$16 BILLION: We finally have a number for the money at risk in the apartment boom

William West/AFP/Getty Images

The impending oversupply of apartments in Australia will hit Melbourne and Brisbane the hardest, according to analysis by CLSA.

Calculations by the broker and investment house show a settlement risk of $16 billion in excess apartments in Melbourne and Brisbane over the next two years.

The oversupply could spark a downward spiral in apartment prices, starting in specific developments because of settlement problems with highly geared developers and spreading to the upper end of the market.

“We have attempted to understand the level of overbuild in particular markets,” the analysts write in a study, Snuffing Puff, about the Australian housing market.

“Acknowledging some significant challenges in drawing conclusions from our analysis, we examined the number of units that are forecast to settle in a particular market, and compared it to its total sales.”

Using this measure, the analysts found Melbourne will have nearly $10 billion of excess apartments, when compared to the usual sales, settling over the next two years while Brisbane has nearly $6 billion.

This translates into 18,941 apartments in Melbourne above normal demand and 14,647 in Brisbane, as this chart shows:

Source: CLSA

CLSA says the property development industry is highly leveraged and sensitive to price changes.

Projects often have 90% bank debt and apartment buyers are also highly leveraged to above 80%.

“This leverage is exacerbated by the time taken from when a developer commits to a development, and when cash is received from buyers — often around two years,” the analysts write.

Buyers are usually required to put down 10% of the purchase price when a sales contract is signed before the apartment building is started.

And CLSA says foreign investors are likely to renege on the purchase agreement if prices fall by more than the 10% deposit.

“The developer thinks that there is a contractual obligation on the part of the buyer to settle, whereas a non-resident speculator effectively has an option to settle,” CLSA says.

“And the speed at which the housing cycle can change … increases the risk of financial difficulty by the developer.”

China is important

CLSA says China remains critical to Australia’s apartment market.

The analysts estimate estimate about 50% of all apartments were sold to Chinese buyers in the 2015 financial year.

But CLSA says it’s detected a gradual tightening of capital flows out of China.

And the states are imposing special taxes on foreign buyers.

Australian banks also have been restricting loans to foreign investors and increasing loan to value ratios for all investors.

“This means that apartment purchasers need to find more equity to be able to settle on apartments for which they have already paid a deposit and are contractually obligated to fulfill,” says CLSA.

“Failure to do so results in a loss of the deposit and risk being sued by the developer if the subsequent sale price does not cover the unpaid amount on the apartment.

“Once new apartments in an area are sold at knockdown or fire sale prices, this sets the benchmark lower for bank valuations. And bank valuations typically rely on the most recent sales with little distinction being made between high and low quality.”

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.