I’m not sure I’d be hanging my hat on it.
I still don’t see any shake-out here affecting the broader market in a huge way, but for me it’s just another reason why high-rises are a no-go zone right now.
There are more than enough opportunities out there. I don’t need to muck around in this market.
Anyone hear any stories of settlement risk kicking in already?