Residential Property - 2008 Outlook

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29 Jan 2008	Article by John Loos

We're into 2008, and as yet there is little sign of the 3-year+ broad slowdown in the residential property market coming to an end. As things got worse in 2007, so the talk regarding possible house price declines, rising bad debt in the housing market, further upside risks to interest rates and prospects for a slowing economy, and the negative impact of the National Credit Act, seemed to escalate.

Understandably, therefore, many property owners are concerned about where it's all going to end. Human beings are often prone to doing their mental forecasting by extrapolating a recent trend in a straight line into the future. Fortunately, real life doesn't work in this manner. Rather, cycles are the order of the day, and my view remains that 2008 is the year in which the cycle will bottom out and begin to turn for the better.

But let's consider the risk of a crash in residential property. Well, firstly, it may be comforting to know that residential property crashes are not common. In fact, in over 40 years since the mid-1960s there has only been one, and that was in the mid-1980s. Already, therefore, this would suggest that the chances are slim.

Examining the graph below, which utilises Absa figures, one sees that since the early-1970s it was only once in 1984/85 that SA experienced a nominal house price decline. That was at the end of a major slump from a price inflation level in excess of 40% in 1981, to deflation of -9% at a stage in 1985.



In real terms (deflating the house price index using the CPI), however, price deflation is far more common. We saw a significant real house price decline in the latter half of the 1970s just prior to the gold-boom-drive housing boom, the slide of 84/85, and further gradual real decline over much of the 1990s to a low in 1997.

Nevertheless, only the mid-1980s slump could possibly be a crash, so it is worthwhile considering its causes.

The 1970s through to the early-1990s was a time of stagnating long term real economic growth, as the country's political situation worsened and isolation and boycotts started to bite; not to mention all sorts of structural rigidities created by restrictive Apartheid legislation at the time. Making matters worse was the onset of commodity price slump from the early-1980s.

If one were to calculate the sum of national GDP for 5-year periods, and then calculate an average annual growth rate for these 5-year periods, thus cutting out short term growth cycles; it is clear that from the early-1970s onward the economy (all-important to the housing market performance) was becoming less and less supportive to the property market in SA;

bar a very short period of spectacular economic growth during the gold price boom of the early-1980s. Mining was a more key industry in SA in those days, and it was little surprise, therefore, to see real GDP growth touch 6.6% in 1980 followed by 5.4% in 1981. In fact, in one particular quarter, year-on-year GDP growth was close to 8%.

But it was all set to end in tears. The gold-boom-driven economic boom was short-lived, proving to be a mere blip in a period of longer term growth stagnation. The housing market began to slide after peaking in 1981, as the economy slid into a recession in 1982/83. The stay of execution came towards 1984, with the economy experiencing a brief recovery, but by 1985 the negative forces were far too great. Not only did GDP growth slip back into negative territory in 1985, never to really impress again until the current decade, but extreme interest rates also contributed to the end of that property party. From 1981 to 1985, prime rate had risen by 10.5 percentage points from 11% to 21.5%.


If that wasn't enough, confidence in the country was not exactly at an all time high, as we headed nearer to Rubicon Speech time in the mid-1980s.


The series of interest rate hikes, coupled with extreme house price inflation, had driven what is arguably the most important measure of affordability to its worst levels on record by 1983.

The ratio I am referring to is the repayment instalment value on a 100% loan on an average-priced house, expressed as a percentage of average income (in index form). The graph below illustrates just how extremely this measure rose in the early-80s boom.

Such levels of "in-affordability" could conceivably be maintained in a thriving economy, but when stagnation returned following the brief growth boom, there was only one way for real house prices and that was down.

And that was the environment which contributed to SA's only house price "crash" in over 40 years.

How does the current environment compare? Well, glancing back at the first graph showing real house price levels, you may be tempted to say that we're at far more risk now than even at the peak of the 1980s boom; with real house rice levels today far higher. And as at late last year, real house price levels were still rising. Such an assertion would be too simplistic, however, as sustainability of house price levels has everything to do with what the market can afford and not what the price level is.

What the market can afford is determined by the combination of price, household incomes, interest rates (for many households) and overall levels of indebtedness.

