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If you would like to read the first article in this housing affordability series, click hereIf you would like to read the second article in this series, click here.


 

Auckland Housing Affordability #3


"SOLUTIONS" TO AUCKLAND'S HOUSING AFFORDABILITY ISSUES

The pressures on the Auckland housing market and housing affordability continue. The latest REINZ and Corelogic indicators show the substantial rise in dwelling prices over the last year, in Auckland and nationally. In-migration levels remain high, and out-migration low. Demand continues to outstrip supply.

Alongside the Government’s continued preoccupation with blaming land supply and “20 years of poor planning by Auckland” as the dominant cause, a number of proposed solutions have been prominent in the media. The Reserve Bank has suggested that migration be curbed. Dr Arthur Grimes recommends building 150,000 houses in Auckland in 6 years to force dwelling prices down by 40%, and Auckland Council’s former chief economist has targeted a median dwelling price to median income ratio of “5 by 2030”. Into the mix now also is the Labour Party’s proposal to build 50,000 dwellings in Auckland over 10 years, half of them as affordable dwellings, though with no specific target as to achieving a downward shift in prices. All of these are worthy of a closer look.

Curbing In-migration

The Reserve Bank has urged the Government to dampen in-migration because of the pressure it is placing on demand for housing, while at the same time it has now opted to alter LVR levels. The Government response has been that net in-migration is predominantly New Zealanders returning and Australians, together with those on work and student visas. Since few of the work and student groups actually purchase dwellings, then they are apparently not major contributors to housing demand. 

However, whether they are dwelling purchasers or renters, or live in student hostels or with host families, they still need somewhere to live. As do those with New Zealand or Australian citizenship coming into or back to this country. 

Which means that the level of migration does directly affect demand for housing. The core issue is the numbers of people arriving, not their citizenship or their status. People are people, and they need somewhere to live.

Moreover, the additional demand for housing relates to the net migration, rather than the gross numbers arriving. Certainly, over the last 12 months (to March 2016) New Zealanders and Australians have accounted for 29% of total long term arrivals. Students have made up 22%, and those on work permits another 31%. 

However, the net migration picture is quite different. The net flow of New Zealanders and Australians has been close to zero, with inward numbers (+36,355) very close to outward numbers (-36,515). The very small net loss nevertheless means that people of other citizenships account for 100.2% of the net gain.

And there are important differences between in-migration patterns for Auckland compared with the rest of New Zealand. StatisticsNZ migration data shows that Auckland region still has a net outflow of New Zealanders and Australians, a net loss of -11,750 over the 3 years to 2016, and -2,541 in the last 12 months. The rest of New Zealand had a small net inflow of New Zealanders and Australians over the last 12 months (+2,381). 

Auckland has had a substantial net inflow of all other citizenships, with +83,802 gained over the 3 years, and +33,771 gained in the last 12 months. 

So Conclusion #1 - in Auckland, at least, the level of migration is well able to be influenced by migration policy.

What does this imply for housing demand? Again, it is a simple matter of numbers. The net gain of people for Auckland in the last 12 months at +33,771 people of other citizenships would (after allowing for say 60% of students to be accommodated in hostels or with host families) still represent demand for somewhere between 6,000 dwellings (at an average of 4.5 persons per dwelling) and 9,000 dwellings (at an average of 3.0 persons per dwelling). The net outflow of -2,541 New Zealand and Australian citizens may have meant that around 800 to 1000 dwellings would have become available to the market. 

So hard on the heels of Conclusion #1 comes Conclusion #2 - in Auckland, at least, the level of demand for housing is well able to be influenced by migration policy, and so is the price of housing. As identified by MBIE, and as the Reserve Bank continues to point out.

Driving Down Housing Prices #1 – Dr Grimes

While the Reserve Bank prefers a demand-side approach, others favour supply-side initiatives to bring the market into line by driving down the price of housing.

Dr Arthur Grimes (formerly chief economist at the Reserve Bank) last week called for the addition of another 150,000 dwellings in Auckland over 6 years, as the “only answer” to the affordability problem. Based on his research which indicates a -2.2% drop in prices for every +1% increase in supply relative to the population, he estimates that massive injection of new dwellings into the market would cause Auckland prices to drop by around 40%. The latest REINZ figures show a median price of $805,000 (REINZ Auckland Region Analysis for May 2016), so a 40% drop would take the median price back to around $485,000. That would equate to a loss in equity of about $165Bn, which is considerably more than the value of the NZX Main Board. 

The reasoning is that if supply first catches up with demand and then surges past, there will be a net over-supply in the market. The whole housing market would shift downward in value by 40%, in response to the changed balance, and the net over-supply. There is no indication in Dr Grimes’ paper of a focus on affordable new dwellings – the impact on the market would come from making sure total supply exceeds total demand by some margin, and then awaiting the inevitable market correction (price drop) to reflect the new situation.

