By John Bolton*
It’s time to pull out the crystal ball and talk property prices. With house prices falling in Sydney (4.5% in the past year), the question is, will the same thing happen here? For this post I thought I’d develop a bottom-up ‘economic’ model.
(You should also check-out my other blog post on the Fallacy of house prices doubling every 10 years.)
Ok, so for my price estimator I’m going to assume an ongoing shortage of supply that will keep prices at their “affordable maximum.” The affordable maximum is the maximum amount a homebuyer can afford based on their income and a 10% deposit. To me, the affordable maximum, when combined with understanding the cost of intensification, gives a steer on house/land prices. I’ll explain this a bit more as we go.
Developing property is hard and risky
Anyone in property development long enough will have serious scaring. Development is cyclical and goes from boom to bust. Developers tend to take on too much risk and invariably go bust at some point. Those that are successful are not defined by one project, but how and when they get in and out of the market.
Whilst lately a few notable construction companies like Fletchers and Ebert have hemorrhaged cash flow, this is only the start of the bloodletting. In time, it will move from builders to land developers and speculators.
Builder get caught out early because they do fixed price contracts during the boom and get hit with capacity constraints, delays and higher build costs. As the market slows and the forward order book reduces they need to lose costs quickly which is why the whole industry is made up of sub-contractors.
Over the past eight years, construction prices have risen 38 percent with labour costs up 18 percent.
As capacity starts to free up in the market, competition should release at least some of this price inflation as it’s not driven by fundamentals.
The problem for developers is they get caught left holding land they paid too much for, or with projects they can’t sell. It is expensive to hold a development project, especially when it has debt funding. During the GFC, developers who were forced to sell into an illiquid market were toast. That’s how the rich get richer; buying up cheap land off bankrupt developers for 20 cents in the dollar. They aren’t leveraged and can have the patience to wait it out.
What about land prices?
Thanks to the unitary plan there is no shortage of land for intensification. Whilst supply is up, demand from developers is reducing. Land has poor holding yields. Nobody wants to hold projects.
On the other hand, borrowing costs are high and banks and finance companies are tough on credit. Finance companies charge all up funding costs of around 11% per year, which gets expensive when it’s held too long.
The easy exit (aka pass-the-parcel to a speculator who’s dumber than you) has disappeared. I am seeing more ‘dumb’ speculators trying to sell. Time will eventually catch up with them and some will ultimately go bust.
Dumb foreign money has fueled our market but a wide range of changes, including foreign buyer rules, tightening up of anti-money laundering rules to include real estate and tighter credit markets have killed it off. With the money out of the market, eventually we must get back to fundamentals and that could hurt a bit.
So, what is land really worth?
For the most part, the optimum use of residential land will be townhouses at 1 per 150sqm. So let’s use townhouses as the “currency” of intensification. For example, a traditional full site of 800sqm can be divided into 5 townhouses.
The first point is to establish an entry-level price. What is the price an average first homebuyer could pay for a townhouse in Auckland? This will differ across the city. For now, let’s use $700,000 (and I’ll explain that later).
If I work on an all-up cost, including a 20% developer margin, I arrive at a development cost of $510,000 per site including GST, and therefore a land value of $190,000 per site (see table below).
| Expense | Cost | |
| Build cost | 100sqm x $2,200psm | 220,000 |
| Subdivision costs | Per site | 90,000 |
| Site prep | 5,000 | |
| Sales and legals | 2.5% + $1,000 | 18,500 |
| Professional fees | 5% | 25,000 |
| Finance | 6 months at 6% | 12,000 |
| Developers margin | 20% of costs | 71,700 |
| GST | 66,330 | |
| Total price | $508,530 |
A quick look online finds an “estate sale” in Mt Roskill on 776sqm listed for $1.2m. Staggeringly, it has a CV of $1.32m so at $1.2m it might be considered a “bargain,” but is it? Based on $190,000 per townhouse it would have an economic value of around $900,000. To be economic at $1.2m would need the developer to believe they can get a sale price of $750,000 per townhouse, or the developer to take a lower margin.
In a tight market, smaller developers will cut margin to stay busy. Equally, with a lack of available property, some buyers will stretch to higher prices.
The observation that current prices are “uneconomic” is valid, but it doesn’t mean prices will fall. Owners won’t sell and developers won’t build. It’s a stalemate. I can’t see anything on the immediate horizon that will force the status quo to change, but at some point we will have another nasty recession.
How long will it take to work through the stalemate?
Assuming no land price inflation, and growth per capital at 2.50% (income growth) it would take about five years to get to a point where current land prices become marginally economic.
