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The Virus And The Rental Market

Feature Stories | Jul 30 2020

This story features STOCKLAND, and other companies. For more info SHARE ANALYSIS: SGP

Covid has caused all sorts of upheaval across Australia’s rented property market, with significant implications for private investors and investors in listed property stocks

-House prices may not see too much damage
-Residential rents nonetheless under pressure
-Unemployment and reduced migration major issues

By Greg Peel

The world is yet to see the full extent of the damage wrought on housing markets by the global recession, suggests Oxford Economics. Activity is distorted by ongoing lockdowns, and re-lockdowns, and statistics are slow to reflect price changes.

That noted, Oxford’s economists believe that once the dust settles, the ultimate damage, globally, will likely be less than that brought about by the GFC.

The key drivers of house prices are affordability, mortgage debt levels and costs, and housing investment, and these are currently working together to mitigate the impact of falling incomes, Oxford notes, as are fiscal policy measures to support households and the postponement of mortgage payments.

The pressure building towards a significant house price correction is now much lower than it was before the GFC. The frothiest housing markets in the world, which included Australia and New Zealand, all saw prices in retreat across 2018-19, Oxford notes.

The risk, however, is one of government support reaching and end and labour markets showing little sign of a quick recovery, thus delivering the hardest blows to household budgets. Notwithstanding second or third waves of the virus would add further stress.

In this scenario, a full house price crash is a distinct possibility, Oxford warns. Without additional waves, a much more likely scenario is sideways movement or a modest house price correction.

It is thus not without trepidation we note Australia’s Melbourne-centred second wave is now greater than the first wave.

Unfortunately, Australia is one exception to a global trend of household debt decreasing since the GFC. Previously low mortgage rates are now even lower, but the flipside is stricter lending conditions. Housing affordability – a prime suspect in housing market crashes, Oxford notes – is more of a problem in countries in which house prices have outpaced incomes for decades, which of course includes Australia.

The problem is mortgage rates now have little room to fall any further, which at any other time would help stave off defaults. This creates a risk of households cutting discretionary spending, Oxford suggests.

On the other hand, this is mitigated to some extent by stricter lending measures leading to fewer higher level loan-to-value ratios, and household savings accrued during lockdowns.

But what about rents?

Analysis of payroll data from the Australian Tax Office has allowed the Australian Bureau of Statistics to break down the virus impact on payrolls by industry. The June quarter Housing Affordability Report released this month by ANZ Bank-CoreLogic notes that between March 14, when the hundredth virus case was notched up in Australia, to June 27, -21.2% of payroll jobs had been lost in the accommodation & food services industry and -18.% in arts & recreation. This compares to a total payroll loss of -5.7%, and only -4.2% in all other industries bar those above.

This has important implications for the Australian rental market, the analysts note, because those employed in these industries are more likely to be renters.

There are, nonetheless, a couple of factors that will have helped offset the impact.

The first are JobKeeper and JobSeeker. These will have helped to cover rents during lockdown. The good news is these schemes will now be extended beyond the prior September expiry. The bad news at a lower rate, and more specifically assessed on a needs basis.

The second is that while the two sectors in question suffered the greatest payroll impact during initial lockdowns, they also enjoyed a sharper rebound over May and June as restrictions eased. Total payrolls rebounded 4.2% in this period, but within that 7.8% for arts & recreation and 19.0% for accommodation & food services.

Note that the report in question is for the June quarter. Melbourne’s re-lockdown began on July 8.

The migration factor

Australia’s international border closed on March 18. It is expected to remain closed for some months yet, and the way things are progressing across the globe in virus terms, likely longer.

ABS data show migration to Australia declined by -98.8% in May, year on year. Past research suggests some 80% of new migrants initially rent before considering buying a property, ANZ Bank & CoreLogic note.

Heading in the opposite direction due to the border closure were an estimated 300,000 temporary workers, overseas students and tourists (such as backpackers in temporary work visas). These foreigners are also renters.

The government estimates 2020-21 will see an -80,000 drop in net migration to around 36,000. ANZ-CoreLogic estimates this will translate into demand for rental dwellings from foreigners falling from around 74,000 in 2019 to 11,000 over 2020-21.