Questions…

Some questions arise. A substantial number of the extra dwellings would need to be built before any impact on prices began to flow through. That number of dwellings (60,000 to cater for growth, the other 90,000 to cover the current shortfall, and to push supply ahead of demand) would require at least 3-4 very major construction entities with a commitment (and budget) to build throughout the 6 years, regardless of outcomes along the way. That means some new, industrial-scale entities would need to be operating in the sector, over and above the 5,000 or so residential construction businesses (predominantly small scale) currently operating in Auckland. 

Based on the current number of dwellings in Auckland, and assuming high population growth continues to 2021, the accelerated build (25,000 per year) would see the market into a net surplus of capacity by about 2019. The high level of build would continue past that point, and by 2022 (6 years from now) total dwelling supply in Auckland would be 3% to 5% or about 30,000 dwellings above projected demand (assuming high population growth, and allowing for catch-up of the current supply shortfall).

Challenges….

This plan poses quite a few challenges. Assuming there could be construction entities established which are large enough and with sufficient skilled workforce to supply the extra dwellings, there are other considerations. It seems unlikely that Dr Grimes’ cited relationship between supply and dwelling price would be linear – the price response will differ over time. His programme indicates two clear phases – a catch up in supply over the first 3 years or so (2016-2019) and then a deliberate move into oversupply in the second phase 2020-2022. Given it would take until about 2019 for supply to catch up with demand, the effect on prices would be limited during the first phase. This means that the desired drop in dwelling values would take place mainly in the second phase, with a rapid and major decline in prices over 2 or 3 years. 

The construction sector (and everyone else) is likely to be aware that supply is moving ahead of demand, and the sector may even suspect that this shift will impact on the sale value of the 60,000 or so dwellings which they still have to build during phase 2. It may be difficult to persuade the construction sector to engage enthusiastically with the notion of building many more dwellings as rapidly as possible in order to drive down the price of those dwellings, so that they would thereby derive considerably less return from their effort - especially when much of the building effort will be by small scale businesses.

Boom and Bust Scenario?

Then there is the question of what is likely to happen after 6 years, when supply is well ahead of demand, and dwelling prices are 40% lower than previously? One obvious effect is that dwelling owners will have experienced a substantial decrease in their equity, which they will not be able to pass on to their banks. Just as they did in the aftermath of the GFC, most will sit tight, and hope things get better. Few would be willing to invest in commissioning or purchasing a new dwelling, especially because their equity springboard to that new dwelling is now several notches lower than previously. The over-supply of dwellings, combined with the drying up of demand for new dwellings, means the residential construction sector will go quite smartly from boom to bust. This is precisely what happened in the post-GFC period when prices fell by only -10%, but Auckland’s residential construction sector quickly downsized by over 20%, and took 5 years to recover. The gap in dwelling supply over that post-GFC period was a major driver of the Auckland housing shortfall and the rapid price increases seen currently.

Effects on households

The impact on households who own dwellings will be substantial, because their equity will take a major hit. All of the impact will rest with property owners. Dr Grimes assures us that “New Zealand’s banks can survive a large fall in house prices”. His concern for the welfare of the banks is touching, and of course those banks are traditionally unwilling to share the load by magnanimously wiping thousands off our mortgages just because our property values have fallen. Some argue that this equity is only on paper, and high property values are not sustainable, so a bit of tough medicine is good for us. 

However, the situation is rather more complex than that, as shown by a bit of simple arithmetic. For example, a property owner with 60% equity (and 40% debt) would see that equity drop by around two-thirds. Those with only 40% equity and 60% debt would lose the lot. Those with less than 40% equity would find their dwellings are now worth less than their mortgages. That would hit first home buyers hardest – they typically have higher than average levels of indebtedness (relative to dwelling value) so they would be most vulnerable to having their equity wiped out. This outcome seems to go directly against Dr Grimes’ objective to improve dwelling ownership levels for young and low income families. 

It is difficult to see that any benefits from having lower dwelling prices would substantially offset the costs associated with this scale of disruption. The impacts of a price collapse would be felt by most households and particularly by first home owners. Moreover, Dr Grimes’ strategy is also likely to perpetuate an ongoing boom-bust cycle in the dwelling construction sector, with consequent impacts on future dwelling prices, and on the wider economy.

Why do it?

The question is whether Dr Grime’s strategy would achieve positive outcomes. Certainly, dwelling prices are too high, and they are continuing to rise rapidly. 

However, Dr Grimes’ proposed solution is very blunt, for a once-off hit, with the objective of driving down the whole market. If all of the market is driven down, then there will be more dwellings in the lower price bands, to the benefit of aspiring purchasers in the lower income groups, and first home buyers in particular. 

