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20th Jul, 2020 Residential Real Estate

Has Flattening the Curve also Flattened our Residential Sector?

For an industry that was experiencing a period of expansion following a grueling 2 years of contraction, COVID-19 has placed the property sector into another potential “lockdown” phase. With Victoria returning to stage 3 restrictions and the rest of the country being ordered to comply with social distancing measures, the residential property sector looks set to be impacted more heavily than the broader economy. Even though the drastic “stay at home” measures have successfully “flattened the curve”, will these measures also be responsible for flattening the property industry in Australia?

Overall demand for established dwellings stagnated significantly during the peak of the COVID-19 pandemic with clearance rates below 40% in March and April. Much of the lower clearance rates were attributed to the restrictions placed on on-site auctions. Thus, when these restrictions were eased in NSW on 9 May 2020, a strong rebound was observed with clearance rates returning to pre-pandemic levels at approximately 70%. Surprisingly, the most recent home index values in July, determined by CoreLogic, show almost no immediate changes in home values between the time of writing and when COVID-19 was announced as a pandemic in March. Although this has been the case, there will be significant medium to long-term impacts as a result of COVID-19. One such material impact is the travel restrictions introduced in Australia, which has resulted in an 85% fall in net migration intake compared to 2018-2019 levels.[1]  Over the next 12-18 months, we expect the plunge in migration volumes to substantially decrease the demand for residential investments, particularly for high-density apartment towers.

More immediately, anecdotal evidence has suggested that apartments below the $1m mark have been hit the hardest during the pandemic. Comparatively, premium grade properties commanding higher prices between $2m – $5m have been less impacted by the pandemic, hinting at a flight-to-quality trend. Nonetheless, the majority of the transactions across the residential sector have been driven by non-discretionary buyers and sellers instead of property investors, who have shied away from selling. In the short-term, non-discretionary sellers may be forced to transact at a discount to secure a sale, thus eliminating the recent 5-10% premiums attached to property sales pre-COVID-19.

On the buyer side, the shift towards working from home has given rise to an uptick in web traffic and inquiries experienced by developers like Pace Development Group, Stockland and Crown Group. This change in work lifestyle has granted buyers and investors additional time to browse property investments in residential properties. Unfortunately, developers have discovered that enquiries are not genuinely qualified, where a majority have been made by those just ‘surfing the net’. Unsurprisingly, the failure to convert enquiries into sales has resulted in transaction activity coming to a crawl.

The off-the-plan apartment market has suffered more than most during the pandemic. Prior to COVID-19, the market had already been shaken up by a perfect storm of events including a credit squeeze arising from the Hayne Royal Commission, construction defects, and oversupply. These factors resulted in over 50% of off-the-plan apartments in Sydney being valued lower than the contract price at the time of settlement, according to CoreLogic data. Furthermore, the sector has underperformed the property market, delivering negative returns in the December 2019 quarter in suburbs like Mascot and Homebush, where structural defects in Opal Tower and Mascot Towers were discovered. The rise of COVID-19 has added further fuel to the fire as investors have shunned the highly uncertain off-the-plan market. Social distancing measures and the media’s portrayal of high-density apartment buildings as “cruise ships on land”, are altering consumer preferences away from compact high-rise apartments, typically offered by off-the-plan developers.

Since COVID-19, developers are reporting that the sense of urgency from off-the-plan buyers has dissipated. It is now more common for potential buyers to visit display suites up to half a dozen times over a lengthy six-month period, before deciding “if” to commit to an off-the-plan purchase. Such off-the-plan purchases are generally transacting at a 10-20% discount to the advertised market price.  Pre-sales marketing periods are also now extending up to 18 months in some instances. Unsurprisingly, many developers are simply not going to market. For example, Aqualand have delayed the launch of their Walker Street development, comprising 441 apartments, as the timing was simply not right to sell. Other developers continue to carry on business as usual launching new projects rather than shelving projects and laying off staff.  Developers, such as Crown Group, seem to be adopting the business as usual strategy, proceeding with developments such as 175 Sturt Southbank and Eastlakes, even without the necessary pre-commitments, in the hope to secure further sales during the construction period.