Developers will struggle along with us materially under-building and that will somewhat insulate current prices. Larger sites and “developer opportunities” will need to be sold based on economic value which will mean lower prices or more intensification.
With little in the way of new stock in the city, rents will continue to gradually increase and prices will stay flat.
Affordability defines the entry-level price
My economic model comes down to affordability for those that can afford to buy – we’ll call them the market price for entry level townhouses.
Fundamentally house prices come down to what people can afford to pay. My hypothesis with my ‘townhouse’ currency is that this is owner-occupied. Without capital growth and with a low rent yield it doesn’t make sense for investors.
If we assume a first homebuyer income of $140,000 with one child, 50% of after-tax income would suggest an ability to pay $4,375 per month on a mortgage. Assuming an interest rate of 7.50% and a 30-year term, that equates to real borrowing power of around $625,000. (Bank affordability calculators suggest these guys could borrow over $900,000 but that’s plain wrong.)
Allowing for a 10% deposit, that puts these buyers at $700,000. A bigger deposit will increase the price they can pay but not the amount they can borrow. Increasingly, to stay in Auckland city, this buyer will have to accept that a townhouse or unit or apartment is the only option.
As we move into other parts of Auckland and the household income drops, so too must townhouse values. If the average household income in South Auckland (amongst those both working) is $110,000 then the maximum borrowing power (again at a stretch) is $500,000. That puts a sales price on it of $560,000. South Auckland prices aren’t there yet and that’s why I think prices need to fall.
Conclusions
Prices on development land will come off 10% to 15% from peak and the price of new stock will gradually fall to meet the market. That will be driven by lower margins and lower input prices. However, in the absence of a trigger, the broader market will likely bump along in a stalemate for the next five years with little or no price appreciation.
Given a lack of turnover, headline prices could temporarily fall 5% to 10% in some areas but like post GFC they will recover again. I’m not in the school that prices need to fundamentally collapse. This ignores the need and cost of intensification and it ignores the fundamental shift to lower equilibrium interest rates.
In other words, more of the same.
House prices won’t fall further, because current prices are mostly explained by low interest rates, and my view is that low rates are here to stay given debt and technology lead deflation.
We will continue to undershoot construction activity, which will underwrite house prices and mean that prices will be governed by affordability.
Ultimately, developers are going to have to adjust what they have been building to deliver houses that buyers can afford. That will come from intensification (more townhouses) and lower land and construction prices.
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*John Bolton is the head of Squirrel Mortgages. This article is used with permission.
66 Comments
Yvil, despite being dismally slow on the uptake, it's encouraging to see you take Kiwibuild and its potential impact seriously! Other Coalition initiatives, such as changes to the tenancy laws and ring fencing are also real game changers and should also be taken seriously.
It's a good time to be a spectator as opposed to a speculator!
its barely starting - and 2025 more likely target - at the moment its kiwi buy -- not build or kiwi replace ( existing developers) but not kiwibuild on top of what was planned and what could have been expected to be planned
HNZ have a green light to buy as much property as they can - and they are getting up to speed and doing that - paying a premium for the privilege - MSD are looking at their kiwibuild applications - which are almost all existing projects that are either consented or between RC and BC - so very little new.
Even a couple of the larger projects they have announced -( not so large once you remove tthe none kiwibuild homes are years away from completion - if they can attract the labour and builders to do them
cheers
I'm not very smart but that makes no sense to me.
Why not choose tulips as an example as well for weird and whacko prices. Houses tend to follow what people can afford and are not highly speculative, only when the market is awash with money and laundered cash this may happen. But in general its what yours truly and most normal people can afford.
Nearly everything in this world has a price and a market and follow normal market rules, bitcoin is an exception, and I'm sure you will get other exceptions, but housing will always follow the norm, well in sane places anyway, unless you have ex prime minister with hidden agendas flogging their property off for 20 mill.
House prices won’t fall further, because current prices are mostly explained by low interest rates, and my view is that low rates are here to stay given debt and technology lead deflation.
Deceptive. Current house prices are the result of easy credit, both pre- and post-GFC. Low interest rates are a consquence of the flood of credit nationally and internationally that have driven private debt levels to astronomical levels that outstrip most people's ability to earn.
Hi J.C., can you elaborate on the mechanism whereby private debt levels rising to astronomical levels causes low interest rates as a consequence?
I'm not having a go, my instinct would just be that a massive demand for loans would cause an increase in interest rates, not the opposite.
Would it not be that the central bankers who set the rates and pump the easing in are motivated to protect the holders of big debts? For varying reasons. >
Central banks set the scene. The commercial banks lend the money into existence. It's a symbiotic relationship.
