1. What’s the outlook for the residential property market for the rest of the year?
We are thinking about the residential property market in two phases for the remainder of 2020.
The first phase is the hibernation phase. This is where we are today. Enforced social distancing and lock-down measures are the rule and the property market remains effectively closed. Transactions are limited and reports on property prices are based on sparse and unrepresentative data. Most people would be well-advised to ignore commentary on property prices through this period.
As the year progresses and continued progress is made in containing the coronavirus, social distancing measures will be eased and the economy will enter the rebound phase. At that point, the fundamentals of demand and supply will begin to re-assert themselves.
We see these two phases playing out as follows:
(a) First, the damage to the economy, incomes and investor sentiment will reduce demand for property. There have been multiple economic shocks in Australia’s history and a typical house price response has been in the order of negative 10-15% on average;
(b) Longer-term outcomes depend on how extensive the damage is to the Australian economy and how quickly we return to more normal settings. Recent IMF projections see a 2020 GDP decline of 6.7% followed by a 6.1% increase in GDP in 2021. In our view that represents the “bull case”. Our base case is that the first stages of the recovery will indeed be rapid as tens of thousands of businesses return to work, but that the recovery of pre-coronavirus peaks is likely to be the work of some years. It remains our view that economies cannot simply be switched ‘on’ and ‘off’, but will take some time to return to a new normal.
(c) Two key variables affecting house prices outcomes are migration and housing construction. Net overseas migration has been responsible for 57.5% of Australia’s population growth this century and is accordingly a material demand-side component. In the short-term, migration is temporarily ceased during the hibernation phase of the coronavirus response and that is a substantial short to medium term headwind for house prices. However, a strong migration program will be critical to budgetary repair post coronavirus and goes hand in hand with our key educational export sector. Further, Australia’s success (so far) in containing the coronavirus will certainly not damage our international reputation with potential migrants. So, in the medium term, migration is likely to again become a key house price tailwind.
Conversely, building approvals have plunged dramatically since mid-2017 and remain at very low levels. They will almost certainly remain at near-record-low levels during the hibernation phase and will take some time to build momentum in the rebound phase. When this is coupled with the normal lag time between approval, construction, and completion, the supply side is likely to be sticky in the recovery and further support house prices.
(d) It should always be remembered that there is no single property market. Each local area has its own drivers and economies and will react to the coronavirus episode differently. Amongst our cities, Sydney and Melbourne have the most diversified economies, attract most population growth and therefore tend to recover the fastest from economic shocks. Despite the fact that their household balance sheets are more stretched than other cities, we remain of the view that they are better equipped than most other cities to navigate the hibernation and rebound phases. Similarly, historical observations are that economic shocks tend to disproportionately affect the most expensive housing deciles, and sometimes the least expensive deciles as well. Typically, the middle deciles – the family homes of “middle Australia” tend to be more resilient.
Overall, we remain of the view that housing will be among the most resilient of asset classes to the economic shock that Australia has and will experience as a result of the coronavirus. That is, of course, because of housing’s role as an essential consumption good, as well as an investment. No matter how bad the economic data, people do still need somewhere to live. We have positioned our portfolios with weighted average loan to value ratios around 63% and have high conviction that this presents a strong margin for safety against likely house price outcomes.
2. Is the risk moving forward higher unemployment and mortgages in arrears?
In the short term, Australia will undoubtedly see higher unemployment and borrowers who are unable to pay their mortgages as a result of the economic hibernation phase of the coronavirus. Most lenders, including La Trobe Financial, have already activated their pre-existing borrower hardship frameworks to assist borrowers through this phase. These frameworks typically allow borrowers to defer repayments for a few months until incomes normalise.
There are a number of reasons to believe that the impact of the hibernation phase on arrears will not be as dramatic as some are projecting. As well as the flexibility of hardship arrangements, we note the following three factors:
(a) Nearly 40% of households have mortgage prepayments in the form of redraws and offsets of at least 12 months and the RBA’s April Financial Stability Review assesses most households as being in good financial health. That is, many households are entering this period with substantial buffers;
(b) The unprecedented $130 billion JobKeeper package will provide 70% of the median income (and close to 100% of the median income in the industries most affected) and for many borrowers will support both living expenses and all or part of debt obligations through the hibernation phase; and
(c) Further flexibility is provided for borrowers in the form of their ability to access up to $20,000 from their superannuation funds to support their living expenses, including debt obligations, in this period.
Longer-term trends will, of course, depend on how quickly the economy rebounds and re- employs the labour force.
3. How will all of this affect small businesses and their loans?
Small business employs 44% of Australia’s workforce and is in many cases a key driver of the dynamism and entrepreneurial spirit that, over times, transforms economies. It has long been a point of pride for La Trobe Financial that our approach makes capital available to this sector in a way that the mainstream banks have been unable to replicate.
In aggregate, small businesses tend to have lower buffers than larger businesses and for that reason are exposed to periods of income interruption. For that reason, it is appropriate that much of the Federal and State government stimulus packages are targeted chiefly at the SME sector. However, small businesses tend to be nimbler than their larger counterparts and are likely to experience the upswing of the rebound phase more rapidly.
In terms of asset performance, portfolios of business loans without real asset backing are likely to experience heightened stress through this period, although there is no doubt that the coordinated government responses will provide a material lifeline for many.
Where there is real asset collateral backing the loan, the SME borrowers will benefit from increased flexibility and, critically, time to rebuild and restructure their businesses as the Australian economy enters the road to recovery.
4. How will this impact La Trobe Financial?
La Trobe Financial remains open for business and ‘on station’ to assist our borrower and investor customers. Our commitment to the delivery of the highest standards of friendly, professional service remains unchanged.
At an investment level, our fundamental investment objective has always been to build portfolios that are resilient in times of economic difficulty. Our careful borrower selection and low loan to value ratios across all of our portfolios will be substantial buffers against heightened levels of borrower hardship. We also note that our pooled portfolios all benefit from Investor Reserves that smooth monthly income and permit our portfolios to weather substantially higher levels of non- payment amongst our borrowers for extended periods. Current internal modelling of our 12 Month Term Account, for example, indicates that our portfolios could withstand 25% non-payment rates (arrears and hardships) across the portfolio for an extended period without need to adjust the distribution rate. For these reasons, we have high conviction that our portfolios are well positioned to maintain performance throughout the coronavirus episode.
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