Compounding the increasing difficulties faced by developers to move stock, major banks are now taking a more hardline approach demanding 100%-120% debt cover from qualified pre-sales before construction funding may be triggered. This is forcing many developers to seek more costly finance from alternative lenders. Alternative finance allows developers to commence construction earlier and therefore ensures their capital invested is returned sooner. This is highly advantageous given that developers run their feasibilities using the internal rate of return (IRR) as an evaluation metric. On the other hand, as the cost of finance has increased, the return on total development costs, typically at 17-20%, has tumbled. On practical completion of the project, banks have observed a prevalence of residual stock loans in the market. In such situations, where a developer is not achieving full debt coverage to pay out the construction lender on practical completion of the project, a more permanent debt facility is put in place to pay down the more costly residual debt and/or release equity for future projects. This allows the developer more time to dispose of the remaining 10-20% of stock in the project that typically proves to be a little more challenging to sell.

From the residential supply perspective, there has been an evolving timeline in the residential markets.

(i) The early stages of outbreak saw increasing concerns with respect to the supply chain. As a major supplier of construction materials for Australia, China’s total lockdown incited fears for developers as the lack of supply of materials, like steel pipes, tiles and plumbing fixtures would both delay project completion and drive construction costs up. Fortunately, buffers of materials stocked in Australian warehouses alleviated some of the pressure from the sudden halt in the international supply;

(ii) As COVID-19 hit Australian shores, the impacts of the pandemic became more profound for developers. Developers were required to implement measures to align with the social distancing guidelines set out by Government. According to Tier 1 & 2 builders, such measures have resulted in a 20% fall in productivity. People movement has been one particular area of concern. Common tasks including the use of construction elevator/Alimak have required drastic changes with measures in place limiting the maximum number of passengers in each hoist. For example, on some high-rise projects, attempts to transport 400-500 subcontractors across various levels caused hours of delay and resulted in cost burdens arising from overtime.

(iii) The increase in uncertainty during the pandemic has resulted in a contraction in the residential construction pipeline as developers look to minimise risks. This is evidenced by a survey conducted by Master Builders Australia finding more than 40% of forward planned work cancelled. The snowball effect may arise as increases of up to 25% – 30% contract cancellations and settlement defaults will impact developer’s cash flows which ultimately restricts future developments. In particular, the delay in launching off-the-plan developments will further diminish buyer confidence and in turn further delay new projects.

(iv) Finally, the reduction in construction projects and lack of development pipeline have left many builders unemployed for the near future, particularly impacting smaller builders with inconsistent pipelines. However, recent efforts by the NSW government have opened the opportunity to leverage the skills of these underworked builders to assist with its agenda to rebuild public housing stock. With over 200 professionals already signed up for the $33 million pilot program based in metropolitan Sydney, this initiative could provide a lifeboat for builders as well as an opportunity for a transformation of the State’s public housing stock.

Looking into the future, there is little doubt that COVID-19 will have a profound impact on housing affordability and on consumer preference where to live. The shift towards working from home has enabled many families to reassess many factors including the possibility of living in more remote areas. Coupling this with the ever-increasing problems of housing affordability, particularly in major cities, the pandemic has helped highlight the potential to move away from high-density living towards lifestyle-based living arrangements. Australia has the world’s second largest household debt burden, with Sydney families on average spending 9x the average household income to purchase a median home. With such high levels of debt, COVID-19 will place significant strain on many households’ ability to repay loans even with the assistance of the bank deferral arrangements. This may further shift consumer sentiment away from high rise developments to look for more affordable properties in the outer suburbs, promoting a healthier and more flexible living in the future.

[1] It is worth noting that falls in migrations numbers have impacted vacancy rates, with Melbourne CBD vacancy rocketing up from 1.5% pre-COVID to 10-15% post COVID-19.