He's explaining that interest rates need to be kept low so h'holds can manage their unprecedeted debt levels. As for "technology-lead deflation", I'm guessing that he means that innovation will keep a lid on general price growth, meaning that interest rates will not have to rise to keep inflation in check.
Exactly - in some areas you're buying the house and getting the land for free - trick is to make sure population growth is solid and city size isn't too small (eg wanganui for me is where I draw the line as being too small with poor population growth). Auckland troubles will simply ensure interest rates are depressed which will see an continuation of price growth up to replacement cost in decent secondary cities
Geez I am confused, why have prices flat lined in Auckland if there is a shortage. If it were a fact that there is a housing shortage and one that apparently has deteriorated further in the past two years , due to historically high migration rates should prices not be rising. I am not a mortgage broker, so maybe I am just one of the dumb ones.
https://www.irishtimes.com/news/dublin-housing-shortage-to-continue-1.8…. It would be funny if it was not.
But Pragmatist the foreign buyers tax in BC started August 2 2016. This is a different timeline to which you show. . Foreign buyers accounted for 14 percent of sales in the first 6 months of 2017 , in 2018 between 0-1 percent. .
I perfectly understand what equates to demand. That is why home ownership rates continue to fall in most parts of New Zealand, in particular Auckland . Individuals cannot ,( unless they go thru some dubious mortgage broker ) demand something they cannot afford.
Pragmatist, you have included two articles to argue the case that Vancouver house prices are falling. Your article states and I quote. "The benchmark price for all housing types in Greater Vancouver has flatlined, slipping to 1093600, down $ 400 from the previous month but up 9.5 percent since June 2017 "
I truly apologise , indeed the resulting decrease in Chinese capital flight ( the tap ) has had consequences of some magnitude in this market.
Aren't you both right? The reason the average price has gone up in Vancouver, is because sales volumes have declined by 35%. Prices are higher, because you can't sell unless you have a premium value site and you can't buy unless you can afford the premium. There are still premium values sites and rich Canadians/Americans to make top end of the market functional, but the bottom tier has been crushed - so the average price goes up.
Did an estimate based on NZ medium family incomes and came up with a figure in the $650,000 to $750,000 dollar range for sustainable median house pricing. If your location is currently above this range you are in cost trouble, if you are at or about this you are in good stead and if you are way below you are in trouble for other reasons.
I think that JB's back-of-envelope finance cost of 6 months at 6% amounting to $12K is wildy optimistic. It assumes that the 'carry' is of $400K for that 1/2 year period (using a simple, non-compounding formula).
Surely the land and other up-front costs alone - consents, consultants, architects etc. are gonna eat that up and more on fairly much Day 1, and then there's still the actual Build to fund? My own PDOOMA estimate of the carry would be closer to $50-70K....
I think some developer-skin-in-game common taters (which, I hasten to reassure y'all, I isn't) need to enlighten us all as to the realistic rather than the assumed parameters here?
I think an excellent set of comments.
I think we are already seeing 2 bedroom townhouses in south Auckland at $550-$580k, and I suspect that is the point that KiwiBuild will be hitting the market in those locations also. There is a risk that KiwiBuild ends up subsidising land bankers rather than FHB's. Land otherwise would be sold with a big discount for risk, which may be removed by the KiwiBuild underwrite of developments
I think the issue of easy credit is a red herring - borrowing money was good sense when property prices were increasing. If they are not increasing why borrow - and why would speculative overseas funds flow in.
New lower-cost developments are often located in fringe areas of outer suburbia - and, as such, not particularly desirable. Over time, their value won't keep pace with better located properties.
In the main centres, the trick is to buy in areas which are close to the CBD. If it's north facing (sunny), fee simple (freehold title), flat with drive-on and near public transport, then you can't really miss. All you have to do is hold - never sell - because you've a great long-term investment.
TTP
Thanks to the unitary plan there is no shortage of [massively overpriced] land for intensification. Whilst supply is up, demand from developers is reducing. Land has poor holding yields. Nobody wants to hold projects.
Thanks to the Unitary Plan choking off land supply to Auckland City, the land is over priced. Auckland will continue to undershoot on construction whilst all the cities Auckland competes against out perform it. A decline of a mere 5 years is way too optimistic, this Unitary Plan expires in 2043 and locks in a decline of 25 years (relative to other cities).
People will not want to live where they pay high rents to access limited economic activity.
'Thanks to the unitary plan there is no shortage of land for intensification. Whilst supply is up, demand from developers is reducing.'
This statement highlights the failure of the UP, because if it did truly open up enough land, then development land would become cheaper.
And for land to become cheaper then land on the fringe has to be opened up and made available NOW as price is set on the fringe and influences pricing all the way into the city center.
