Crunch time looms in the Brisbane apartment market

PROPERTY

Property Postcard FH

The current over supply in Brisbane’s new residential apartment market has been well documented. In this postcard, we analyse the market fundamentals that are driving this situation and how developers and financiers can respond.

With new APRA imposed lending restrictions, spectre of rising interest rates and ongoing debate around housing affordability measures, the signs of stress on the Brisbane apartment market are only set to amplify.

This perfect storm could be disastrous for some residential apartment developers, financiers and investors.

Soaring supply

Building approvals for non-house residential construction in Brisbane increased substantially between 2013 and 2016, with the current level of approvals remaining high.

The increase in building approvals was driven by a number of factors including:

  • more favourable financing conditions for developers post-GFC
  • increased demand from residential buyers as fears from the GFC dissipated
  • record low RBA cash rates declining from GFC highs of 4.5% to 1.5%
  • urban planning changes allowing for higher density development in areas close to the Brisbane CBD and/or public transport hubs
  • increased risk appetite from developers and investors.

 

Building Approval Chart 

Source: ABS

The trend is also a national one. In April 2017, the RLB Crane Index showed that Australia’s major cities have more cranes in use for apartment construction in Sydney, Melbourne and Brisbane (486) than in New York, Boston, Chicago, San Francisco, Seattle, Los Angeles, Toronto and Calgary combined (<200).

In light of the above, the graph below shows there are over 10,000 apartments due to complete throughout 2017 in Brisbane, based on projects of 25 or more apartments within 12km of the CBD.

Forecast Completion Chart

 Source: Cordell Connect, Azurium Real Estate

Whilst a number of experienced property developers were quick to scale up and take advantage of favourable residential development conditions early on, they have been joined later in this cycle by a large number of less experienced developers.

While building approvals remain high, a number of factors are working to constrain future supply, including:

  • tightened lending conditions for developers as banks pull back due to oversupply concerns
  • dampened investor demand off the back of negative publicity regarding oversupply concerns
  • increased construction costs throughout 2015 and early 2016 in particular, reducing the viability of development projects with anecdotal evidence of 10% to 15% increases in construction costs over the past 12 months.

The key factor contributing to large increases in construction costs is the current wage demands of construction workers as the residential supply cycle peaks.

Demand dynamics

There are two key factors to consider with demand:

1. Owner occupier and investor demand to purchase off the plan apartments.

2. Tenant demand for new rental apartments.

Owner occupier and investor demand

The graph below shows the volume of apartments sold from December 2011 to March 2017, together with the weighted average price of apartment sales within Inner Brisbane (0-6km).

Apartment Sales Chart

Source: Place Projects

The weighted average sales price stagnated in the March 2017 quarter and sales volumes decreased further.

Owner occupier demand has increased relative to investor demand over the past year according to industry sources, noting the peaks in sales activity which occurred in late 2014 and throughout 2015, were driven primarily by interstate and foreign investors.

Many of these investors were sourced by investment marketers who typically charge commissions upwards of 5% to 8% or $25,000 to $35,000 per apartment.

For those developers once seminar costs are paid and investors are offered a rent guarantee and/ or a furniture package, the total cost to some developers is up to 12%.

Brisbane does however remain an attractive investment option due to its comparative affordability relative to either Sydney or Melbourne.

Anecdotally, self managed super funds are also a key driver of local demand where they can make up to 25% of apartment sales in some developments.

Meanwhile, the Chinese investors have dominated demand from foreign investors who are looking for property investment in Australia.

Regulatory and funding changes

Many of the new apartments currently under construction were marketed and contracted throughout 2014 and 2015.

However, in 2015, due to increasing concerns of systemic risk in the banking sector, the Australian Prudential Regulatory Authority (APRA) increased the capital requirements of banks with residential mortgage exposure aimed at curbing investor lending growth.

As a result of these changes, some banks started to increase interest rates charged on investor loans, and reduced the loan to value ratio available to investors. Higher deposits were also required to mitigate settlement risk.

