Since the commodity boom, the only game in town has been residential house and apartment construction. Virtually all of this construction has been financed by offshore lenders, through local banks.

This made eminent sense when Australia’s cash rate was much higher than the rest of the developed world. However, this month it was cut to 1.5% and is expected to go lower. Lower rates have encouraged more borrowing for houses but, at some stage, foreign lenders won’t play.

The banks have been primarily lending against residential housing. This is at the expense of lending to fund business growth, research and development and the like. The ‘Big Four” (ANZ, CBA, NAB, WBC) Australian banks consider residential mortgages far less risky than other forms of lending. Consequently, low risk weightings have led to highly leveraged balance sheets.

In Sydney there are around 300 cranes on the skyline, with about 80% on residential construction, the rest mostly on government boondoggles. This is an increase of about 30% since 2015. Remarkable when compared with the low point of only 10 in 2000. The situation is similar in other cities.

This building frenzy is leading to an increasing glut of new apartments. In inner city areas rents are falling and competition to sell or rent near identical, poorly made, apartments is growing.

Off the plan sales of proposed apartment developments are primarily marketed in China and Australia. With off the plan sales, the prospective purchaser puts down a 5-10% deposit before construction commences and pays the balance when construction is complete. If the purchaser is unable to make the final payment the developer has a problem, and so do its lenders.

The situation with Chinese buyers is the most dire. Australian banks have restricted mortgage funding for Chinese buyers and Beijing is restricting currency leaving China. Buyers are walking away from contracts, forfeiting the deposit.

There are problems for domestic buyers as well. Assume a purchaser agrees a price with the developer, let’s say $600,000 for a one bedroom apartment. When it comes time to take out a mortgage, the bank is not interested in the agreed price. They value it at, say, $400,000. The purchaser has to either find an additional $200,000, or default. These defaults are also increasing.

Struggling developers are even offering free overseas holidays for apartment buyers. For some developers, 20 – 30% of purchasers are unable to settle.

In sum: a huge apartment oversupply (with many, many more on the way); lower prices and rents; and rapidly increasing failures to settle are putting numerous developers at risk. This in turn will put pressure on the developers’ lenders.

A collapse in the real estate bubble is likely to send Australia into recession. It is entirely possible that our banks will require a taxpayer-funded bailout and the dollar will freefall. There is nothing to fall back on and so Australia’s deficits will continue to grow. But borrowing will become expensive as the country’s AAA rating will head south, as will the bank’s ratings.

Australia already has over $1 trillion in foreign debt (a dangerous 65% of GDP) and adds to that at around $2 billion per week. It has run a persistent current account deficit, even during the commodity boom. A housing collapse will make Australia look like a developing nation. To revisit the words of past Prime Minister Paul Keating.

“Australia is basically done for. We will just end up being a third rate country…a banana republic”

Paul Keating, 1986

And finally, in 1980 Lee Kuan Yew said that Australia risked becoming “the poor white trash of Asia”, without market reforms.

Hopefully things won’t be that bad, but the omens are not good.

 

Read more about Australian real estate here, here and here

11 August 2016 Markets