However (as described in recent MEMOs) that underlying rationale has some important flaws. It seems to be based on the belief that there is only a single housing market that the high prices mean that the whole of the market is unsustainable, and therefore the whole of the market needs to be driven down. In our view, a finer grained approach is appropriate. The high levels of sales activity even at high prices is clear evidence that the whole Auckland housing market is not unsustainable. For many purchasers, the high prices are not unaffordable, but rather are quite sustainable because their debt to income ratio is manageable (broadly within the 4.5 to 5 range). For them, the overall dwelling price to income ratio is almost completely irrelevant. As a consequence, because they account for a substantial share of demand, the overall median price to median income ratio is not very useful as an indicator for the entire housing market.

The obvious question is why seek to drive down the entire Auckland housing market simply in order to make the median-priced dwelling affordable to a first home buyer at the maximum level of indebtedness. The pre-occupation with the median price to median income ratio as an appropriate indicator of affordability appears to be both distorting assessment of the market, and skewing the proposed ‘solutions’.

Driving Down Housing Prices #2 – “5 by 2030”

The same issue is evident in the “5 by 2030” plan. This is another approach based on driving down the entire market in order to increase the size of one component of housing supply – lower priced dwellings. It was proposed by Chris Parker, former chief economist for Auckland Council, and it has support from Dr Grimes. 

The 5 by 2030 strategy seeks to have the ratio of median dwelling price to median income down to 5 in Auckland, by the year 2030. 

The median price would need to be lowered from the current $805,000 to $515,000 by that year (we have allowed for income growth of 1.5% pa. The initial indication was that the target assumed nil growth in median income, which would put the median price at around $415,000. However, an expectation of nil income growth is unlikely in an urban economy growing as quickly as Auckland’s). The implied $515,000 median is similar to Dr Grimes’ $485,000. 

Lower cost new dwellings

This would not be based on large-scale initiatives to build more dwellings, but rather by strategies to reduce the cost of new dwellings. Constructing smaller and lower cost dwellings would account for about 70% of the price reductions. Another key part of the plan is based on greater efficiencies in the residential construction sector (these would account for over 20% of the cost savings), although it is not clear under what mandate Auckland Council as a unitary authority might seek to achieve this. 

The rationale is that if new dwellings are produced at much lower cost than currently, then these lower prices would flow through to bring down prices across the whole market, to achieve the 5 by 2030 ratio. The mechanics of this price drop are interesting. It could not be achieved by ensuring that all new dwellings built between now and 2030 (about 195,000 according to SNZ household projections) are low cost – even if all the new dwellings were built at zero cost, that would not be sufficient by itself to bring the median price down to the target.

The median of $515,000 would apply both to new dwellings and to the existing housing estate. For new dwellings, it would require a major shift in the residential construction sector, to deliver the majority of new dwellings as apartments, and priced under $500,000. It would require a correspondingly strong shift in the preferences of new dwelling purchasers. It is not clear how these responses might be achieved. 

In broad terms the new median would mean a drop of about 36% in value for the 520,000 or so existing dwellings. As with Dr Grimes’ scheme, this presents a challenge. A drop of about $290,000 in the median dwelling value would amount to a reduction in equity of around $150 Bn. At the same time as this drop in value was occurring, existing owners would be paying off loan principal. So it is more than simply a loss on paper. The very large size of the Auckland dwelling estate means a price drop of such magnitude would have major negative effects. 

The obvious question is – why do it this way? There will be about 195,000 new households in Auckland by 2030. Up to 30% of those (about 60,000) will require affordable dwellings. There would seem to be more cost effective ways of providing for affordable dwellings than wiping $150 Bn off the Auckland housing market. That would equate to wiping off about $2.5m in current owners’ equity, per affordable dwelling required. Quite a lot of collateral damage, then.

Is it the right target? 

Considerable mention is made of the median price to median income ratio, as a justification for driving prices down to a ratio of just 5.

This goal needs further examination. The ratio of 5 assumes that dwellings are predominantly debt-funded, with debt representing 80-90% of the dwelling price. That is often the case for first home buyers. However, it is not the case for most owner-occupiers, who have built up some equity over time, for whom a ratio of 5 is simply not appropriate - and who account for the major share of the total market. Moreover, the rationale is not clear as to why the market should be geared toward first home buyers purchasing at the median price – historically most households have purchased their first dwelling in the mid-lower price bands, so the 25th to 35th price percentile would seem a more appropriate target for that group. 

Hence, another obvious question - why seek to gear the entire housing market to a target which is not appropriate for most of that market, and not appropriate even for the targeted sector ? 