Australia’s major banks have also implemented stricter lending conditions on foreign buyers, and in many cases, the major banks are not lending to foreign purchasers unless they can demonstrate they have income sourced within Australia.

To counteract this, some foreign buyers have been getting their Australian based relatives to purchase the properties for them, however this won’t be possible for all purchasers.

In addition, various lenders have blacklisted certain suburbs which they consider to be high risk due to supply concerns, including a number of inner city suburbs in Brisbane.

This tightening of lending conditions is a major reason for higher settlement risks for off the plan residential apartments.

The RBA shares these views, recently raising concerns in its latest biannual Financial Stability Review that isolated pockets of oversupply in the Brisbane market is weighing down rental and apartment prices.

Despite the investor lending curbs already implemented, regulators are considering additional measures aimed at subduing investor lending as a result of rampant property growth in the Sydney and Melbourne markets.

APRA recently announced on 31 March 2017 further measures to reinforce sound residential mortgage lending practices including limiting new interest only lending to 30% of total new residential mortgage lending.

Adding further concern regarding settlement risk, is the likely contraction of foreign purchaser demand associated with a 3% stamp duty surcharge applying to foreign purchase contracts entered into from 1 October 2016 in Queensland.

This all comes at a time when the majority of economists are predicting that interest rates have bottomed, particularly as some banks have already commenced raising interest rates due to higher funding costs, irrespective of the RBA cash rate.

Conversely, as the major lenders have retreated from the market place, private lenders have come in to fill the gap, to both developers and investors. However, these lenders typically charge higher interest rates and lend at a lower loan to valuation ratio, to shore up their equity position in the event of default.

The Federal government is not remaining idle either, implementing a number of property investment reforms in their latest budget which are aimed at addressing the housing affordability crisis. Coupled with the potential of additional mooted reforms, further disruption to the residential market seems likely.

Tenant demand

The Brisbane inner city residential vacancy rate has increased to 4.4% as at 31 March 2017, as shown in the graph below.

Vacancy Rate Chart

Source: Real Estate Institute of Queensland

Meanwhile, the vacancy rate for the middle ring (5-20km) decreased slightly in the March 2017 quarter.

While vacancy rates remain high, the graph below shows that in the March quarter, median weekly rent for a two-bedroom apartment decreased to $480 in Inner Brisbane while the Brisbane-wide weekly rent remained steady at $420.

Rental Value Chart 

Source: Queensland Residential Tenancies Authority

The market is awash with incentives reportedly ranging up to four months rent free to secure a 12-month lease for some newly completed buildings. This is to fill vacancies during 2017 and into 2018 where rental guarantees have been offered to investors by developers, as part of their purchase.

With significant supply due to come on line during 2017 and into 2018, we anticipate the vacancy level to increase and rental rates to decline.

Further, we anticipate owners of older buildings with reduced amenity and facilities will be most at risk from rising vacancy rates and reduced rents, as tenants are lured into freshly completed apartments with various common property amenities, attractive incentives and competitive rents.

The bright spots

Just as the residential apartment market is coming off the boil, anecdotal evidence suggests the middle and outer ring suburbs are booming, as investment marketers are herding investors into house and land packages, whilst owner occupier demand for house and land also remains firm.

With increased sales rates and modest increase in prices in these areas, developers are swarming to development approved sites, forcing site values up.

For the time being, the banks are continuing to lend to investors in these areas, however with the increased level of activity, it is possible their appetite may change as supply outpaces demand over time.

As always demand remains for quality product, especially in premium locations.

Current outlook

 Current outlook

Source: Azurium Real Estate

With the volume of apartment settlements presently in the pipeline, we are currently seeing the following impacts:

  • Settlements are taking longer to finalise with timeframes for larger projects typically doubling from two months to four months.
  • Foreign (particularly Chinese) purchasers who are unable to obtain finance from Australian lenders are rescinding contracts, with new contracts being entered into by local residents, usually family members.
  • Early discounting of some projects to clear residual stock.

