OPINION: SO, we’re going through a period of inflation, it would seem. OK. The Reserve Bank is doing what it thinks is right and is trying to curb inflation by increasing official cash rates (OCR). This would make sense if we were seeing demand-led inflation, but that is another point of conjecture.
According to the RBA’s head of domestic markets Jonathan Kearns, the rapid rise in interest rate would “tend to depress residential and commercial property prices”. RBA Governor Phillip Lowe expressed similar sentiments last week, suggesting a 10% fall would not surprise him. So, for those in the country holding or managing large property portfolios, this is a worry then? Not so fast.
When it comes to real estate, inflation can be both a friend and a foe. In the short term, high inflation can help to reduce the real value of a mortgage, making it easier for homeowners to keep up with their payments. In addition, rising prices can also lead to increased equity in a home, providing homeowners with a valuable safety net in case of financial difficulties. However, inflation can also put downward pressure on real estate prices, particularly if it outstrips wage growth. This can make it difficult for prospective buyers to afford a home and may even lead to negative equity if prices fall far enough. As such, while inflation can have some benefits for homeowners, it is important to keep a close eye on market conditions to ensure that your investment is protected.
Current RBA estimates for wage growth sit at 3.5% by mid-2023 and 3.75% by the end of 2024. Yet the RBA also expects CPI to be at around 6.25% over that period.
But looking at the bigger picture, recent history might suggest a reason for optimism. Real estate is a tangible asset whose value is derived from the land itself, rather than from paper assets that can be devalued by changes in the economy.
Real estate is also a relatively illiquid asset, which means that it can be difficult to sell quickly in times of economic turmoil. This lack of liquidity can be seen as a positive during periods of high inflation, as it gives investors the ability to ride out the storm without having to sell their properties at a loss. For these reasons, real estate has historically been a stable investment during periods of inflation.
Crunch in construction prices curtailing the upside
Inflation soared in the June quarter, with the cost of petrol and building materials pushing prices up by 6.1% on the previous year. According to the ABS, the Consumer Price Index (CPI) was up 1.8% over the June quarter, with new dwelling purchases by owner-occupiers increasing by 5.6%. Treasurer Jim Chalmers said that these numbers were “confronting” when it came to the cost-of-living pressures that Australians were feeling. New dwelling prices have been placed under increasing pressure by maintaining high rates of construction activity in tandem with ongoing shortages of both materials and labour. Seeing as new homes compete with existing homes, this statistic only underpins existing home prices.
Developer POV
The state’s greenfield land market experienced a slowdown in Q2 as inflation, high construction costs and rising interest rates took their toll on the sector.
“Many buyers have been forced to re-assess their borrowing capacity and re-evaluate their buying decisions in light of interest rate rises, including the most recent 0.5 percent increase in the OCR to 1.85 percent,” said Luke Kelly, managing director of project marketing at RPM.
The year saw a rolling 12-month total of 25,950 vacant lot sales and 4 856 during quarter two alone which is indicative of an overall trend occurring across Australia’s real estate market. With prices continuing to rise and interest rates on the increase as well it will be likely we’ll see more people priced out within the coming months.
Financial Institutions are adjusting lending covenants as market changes
“As the official cash rate ratchets up, lenders have again changed their policies back to historical requirements of 1.5-1.7x ICR – a covenant that most customers will be able to meet ” said Vincent Marotta, Director, Red Deer Capital.
The change in official cash rate (OCR) is leading to adjustments by financial institutions, who according to Vincent Marotta, Director of Red Deer Capital “foresaw the future challenges that would be created by the reduction in the official cash rate (OCR) to historical lows and changed their lending policies accordingly.” This allowed financial institutions breathing space, which as OCR rises again is no longer required. Accordingly, the ICR requirement has moved back to the 1.5 – 1.7x ICR, “a covenant that most customers will be able to meet.”
Mr Marotta elaborated on how the market has changed for commercial loan customers: “The dynamic of the change in OCR (current and forecasted into the future), coupled with years or strong growth has added further complications to the lending equation. Institutions are looking ensure they don’t create future problems (non-compliant transactions due to ICR and LVR pressure) and ensure they obtain an adequate return on their capital. As a result, different lenders will offer the same client a proposal that varies markedly. In one case, 2 lenders were offering terms that were close to 20% lower in max LVR and 1% higher in interest rate.”
Final Word
A lot will depend on wage growth, but if the Reserve Bank is correct, and this inflationary period is demand-led and not a result of supply chain issues, then inflation will be a good thing for property investors. The real value of a mortgage decreases for one, so equity in real estate will increase. Household costs are included in the ABS basket of costs calculated in CPI, so many landlords are benefitting from increased rents. Commercial properties as already detailed, often have rent reviews linked to CPI. Illiquidity is a positive too, as it is far easier to dump holdings in ASX-listed stocks than it is to exit the property. And with Australian residential property dominated by owner-occupiers, market whims do not affect the thinking of most homeowners.
By Chris Wolfe, Executive Director, Wolfe Advisory Group & CEO, FeasoPro.*