All the UP has achieved is try to concentrate develop on brownfield sites close to transport hubs. Many brownfield sites have holding income, and/or no mortgage that allows the owner to sit on the land until it becomes scarce again.
The 'canary in the coalmine' developers, ie the ones the have bought land at inflated prices, and need to sell the house and land package at high price minimums to make a buck before holding costs eat them up (a 18 month max turn around) will be the ones worth watching over the next 6 months as they are the first experience trouble as they have no holding capacity and are on short leashes from their funders.
I concur and yet at the risk of rehashing the Monty Python Four Yorkshiremen sketch, it would be a luxury to have a UP that was merely as incompetent as just making Auckland land expensive.
The AUP is also spreading large exurbs several kilometres away from the city. These exurban mini-cities are planned to have a high growth rate for employment and population (ask nymad). The AUP therefore both inflates the cost of and lowers the value of the transportation hub developments that it seemingly aims to encourage. There is policy at cross purposes with policy.
AUP is a command and control/'smart growth' ideology of making houses so expensive that you can only afford a small apartment, and cannot afford to own, store, or run a car.
Which as you point out, increase cost, not only by making land more expensive which is a direct windfall to the land owner, but their bureaucracy is also expensive.
Remembering of course what is a cost to us, is revenue opportunity to them.
They will never come up with a solution to make housing more affordable if it means a decrease in the need to pay them their income or reduce the size of their organisation.
I agree with most everything you say, especially the bit that does not allow for the reduction of staffing level. However it is even worse than you think and the AUP is not this:
AUP is a command and control/'smart growth' ideology of making houses so expensive that you can only afford a small apartment, and cannot afford to own, store, or run a car.
The AUP applies smart growth for contiguous Auckland City only, where it does drive up costs. However the AUP is also a plan for massive greenfield expansion at every urban centre in the region. The AUP is the worst aspects of smart growth and expansive growth combined to create a retarded growth hybrid plan.
I suspect the whole thing is about raising staffing requirements and empire building. Smart Growth was the way to maximise staffing requirements in urban Waitakare, North Shore, Auckland and Manukau areas. Expansive Growth was the way to maximise staffing requirements in rural Papakura, Frankling and Rodney. So when Auckland Super City was formed they did both.
30,643 properties for sale across the country now, an almost 1% increase in the number of unsold homes in a week. You can try and rationalise the market as much as you like but when when buyer expectations are for ‘cheaper tomorrow’ it doesn’t always matter how much the banks are prepared to lend them. Let’s see where we are in 12 months and in amongst the averages there will be a few car crashes.
‘Increasingly, to stay in Auckland city, this buyer will have to accept that a townhouse or unit or apartment is the only option.’
That’s not how a market corrects i’m afraid John, it corrects when pressure is exerted on the overleveraged. They set the market to the fewer ‘willing and able buyers’ as the market compresses from the top down. The sensible first home buyers should only be using their maximum borrowing ability by forcing the middle market to meet them.
I always find articles about property from purveyors of debt sadly misleading in the realities of market forces.
I've just been to Bayleys afternoon auction, 4 houses on offer:
1st house was tiny and old in Grey Lynn, had a pre-auction offer of $1.060 M which was the CV, auction went crazy with 6 bidders, sold for $1.312 M
2nd house was a large house in Ponsonby with a lowish CV of $2.7 M, very competitive auction with 4 bidders ending up with a sale for $3.511 M
3rd offering was a cross lease attached 2 bedrm flat in Point Chev, no bidders, vendor's bid at $600k, didn't sell
4th auction was a brand new large home in Westmere on 1/2 a section, no bidders, no vendor's bid, I know the vendor's would like to sell for mid $3 M
So either very hot competitive auctions or totally dead with no bids...
This rather assumes a steady as she goes, she'll be 'right, sort of outcome. It is possible and not particularly unlikely, and the author is a credible source. I can't help wondering though about a shortage of well paid jobs in Auckland as uneconomic construction projects are completed and as Aussie pay levels, with their better and cheaper housing and petrol, start drawing the better people over there. Does Auckland become the city everyone wants to leave? Overcrowding, crime rate, low pay, high rents, leaky, mouldy shacks and expensive petrol anyone?
"House prices won’t fall further, because current prices are mostly explained by low interest rates, and my view is that low rates are here to stay given debt and technology lead deflation"
Ummm. Its easy to say things like this. Its also easy to say things like:
The western governments will aim to inflate away their debt....
If growth slows and too many loans were made and defaults become excessive and banks start to look wobbly. That's when the state steps in to rescue the banks. Rates are lowered further and future assett buyers, ie younger people, savers/ retirees get done over as assett prices rise because the current value of money has been chopped. Sound familiar?
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