CLSA sees apartment crash

From CLSA:

The team are of the view that the Australian housing cycle has peaked and they consider base case and worst case scenarios which are likely to play out. Issues of affordability and household debt are overextending Australia’s real estate bubble, which is being held aloft by foreign capital. Tightening bank credit standards are the likely catalyst for a correction. Our base case has the crisis starting with cheap apartments and later spreading to other flats in close proximity. This is likely to lead to defaults among small developers and a sharp contraction in apartment construction. However, it is unlikely to result in sharp price declines in other regions. Our worst-case scenario would result in dwelling prices falling sharply in all areas, eventually leading to a recession.

We believe the correction will start with settlement problems for low-quality apartments. Our proprietary analysis of 35 years of house-sales data indicates expensive flats in those areas will not be immune. However, contagion to dwelling prices in other areas will be limited. Construction will follow prices, so we expect apartment building to be hardest hit over the next five years. Our recession scenario is likely to require price contagion to extend to other regions and include houses, with household debt at 122% of GDP and price-to-income ratios of up to 12x increasing this risk.

Banks the catalyst for correction – In February, we cut our apartment forecasts due to concerns around ongoing bank tightening and capital flows out of China. The squeeze from lenders continues, albeit recent actions indicate it is highly targeted towards foreign investors and apartment-focused lending. Regulation aimed at foreign buyers (and we expect more to come) will also create an impact. While there has been an official crackdown on capital leaving China, it appears to be less of a constraint than we thought 12 months ago.

Housing cycle has peaked –  We believe the housing cycle has peaked and that new construction will decline over the next two years. Our forecast is based on a scenario where over the next few years, we will see a number of apartment buildings struggle to achieve reasonable levels of settlement, leading some small, private developers into receivership. This will expand into surrounding apartment buildings. While we believe that there will be limited settlement risk on high quality flats, it will result in a sharp slowdown in new apartment developments. Single-family housing will experience a more modest slowdown, in line with previous cycles

Base Scenario – Under this scenario, apartment prices and construction would be most affected, with falling prices for both cheap and expensive apartments, while approvals and construction fall sharply over the next few years. However, the contagion to prices and construction in other regions – and also to single-family houses – is muted and its impact on the broader economy is also not significant enough to push Australia into recession

Recession only in the worst-case scenario – Our worst-case scenario would see falling apartment prices in specific areas, expanding into other regions and impacting house prices. The high level of household debt and housing (un)affordability increases this risk. We would expect housing construction to follow prices, resulting in lower employment; it is particularly problematic if we see a sharp reduction in the building of single-family houses. And falling house prices will also affect GDP via the so called wealth effect, where consumers spend less when house prices fall. This scenario would result in dwelling prices falling sharply in all areas, eventually leading to a recession.

I agree with their scenario though the recent evidence of foreign funding suggests that the boom will run until disrupted externally, delaying it but making it ultimately worse with even greater supply and exposure to reversing foreign demand, increasing the risk of the worst-case scenario…