These delays to settlement at a time of peak debt for the developer add substantial interest costs, eroding the developer’s equity position, and potentially the return to the mezzanine providers. We are also aware of significant roll over fees being charged to developers where their facility is not paid back on time.

Those developers with an effective and streamlined approach to managing settlements will fare better than those developers who do not have an appropriate strategy in place to work with purchasers.

Should confidence continue to deteriorate, particularly where apartment values fall by more than 10% of the purchase price, then a significant number of purchasers are at risk of default and walking away.

If this eventuates, it will not only be the equity and mezzanine funders who will incur losses, but senior lenders may also be at risk, depending on their exposure.

The determining factors for those projects that will succeed are linked to the quality of the project in terms of:

  • location
  • building quality and visual appeal
  • number of apartments
  • size
  • layout
  • extent of allocated and unallocated parking
  • views
  • amenity
  • price point
  • purchase price as against valuation.

Driving past any of these projects, it is worthwhile considering, would you live there and under what circumstances? If you wouldn’t, then its likely others will have similar views. These views impact what rent can be charged, and consequently what a purchaser is willing to pay once the project is complete compared to competing stock.

This is critical, as a typical off the plan investor, buys on the basis they are purchasing the apartment at a discount, and hope that when construction is completed, there is likely to be some capital appreciation.

Conversely, once an apartment project is completed, buyers are not buying ‘hope’ but rather ‘reality’ whereby the apartment’s fundamentals are on display to compare against other apartments.

With all the headwinds facing the residential apartment sector in Brisbane, we anticipate sales prices for new apartments will decline, as will sales volumes for off-the-plan apartments, with settlement risk being a significant concern.

Owners of older stock will come under increasing pressure on the back of ample choice for renters, who are now in the box seat when it comes to selecting a rental property and negotiating terms.

While inner city areas such as Newstead and Fortitude Valley, West End and South Brisbane will face these pressures, we have heightened concerns for developers and financiers with exposure to middle ring suburban areas such as Albion, Nundah, Cannon Hill and Chermside where significant apartment projects are completing now and throughout the rest of 2017.

Financiers exposed to the larger residential projects in this sector need to be prepared to work closely with developers where they have an exposure to mitigate the risk of loss.

Managing project risk is critical

When assessing project risk it is critical to understand:

  • current market conditions and how buyers may be positioned
  • the supply and demand for similar, competing products
  • the advantages and disadvantages of given product as against the competition including other new stock and older stock
  • legal matters such as the enforceability of pre-sales contracts relating to:
    • building specification differences to marketing plans
    • any looming sunset dates
    • body corporate disclosure statement variances
  • level of deposit
  • buyer origin, being either local, interstate or foreign
  • nature of purchasing entity such as whether changes may now restrict a SMSF from purchasing.

Once these factors are understood and risks identified, it is then critical to implement appropriate measures to mitigate settlement risk, such as:

  • regular communication with buyers regarding benefits of investing in the project
  • educating buyers with respect to market cycles
  • offering buyers a monetary incentive to settle rather than default
  • assisting buyers in obtaining loans by referring them to a reputable broker / mortgage provider
  • rescinding the contract and entering into a new contract with alternate buyers where possible
  • providing additional time for purchasers to settle
  • providing a senior loan sufficient to complete, subject to obtaining a first mortgage
  • providing a residual loan sufficient to complete, subject to obtaining a second mortgage
  • terminate the contract, retaining the deposit, reselling the apartment and pursuing the buyer for any shortfall.

How can we help?

We have a team of experienced property professionals with extensive involvement in the residential apartment sector. This team includes our Azurium Real Estate experts who have coalface experience stemming from their background in senior leadership roles at market-leading organisations.

Where appropriate, our team can work with and advise developers and financiers with regard to their exit strategy, facilitating project completion, mitigating settlement risk and sale of remaining stock.

To find out more, or for further information as to how we can assist, please contact one of our property team members below or Azurium Real Estate experts.

 

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