Apartments casting a shadow over the Australian economy

There’s nearly $100bn in apartments being built out there. What happens if buyers start ditching deposits and walking away?

Developers hoping for off-the-plan sales rely on artists’ impressions of properties to entice buyers.

According to the ABS there are 225,221 apartments under construction in Australia, or at least there were last September, which is the most recent data available.

Going by the building approvals data it looks the average value of those dwellings is around $400,000, which sounds about right, so there is a bit less than $100 billion worth of apartments in total being built. More than half of them — 135,000 — are in Sydney and Melbourne.

Most, if not all of them, were sold off the plan. Not many developers can afford to fund a block of apartments on spec, and financiers want deposits to have been paid before lending the money.

Deposits are typically 10 per cent. Sydney dwelling prices, on average, have now fallen 11.1 per cent; some places more, some less. The average decline Melbourne, from peak to January 2019, is 7.2 per cent, in Perth 15.6 per cent and Darwin 24.5 per cent.

The question that developers and their funders are wondering is: how far out of the money does an apartment buyer have to be to forgo the deposit and walk away? Do they dust the deposit as soon as the loss in value is bigger than it? Unlikely. Is it the deposit times 1.5, or 2?

And everyone’s different, of course. Some buyers might kiss the deposit goodbye if they think it just looks like they’ll lose that amount or more off the value over the next year. Others might need hard evidence that the loss was already double the deposit.

Such are the swirling thoughts that would be keeping developers and the many non-bank apartment financiers awake at the moment.

So far apartment contract cancellations are still running at very low levels, but the number of “land sale nomination” ads on Gumtree is steadily increasing.

More to the point, bank lending for the ultimate buyers — both investors and owner-occupiers — has collapsed. Loans to investors is down 27.8 per cent on a year ago and for owner-occupiers 16.2. For both categories, the pace of decline accelerated in December.

The banks have not been touching developer business, but they were lending like mad to the buyers of the apartments, on very high loan-to-value ratios and in many case, interest only. Now they’re not.

The developers have typically funded the construction through non-bank mezzanine financiers at interest rates up of up to 15 per cent, which is OK since the loan is short-term and the funding costs are loaded into the margin on the apartments.

So the developers of 225,000 or so apartments now under construction around Australia, worth close to $100 billion, are sitting there with something close to that amount of high-interest debt, hoping their buyers can and want to borrow the money to settle on the contract.

In its quarterly review published last week, housing research house CoreLogic commented: “There is already evidence suggesting that in certain areas and markets settlements are taking longer and valuations are coming in below or at the purchase price.”

“With a relatively high proportion of off-the-plan unit valuations coming in below the original contract price in certain cities, if the decline is less than or similar to the deposit amount it is unlikely buyers would walk away.

“If the differential between contract and value at the time of completion grows we may see an increasing number of buyers unable or unwilling to settle their contract.”

In some ways the situation is similar to what happened in the United States before during and after 2008.

In the US the mortgage loans were provided by “shadow banks” outside the banking system, sold by brokers on commission and passed on immediately to investment banks, which packaged them into multi-layered securities called Collateralised Debt Obligations and sold them to investors.

Here the lenders are also shadow banks, and the loans are usually packaged up for high net worth investors and institutions, although they’re not called CDOs.

When American house prices fell, there was what became known as “jingle mail”, where homeowners apparently sent the keys to their house in the mail to the mortgage broker, and went off and rented somewhere else, possibly in a trailer park.

The other expression being used in the US at the time was “NINJA loans” — no income, no job or assets — and it was those borrowers who mostly walked away. They had been lent money by brokers chasing upfront and trailing commissions, and who didn’t look very hard, if at all, at the financial circumstances of the borrowers.

Likewise in Australia, as pointed out by Kenneth Hayne in his final royal commission report. Too many loans have been based on the Household Expenditure Measure rather than actual income and expenses data from borrowers, and the system has become corrupted, according to Hayne, by mortgage brokers’ conflicted remuneration — upfront and trailing commissions.

The situation is different here because in the US home mortgages are non-recourse — that is, the lender has no access to the other assets of the borrower, whereas in Australia they do. “Jingle mail” is less likely here because the bank would take everything, not just the house, and send the borrower bankrupt.

But the looming problem in Australia is not so much that owner-occupiers will walk away from their houses and post the keys to the bank or broker, but that off-the-plan apartment buyers who have paid a deposit but not yet signed the mortgage paperwork to borrow the rest, decide not to do so, or can’t.

This looks like the key risk facing the Australian economy in 2019.

If there is a wave of settlement failures and developer bankruptcies, there will be fire sales of the apartments by receivers, which would push the decline in house prices into 20 per cent-plus territory, in which case there would be a recession caused by the negative wealth effect on household saving and consumer spending.

Alan Kohler is editor in chief of InvestSMART