NZ House Price Boom Rekindled

NZ House Price Boom Rekindled

After a couple of years of idling, NZ house prices are once again moving into top gear with REINZ's data showing the median New Zealand house price sale was $400,000 in March compared with $370,000 in March 2012, an annual increase of 8.1 per cent, whilst Auckland's median house price increased by 13.5 per cent, from $495,200 to $562,000 over the same period. These sorts of increase are a worry for both the Government and the Reserve Bank and are exactly what they were hoping to avoid, unfortunately they have both been long on talk and short on action, and without fundamental reform to address supply and demand side issues, this is one problem that will not go away.

I discussed the overvalued state of the housing market back in October 2012, in my post ‘ The New Zealand Property Market - The Bubble that Never Bursts', in it I outlined a number of the current problems, a few possible solutions and also illustrated that despite public perception, house prices can and do go down. However I also said that it would probably need the next global financial crisis to trigger the correction, because waiting for governments and central banks to do the job would likely be a long and painful experience. They are much better at talking a good game than implementing it, especially when it directly affects many of their supporters. For those of you that would like to catch up on that post you can find it here http://kiwiblackers.blogspot.co.nz/2012_10_01_archive.html

So let’s have a look at some of the issues currently affecting the housing market and see what we can discover.

 

1. Is this rally only a NZ phenomenon? 

 

No, a number of other countries are experience an uplift in their property markets, among them the US and the UK, however there are many other countries that are still seeing static or falling prices. It really is a very mixed bag seemingly dependent upon the economic situation in the respective country. But one very important point to note is that the countries that are now having the rally, also had the correction from the 2007 peaks, with both the US and the UK property markets falling by around 30% from their peak in real terms, once again making them attractive in valuation terms. By contrast, the most that NZ experienced was a 15% correction in real terms, nothing like the fall necessary to make them ‘cheap' once again. 

 

2. We already know about land supply constraint, the lack of houses being built and the cost of construction but is there anything else driving the rally?

 

•   Persistent low interest rates are having multiple effects:

   

  It conditions borrowers to cheap credit and skews their perception of the risk and probability of interest rate rises, so encouraging them to take on debt.

   

  It forces investors to seek out yield in riskier assets because they cannot earn enough from deposits, so boosting speculative investing in housing.

   

  By allowing those with a mortgage to continue to service their debt at artificially low interest rates rather than having to sell the asset, supply is taken out of the market and the correction process is delayed, this creates pent-up demand from first time buyers and forces them to over leverage. 

   

• Consumer confidence is at its highest since the 2008 GFC, and when people feel confident they spend money, and the more confident they feel the more likely they are to spend on big ticket items, and items don’t get much bigger than housing. (A side note is that consumer confidence can be used as a contrarian indicator, it is often at its peak just before the economy rolls over, and at its low just before the recovery begins). 

• Little to no changes in tax policy towards housing as an investment asset means that investors continue to see housing as the best game in town and are now re-entering the market, and as such will continue to compete with those trying to buy a home rather than an asset.

   

   And probably the most important aspect:

• In Auckland where the problems are most acute, there is clear evidence of extensive foreign buying of property. There are numerous stories of developers being outbid by mainly Asian investors for development land, with some people speculating that this is being used as a ticket into NZ because owning real estate increases immigration visa points. There are also many stories regarding young Asians able to buy properties by accessing large deposits out of Asia.

It is the combination of many factors over a considerable time period that has allowed the distortions in the housing market to develop, but it is the inflow of funds from offshore that are likely to really exacerbate the problem. The arguments that the critics of Asian buying are being racist, and that because this buying only makes up a small % of the total number of housing transactions it is not a problem, are completely missing the point.

 It is irrelevant whether the buying is from Asia, the US or Europe,the problem is not who is buying, but that the money is coming from an external source that is completely disconnected from the local market, which allows prices to be driven far above the levels that fundamentals are able to justify. It is also important to note that the price of any asset is set at the margin, which means that it is the buyer that pays the highest price for an asset that sets the price, it doesn't matter how far adrift the other potential buyers are, you only ever need one buyer to drive up the price. 

 

As an example consider a row of 20 identical houses in a street that are valued at $300000 each, there is only one house currently for sale and 2 buyers, one a local hoping to buy it for $300000, but able to pay up to $325000, and one from out of town that needs to buy a house that week and can pay whatever it takes. Unsurprisingly, the bidding is won by our 'out of towner' for $350000 and the effect is that all the other owners now have an expectation that their home is worth $350000 and will not sell for any less, forcing the buyers to pay the new asking price ($50000 above fair value) if they want to get into the market.  

 

In this example we see the effect that a solitary buyer has on price and perception, it should also then be clear that when that external buying is prolonged, major distortions will occur, and the greater the gap between price and fundamentals the more painful the correction when it happens.

 

So now we know what is driving the rally, how long is it likely to last?

 

The flippant answer is as long as there is fuel to drive it, meaning low interest rates, an ongoing flow of external capital and a lack of structural reform.  

 

Of these three, the least likely to occur is meaningful reform of all aspects of the housing market, the chances of a government led, co-ordinated overhaul of all the problem areas anytime in the near future are virtually nil.

 

Over the last couple of weeks global interest rates have risen as markets start to discount the reduction in direct US stimulus as recently indicated by the US Federal Reserve, and markets will remain vulnerable to any comments from the Fed about its $US85 billion in monthly bond purchases, which have driven bond prices up, kept interest rates at historic lows and helped drive the stock market's rally the last four years.

 

This is likely the start of what will be a long road to much higher interest rates as a new bear market develops in the Sovereign Debt market, and this will put severe strain on the housing market as debt servicing costs soar. You may like to review a previous post on the future for interest rates at http://kiwiblackers.blogspot.co.nz/2012_08_01_archive.html

Lastly, and the most difficult to predict is when the flow of overseas funding runs out. My best guess is that this will coincide with the next down-leg of the ongoing GFC, as this time it will likely impact Asia, Australia and therefore NZ to a far greater extent than in 2008, and I would expect to see global economies start to roll over within an 18 month timeframe.

To conclude, in spite of the ongoing over-valuation of NZ property, the conditions are currently ripe for further gains in the short to medium term, however it is crucial to understand that prices have disconnected from fundamentals and it is predominantly the combination of an ongoing supply of foreign money and cheap domestic credit that is levitating it. 

 

Once these drivers come to an end (and they always do!) it will be a long way down. Anyone choosing to invest now, especially in the Auckland area is buying into the 'greater fool' theory, namely they are relying on some greater fool to buy it off them at some point in the future!