CITI: Where Australia’s apartment boom could unwind

A worker holding a stop sign in front of an apartment block under construction in Sydney. Photo: William West / AFP / Getty Images

One of the biggest questions in the Australian economy is whether the explosion in apartment building in the eastern states has been too fast.

Can the huge increase in the supply of apartments be met by sufficient demand? Will the major cities have enough people wanting all these apartments that are getting built?

Paul Brennan, Josh Williamson, and Vivian Jiang of Citi’s economics research team of have had a close look at this in a new research note to clients. In their view, “the developing oversupply will continue to build into 2017 and 2018”, and that “will intensify settlement risks which so far are low”.

A quick step back. This first chart showing the mixture of houses and apartments in the building approvals shows the nature of the current construction boom.

Citi Research

Apartment approvals are at record highs. This is essentially all concentrated in the major eastern cities of Sydney, Melbourne, and Brisbane. In many ways this has been a huge positive for the economy, putting a rocket under construction activity in those cities, addressing long-standing housing supply issues, and helping to cushion the blow from the dramatic slowdown in the labour-intensive phase of Australia’s mining investment cycle.

As you can see from that chart above, the surge has all been concentrated in apartments, and it has been visible in the crane-pocked skylines of Australia’s eastern cities for years. We’ve seen an “apartment supercycle”, and there are big questions about how it will all end.

The supply explosion is clear, but the demand equation is a bit more complex and dynamic than some of the arguments you’ll hear about the potential for this to be a disastrous bubble. Here’s Citi:

The surge in apartment construction need not lead to oversupply depending on the level of underlying demand. This is a function of household formation, demolitions and vacant/second homes. Foreign demand is not explicitly included in this calculation, although to the extent the foreign purchases aren’t occupied, as is often reported, they will be reflected in the number of vacant properties. And many foreign resident purchases will be occupied by relatives studying in Australia. These students will be captured in the population statistics and therefore the estimates of underlying demand.

And the presence of foreign buyers in the Australian property market has been surging. The latest quarterly ANZ-Property Council Survey showed that foreign buyers, mainly from China, accounted for an astonishing 24% of all residential property sales over the three months to June.

Federal approval for foreign housing investment totalled $61 billion in 2014-15, up 75% on the previous year.

As the Citi team points out, you also need to factor in the nature of households. Are families smaller in particular areas? How many homes are being demolished to make way for infrastructure or apartment buildings?

All rolled up, you’d might be forgiven for thinking that the demand side is looking reasonably strong.

And you’d be wrong, according to Citi.

“Brisbane already is in oversupply, and Melbourne is on the way to oversupply,” the Citi team wrote. “When account is taken of approvals, only Sydney has underlying demand slightly higher than the level of approvals. This reflects the relatively greater scale of previous undersupply in Sydney in the ten years prior to the current construction boom.”

There’s another problem which some investors sometimes stumble over when it comes to property. You don’t typically invest in “housing” as an asset in the same way that you might in stocks or bonds or cash. For example, your savings might have an allocation to stocks but for most people this means a portfolio of companies with exposure to different parts of the economy like retail, mining, or energy. But typically with housing, you buy a single asset and if prices in that particular geographical area go up or down, so will the value of your property.

Location, location, location, and all that.

But it does mean that while the value of homes or apartments in a specific place can rise or fall spectacularly, the same may not happen to other properties in the same city, even those within a short distance.

So Citi has looked at the parts of Sydney and Melbourne, sorted by local government authority, that are most at risk of oversupply when they factor in their projections for population growth and density in those areas.

Melbourne is straightforward – the risk is all mainly in the city centre:

Citi Research

But here’s Sydney, and these local government areas are spread around the city.

Citi Research

Down at the bottom right there is Botany Bay, the area near Sydney Airport to the south of the city. The other areas are in the city’s north and west.

A market being in “oversupply” doesn’t mean a crash is a certainty by any means, but it does make prices falls of some level likely. The Citi research team notes: “The extent of oversupply will depend on whether developers proceed or not with all the approvals to build… If this trend [of building all approvals] continues, as seems likely given no prospect of the RBA tightening, the risk of oversupply will increase.

“These findings of oversupply are consistent with reports of downward pressure on apartment rents and prices in inner city Melbourne and Brisbane. For example, we have heard of agents offering iPads, rent free periods and other incentives to attract tenants, a failure of buyers to settle on purchases and developers lengthening terms to delay settlement.”

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