This means the focus on a ratio of 5 is flawed. However, that flaw is a key rationale for the supply-side approaches of both Dr Grimes and Mr Parker. A strategy of driving down the entire housing market in order to achieve a simplistic price to income ratio - which is itself a poor indicator of affordability across the market - makes little sense. It would cause very major disruption to the Auckland community, and generate a range of negative outcomes for people and the economy. Importantly, these negative outcomes are easily discernible with just a bit of thought as to how the housing market works and the nature of dwelling owners.

This does not diminish in any way the problem of low housing affordability for first home buyers and lower income households. Addressing affordability is a critical issue for our society and economy. 

But that needs to be done with well-thought-through strategies and policies.

Labour Party Proposal

The Labour Party housing proposals would have a different approach. The plan is based on beefing up one specific component of the market, rather than seeking to drive down the whole market. It is further based on recognition that the private sector is failing to deliver an appropriate mix of dwelling values, and that it may not do for some time yet. 

Part of the rationale is that adding dwellings in the lower price market positions would have some direct flow-on effect for prices across the rest of the market, though the smaller number of new dwellings proposed would mean a lesser impact on prices market wide. While deliberately seeking to plug the gap in supply at the lower price end, the number of dwellings required to do this is substantial. The proposal implies that at least one major entity would have to be charged with the specific purpose of providing lower cost dwellings. 

The proposal is to build 10,000 dwellings in Auckland annually, of which 5,000 would be in the affordable range. This approach is intended to deliver a (socially) better distribution of dwelling prices by adding at the lower end, rather than trying to force the whole housing market down so that the lower end of the market gets larger. The strategy would specifically add lower priced dwellings to the market, and seek to achieve a shift in the market’s price structure by ensuring that a disproportionately high share of new dwellings built are in the lower price bands. To do this it would need to deliver sufficient dwellings to make a material difference to supply.

For evidence to the IHP on the PAUP, we developed estimates of the numbers of new affordable dwellings (under $450,000, $500,000 and $600,000) which the Auckland market would require over the period to 2026. Taking into account the catch-up needed in the market, the scenarios indicate 3,500 dwellings (low-medium affordability emphasis) to 4,500 (high affordability emphasis) annually over the next decade and beyond. The Labour package indicates 5,000 per year in Auckland.

A priori, this approach would have considerably less impact on values in the middle and upper echelons of the housing market than would the Grimes and Parker approaches, while the numbers proposed suggest that a considerable share of the supply shortfall in the lower price ranges might be met. That scale of input would have a flow-on effect for the balance of the housing market by reducing prices at the lower end (especially by eliminating any price premium for scarcity) and also slowing the rate of increase in prices across the market generally. However, it is less likely to cause a dramatic fall in housing values across the market as a whole – with its attendant impacts on dwelling owner-occupiers, and the economy in general. The inputs to the Auckland market, at 10,000 dwellings per year, would be only around 40% of the volume that Dr Grimes proposes, so any unintended distortions of the market would also likely be less.

What does it all mean?

The different strategies highlight the complexity of the problem. Dwelling prices are too high, and the community and economy would have been better off now if prices had been lower. 

But we are where we are. Any strategies must be to improve the situation, not make it worse. The length of time over which change occurs is important. Slowing or stalling price growth is a necessary initial outcome, but only part of the solution. The Reserve Bank expects its latest move to increase the investor LVR to 40% will dampen annual price growth by 2% to 5%. A sudden stall is more likely to be followed by a substantial “correction” – aka a price drop. The largest correction in Auckland during the last 20 years was one of around -10%, in the post GFC period, and it was accompanied by a major drop in new dwelling consents of more than -40%, with the construction sector decimated. Which suggests a correction of more than about -10% is likely to have substantial negatives for the economy. So, a slow stall in price growth followed by a moderate correction (-5% to -10%) would bring some improvement, and probably without excessive damage for dwelling owners.

However, a correction of that scale would not push enough dwellings back down into the lower price bands to make a material difference to affordability. This means that addressing affordability without messing up the wider economy depends on construction of sufficient new affordable dwellings. The reticence of private sector construction to participate in this end of the market suggests that deliberate public sector involvement is essential. Such involvement, of course, would also exert some downward pressure on dwelling prices. And it would need to be at some scale, which would mean the wider construction sector is less likely to nosedive even if prices are static or falling. 

Any strategies to succeed are likely to be complex and need to simultaneously address the key drivers of change – especially migration, skills and training, planning, the construction sector, taxation, and the banking system. This will take longer than an election cycle. 

NASA is targeting 2039 to have humans on Mars. Unless we start thinking and acting more strategically, NASA may well find some Kiwis already there, looking for something affordable.

For further information about this article, contact Douglas Fairgray on doug@me.co.nz or phone 09 915 5514.

To read the next article in this housing series, click here

     

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