As well as creating an initial surplus of rental vacancies and downward pressure on rental prices, the analysts note, this will have longer term implications for the level of investor activity and supply of rental stock.

Property investment

From the start of 2012 to August 2016 the RBA cut its cash rate from 4.25% to 1.5%. This resulted in a surge in demand for investment property. As the RBA’s concern of a housing price bubble intensified, APRA stepped in in late 2014 with macro-prudential controls designed to limit rampant property investment.

The impact was short-lived. From early 2016 and into 2017, a second wave of investor interest ensued, particularly in apartments.

Developer activity increased significantly to accommodate the demand from investors, ANZ-CoreLogic notes, particularly in the apartment segment. In the 12 months to August 2016, unit approvals peaked at 123,404, which was 42.5% above the decade average.

APRA was thus forced to step in again, with further lending restrictions in September 2017. This time it worked.

And we can now say the resultant decline in property investment from late 2017 into 2020 was fortuitous. The vacuum was filled by owner-occupiers, who are less likely to sell out in times of economic uncertainty than investors.

If investor participation remains low, this could keep rental market conditions relatively steady, the analysts suggest. It signals that the fall away in demand will be met with less new supply.

However, ABS data suggest that even as approvals and commencements for new dwellings are moderating, there is still an above-average level of units under construction across Victoria and NSW. At March 2020, the number of units under construction was 18.8% higher than the decade average across NSW, and 24.0% higher across Victoria.

This poses added risk to future returns within these unit markets, ANZ-CoreLogic notes.

Another contributor to increased rental supply in the short term is the conversion of short-term rental into long term. Yes – Airbnb.

Researchers from the University of Queensland estimate 346,581 unique properties, or about 4% of the country’s housing stock, had been used for Airbnb at some point between July 2016 and February 2019. Those prepared to go through the process and risks of ever-revolving tenants were reaping the benefits of much higher short-term rents than your typical 6-12 month lease.

And one obvious source of Airbnb properties were holiday homes. But now, without foreigners, and also domestic tourists during lockdowns and state border closures, property owners are scrambling to find longer term tenants for their previously Airbnb-ed properties.

This means more supply on the market.

Using a 28-day rolling average, CoreLogic found that total listings of rental properties hit a low in early 2020, pre-virus, down -15.3% year on year, given the decline in property investor demand. There followed an increase in new listings in May, followed by stabilisation in June. This may reflect a slight increase in rental demand in June, the analysts suggest, or it may reflect landlords giving up and pulling their listings.

CoreLogic reports gross rental yields for investors across Australia’s individual capital cities at the end of June 2020 were recorded at 2.9% in Sydney (a record low), 3.2% in Melbourne, 4.4% in Brisbane, 4.4% in Adelaide, 4.4% in Perth, 4.7% in Hobart, 5.9% in Darwin and 4.7% in Canberra.

The low yields in Sydney and Melbourne are unlikely to improve as dwelling values are tested in the coming months, the analysts warn, and investors should note that inner-city unit markets pose a particular risk in the current environment, with rental values likely to fall alongside property values.

Overall, rent yields have been steadily falling across capital city markets amid the upswing in dwelling values across Australia between June 2019 and the start of 2020. Rental yields may be steady or compress slightly more in the coming months, as both property values and rent values are likely to see a decline, ANZ-CoreLogic suggests.

The Big Developers

Morgan Stanley analysts have compared and contrasted their outlooks for Australia’s leading listed residential property developers Stockland Group ((SGP)) and Mirvac Group ((MGR)) on near-term and medium-term basis, heading into the “New Normal” of a post-covid world.

They see the New Normal as a “journey” rather than a step-change.

In short, Morgan Stanley sees Stockland’s residential business as better placed over the next 6-36 months, with Mirvac facing greater challenges beyond residential. The housing market is currently being supported by fiscal stimulus but this will of course be temporary, yet the broker believes the repercussions will extend beyond their effective period.

The “journey” nonetheless will be impacted by migration issues and a shift away from apartments to detached housing, which will lead to market volatility.

