FEATURED IN: The Australian – Take a long-term view on the cycle
3 November 2022
High rates may create a feedback loop but will not kill apartment building
By Andrew Schwartz, Group Managing Director and Co-Founder at Qualitas
Brace yourself. In 1970, the median price of a unit in Sydney was $13,500 – the cost of a modest kitchen renovation today. Three decades later, as Sydney prepared to host the 2000 Olympics, the median price had soared to almost $260,0001.
What’s notable about the difference – apart from a remarkable return of 19 times for an astute investor – is that this 30-year period included the highest inflation and interest rates to hit Australian households in living memory.
At the start of 1990, the Reserve Bank’s cash rate target hit 17.5 per cent – a level that has never been surpassed. At that time, inflation was running in the mid-high single digits but in the early 1970s it had spiked at an annual rate above 15 per cent during the global oil shock.
The point I am making is that, higher inflation and interest rates do not necessarily mark the death knell of demand for apartments. That’s certainly not evident from the period of 1970 to 2000 when inflation, as measured by the CPI, was more volatile than recent decades and generally ran above 5 per cent before moderating during the 1991 recession.
There were periods in those three decades when apartment development was almost non-existent, such as the 1980s. Similar to today’s conditions, this was a period of adjustment after a long, strong growth period, with less construction giving the market time to reach a new equilibrium.
But overall, the same longer-term trends that drove apartment building and prices from 1970 to 2000 are alive now – urbanisation, economic expansion (through boom-and-bust cycles) and healthy population growth supported by skilled immigration.
And that’s why we have every reason to believe that construction of apartments will continue in the future. It’s about taking a longer-term perspective.
There’s no doubt that we’re in a volatile economic climate. Right now, the Australian economy is in what I would describe as an ‘inflation feedback loop’.
It’s well established that the current bout of inflation has been caused by both demand and supply side inflation.
Demand has been fuelled by the massive stimulus tipped into the economy by governments during the pandemic and the generally (surprisingly) strong consumer economy, buoyed by household confidence and 48-year low unemployment.
On the supply side, prices have been driven higher by the COVID- and weather-related disruption to local and global supply chains and by the impact of the war in Ukraine, particularly on energy prices. Labour shortages, reflecting the low unemployment and the temporary closure of our borders to students and skilled migrants, have not helped.
The result of these combined forces is inflation that has exceeded all expectations. The Consumer Price Index hit 6.1 per cent for the year to June – the highest since the Reserve Bank introduced its 2-3 per cent inflation target in the early 1990s. In an effort to fight back by cooling demand, the Reserve Bank has now raised rates five times since May and signalled more increases are going to be necessary.
The big risk is a wage-price spiral. This is where the inflation feedback loop begins its vicious and, if not addressed, unbreakable cycle. As wages go up consumer demand increases, prices rise, interest rates rise, the cost of owning property rises, rents increase to recover higher costs (they’re up a CPI-busting 10 per cent in the year to September 302) and shortage of supply – and then it all starts again with higher wage demands. It’s a like a microphone placed next to a speaker – painful.
The key questions are how the cycle is broken, and, for us, where is the real estate opportunity?
Dr Lowe, for one, recognises the key role the labour market will play in determining the outcome, warning that pay increases must be kept under control for unemployment to stay low and to avoid the central bank inflicting a hard landing.
Broadly, there are two ways to break wage inflation. Both involve increasing available labour to ease wage pressure and they are not mutually exclusive.
There’s the hard way – engineering a recession that drives up unemployment. No one would consider that a desirable outcome. A second way is to increase the pool of labour through measures such as lifting immigration numbers, which have been severely constrained during the pandemic. That is much more desirable.
In September, the Federal Government signalled its choice by announcing an increase in the permanent migration cap from 160,000 to 195,000 for this financial year to help fill immediate gaps in healthcare, infrastructure and the technology sector.
We all feel Australia is the country of choice for migrants due to its clean air and food, a sense of geopolitical security and a natural pool of energy resources far away from the war in Europe and the resulting energy crisis. But these beautiful attributes are not enough and we competes for skilled migrants with other countries, such as New Zealand and Canada. Their decision-making is based on a number of factors, which include obtaining a secure job, finding appropriate, affordable and available housing.
Ultimately, every person who comes to Australia as a skilled migrant or student will need somewhere to live and, for many, apartments will be the best option.
The problems is that the Government’s efforts to open the doors, while welcome, come at a time of chronic undersupply in the housing market, particularly rental housing with record low vacancy rates around 1 per cent, and what we expect is a temporary fall in dwelling approvals and construction activity.
Australia has underinvested in housing since the onset of COVID, for all the well-document reasons, and the only solution is another round of investment, including in high-density apartments across the fast-growing build-to-rent space, which will represent more than 10 per cent of all apartment building this financial year3, and traditional build-to-sell units.
History tells us that the majority of immigrants settle in the capital cities and, of those, the majority will find homes on the eastern coast. Investment in apartments will follow the demand but there is a need for multi-storey housing nationwide.
As an alternative real estate investment firm, we view property as an upfront sum to acquire the asset and then a series of cash flows over a medium-term duration. Through that lens, we see current supply imbalances, with increasing demand driven by labour issues, rising rentals (cash flows) and increasing replacement costs due to inflationary pressures.
Just like in the 1970-2000 period, there will be cycles within the longer 30-year, 19-times returns cycle. That is why it’s important as an investor to focus on the long term and try as hard as possible to avoid the noise of the day, which can create short-term distortions and feedback. I have no doubt that markets will always be cyclical, with short term volatility, but that the longer-term fundamentals will always play out well, including for apartments.
As featured in The Australian (subscription required) – 3 November 2022.
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