Going back to the affordability graph, which combines all of the above factors except overall indebtedness, one will see that the recent boom has not seen affordability deteriorate nearly as badly as the early '80s. The index reflecting the average house price/average income ratio (more relevant for the cash buyer) has shown a sharp increase since the late-1990s, but is still not back at early-1980s levels. Due to the massive interest rate drops from 1998 onward, though, the index reflecting the ratio of repayment instalment value on a 100% bond on an average priced house/average income has risen far less extremely, and at a reading of 181 by the second quarter of last year was still far lower than the 297 level reached at a stage in 1993. This containment of the deterioration in affordability is not only due to interest rates but also in part to strong household disposable income growth as a result of a strong economic growth performance in the current decade, growth which has been far more stable and seemingly sustainable than the boom/bust cycle of the early-1980s.
The continuation of this solid growth performance is crucial in staving off the risks of collapse in the housing market. And risks there are. Globally, the increasing possibility of a US recession looms large, while locally it is the spectre of rising interest rates that threatens growth. If we were to go back to interest rates near 20% (or even above), then indeed significant real house price decline would most probably be on the cards. This would contribute directly to the affordability deterioration for credit home buyers, as well as indirectly by stifling job creation and income growth.

So one's view on whether housing is in trouble or not must essentially be driven by your view on interest rates and economic growth, to name but the most important 2 macro variables.

Based on our expectations for a fairly moderate growth slowdown in 2008, and, if any, only limited further interest rate hiking, a deterioration in the local economic environment to such an extent that it would precipitate SA's second major housing market crash on record seems unlikely.
The long term economic growth graph indicates that SA has been on a long term growth acceleration since the early-1990s. This was to be expected following the end of restrictive Apartheid laws along with boycotts and sanctions, and the country is still positively adjusting to the greater degree of economic freedom that this political change brought about.

So, when we talk about real economic growth slowdown in 2008, we're talking about to around 4% from an estimated 5% last year, hardly a train smash. Can the US economy's woes drag SA's growth far lower than this? It isn't impossible, but our view is that other regions of the world, most notably East Asia, are these days better equipped to grow endogenously, with less dependence on the US, thus providing an important growth engine whilst the US sorts out its issues. Therefore, we anticipate a soft landing for both the global economy and ourselves despite the US and its sub-prime and other challenges.
But even should the economic and interest rate moves in 2008 prove to be moderate as we anticipate, you may well ask whether households can keep head above water given their high levels of indebtedness?

If one were to emphasise the household debt-to-disposable income ratio as the key predictor of a looming credit crunch, one may be tempted to raise the alarm bells as this ratio heads towards 80%, now by far the highest ever.

But more important is the debt-service ratio, i.e. the debt servicing cost of the total household sector debt burden (interest + capital)/household disposable income. This ratio had risen to 10.4% by the third quarter of 2007. The rise signifies greater stress for the household sector mounting, but by historic cyclical increases it would not appear out of kilter. The previous 3 big cyclical peaks saw debt service ratios of around 12% (ignoring the 14% blip in 1998 and the small rise in the abnormally good 2002 cycle).

So deterioration yes, but crisis no…based of course upon our moderate macroeconomic assumptions.

What then do the bad debt figures for banks show to date? Once again, a fairly moderate situation. DI500s unfortunately only go back as far as 2001. Special mention mortgage loan accounts (accounts 1-2 months in arrears) rose through 2006/07 to near 3% of the total mortgage book for SA's banks, similar levels to the peak of the 2002/03 cyclical deterioration (the abnormally good cycle). Sub-standard loans (in arrears by 3-5 months) have risen to 1.5% of the total book; doubtful loans (in arrears by 6-12 months) sit at 0.6%; and losses (more than 12 months in arrears) measured 0.9% of the total book as at November 2007.

Some alarmists may want to emphasise that losses have risen by over 60% since end-2006, and this is true. But off a low base that growth figure is largely insignificant, and of course the total book has grown by near 30%, since then.

Therefore, while deteriorating, and I expect further deterioration in credit quality during the first half of 2008, these ratios would hardly point to a crisis situation in which a major portion of households would be having houses repossessed.

Therefore, at current interest rate and economic growth levels, the key ratios suggest that SA's residential property market is in far better shape than was the case in the mid-1980s.

There are no guarantees that things can't still go pear-shaped, should the interest rate and economic growth environment turn dramatically for the worse; as the risks are always there. But based on our forecasts of a mild growth slowdown to 4% in 2008, and interest rates going into a sideways trend very soon, disaster should be avoided.

OUTLOOK

This doesn't mean the end of the road for market weakening just yet. I believe we should prepare ourselves for a dip into single-digit year-on-year house price inflation within the next few months, and it is conceivable that house price inflation could dip below a resurgent CPI inflation rate briefly in the near future, indicating some real house price decline.

But later in 2008, I remain of the view that we will see the turning point in the market, and a resumption of real house price inflation to even higher levels. As soon as interest rates level out, we can expect to see some recovery in growth in new mortgage loans granted (which showed negative growth in the third quarter of 2007), a good indicator of residential demand. This is anticipated during the second quarter. This event normally coincides with an upturn in month-on-month house price inflation, and with a considerable lag and turn in year-on-year house price inflation.