The federal government’s HomeBuilder grant of $25,000 will likely lead to a flurry of interest in the new house & land segment, resulting in a likely uptick in sales volumes for developers, albeit temporary, and elevated revenues into mid-2021, Morgan Stanley suggests.

Stockland has the edge here, given the company’s “affordability tilt” means some 95% of its active residential stock could be eligible for the grant, being dwellings of $750,000 or less in value. This compares to around 73% for Mirvac.

Stockland also has one of the largest residential land banks in the country, boasting 53,000 active land lots and material exposure to Queensland and WA (53% of total), which are experiencing the most material lift in sales on the back of HomeBuilder. In contrast, the broker notes, Mirvac has only 15,000 active land lots.

History nevertheless shows that buying activity peaks in the run-up to the expiry of stimulus, then drops, then normalises, leading to sales volume volatility. Investors in the two big developers must be prepared for a tough period in the March quarter next year, Morgan Stanley warns, in terms of pre-sales.

Stockland has no exposure to apartments, which Morgan Stanley estimates could suffer a -50% decline in volumes over the next 3-5 years. Mirvac could see settlements declining by up to -20% in FY21 due to a lack of apartment completions. This would drive a -15% decline in funds from operations, or earnings by any other name.

With regard migration, looking beyond the near-term impacts noted above, Morgan Stanley suggests the potential for longer term changes in net migration patterns could alter overall demand for housing in Australia. Migrants typically prefer detached or semi-detached houses, the broker notes, and typically wait over two years to buy after initially renting.

Detached housing is Stockland’s “sweet spot”.

During the 2014-18 housing boom, Mirvac enjoyed an increase in pre-sale volumes to around 3,000 per year, largely on the back of an uplift in apartment projects. But it’s tough to see those days returning, the broker suggests, not just because the banks will be stricter on lending but because the virus will likely drive a trend away from crowded apartment block living.

Mirvac has the “first mover advantage” on the build-to-rent market for aspiring property investors but Morgan Stanley believes the economics are questionable, especially against the backdrop of a weak rental market on a 1-3 year view.

Guidance

What guidance?

Morgan Stanley can’t see either company offering FY21 guidance with their FY20 results, or if they do, guidance ranges will be by no means tight. Uncertainty around simply collecting rent (particularly in the retail space), the accounting treatment of rent relief, the extent of the effect of government stimulus, and its timing, all lead to uncertainties that would preclude Stockland or Mirvac from having an informed stab at earnings and dividends ahead.

Consensus analyst estimates for these numbers are already wide, and real estate stocks are likely to remain volatile over the next 12 months.

That said, Morgan Stanley has re-set its earnings estimates, and is assuming a 75% dividend payout ratio for Stockland and 70% for Mirvac. That would put Stockland on an 8% forward dividend yield, above a historical average of 6%, while Mirvac’s 4.5% yield would be in line with its historical average.

Taking all of the above into account, Morgan Stanley has an Overweight rating on Stockland and a $4.35 target, and an Equal-weight rating on Mirvac with a $2.40 target.

The Bigger Picture

Expanding out into the wider developer/REIT space, Morgan Stanley can only provide recommendations for the aforementioned two developers, being currently restricted on Lendlease ((LLC)) due to the broker’s involvement in the sales of its engineering business.

In retail, the broker likes Scentre Group ((SCG)) for its modern malls and Shopping Centres Australasia ((SCP)) for its convenience exposure, rating both Overweight.

Vicinity Centres ((VCX)) is deemed to have a “tired” portfolio while Charter Hall Retail REIT ((CQR)) has a lower demographic and sub-regional focus in its mall portfolio, albeit the trust is trying to rectify this. Both are rated Underweight.

Among commercial REITs, Morgan Stanley has Overweights on Goodman Group ((GMG)), Charter Hall Group ((CHC)) and Dexus Property ((DXS)) and an Underweight on diversified REIT GPT Group ((GPT)).

In “alternative” trusts, the broker has an Overweight on Arena REIT ((ARF)), an Equal-weight on National Storage ((NSR)) and an Underweight on what is now known as Waypoint REIT ((WPR)), the former Viva Energy REIT (VVR).

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