The Australian residential property sector is walking a fine line. High rates, high inflation, low supply, and a surge in immigration.

On the flipside, banks' loan books are strong, mortgage arrears are low, and most borrowers should be able to withstand rising rates.

This article answers investor questions addressed at the S&P Global Ratings' Property Spotlight seminar in Sydney on July 25, 2023. It complements another commentary (Credit FAQ: Australian Property Spotlight: Commercial Sector At A Crossroads, Aug. 3, 2023), which covers the panel's discussion on the commercial property sector.

Frequently Asked Questions

What macroeconomic factors underpin your property forecasts?

Anthony Walker:  In late June we revised down our real GDP forecast for Australia to 0.6% due to weak consumption and investment conditions. Importantly, strong population growth underpins this. When adjusting for the expected surge in population, we expect the economy to contract by 1.7% on a per capita basis.

We expect labor market conditions to soften. We forecast unemployment to rise to about 4.3% by June next year. This is still low and is not a material risk to the property market.

We project inflation to remain above 5% through 2024, with the Reserve Bank of Australia (RBA) to raise the cash rate to 4.6% by December this year. This is lower than the post-GFC peak because higher household debt makes borrowers more sensitive to rising rates.

Population growth will be the strongest in decades. We expect growth of more than 2% per year from 2023 to 2025, driven by very strong immigration, which will compensate for the loss of immigration during border closures. This may affect rental markets, particularly in capital cities. It is driving yields higher for property investors.

Supply in the property market will be constrained over the next few years. Completions down by close to 25% from pre-COVID highs; we expect them to fall further because of rising unemployment, soft investment conditions, and increasing mortgage and construction costs.

Transaction volumes across capital cities are low, with listings down more than 30% since 2021. This reflects the unwillingness of sellers to accept lower prices.

Inflation in the construction sector has surged, affecting margins at many builders, resulting in a rise in construction sector insolvencies. This is limiting new supply further.

What is S&P Global Ratings' view on the evolution of residential property prices?

Sharad Jain:  The recent double-digit annualized growth rate in house prices suggests that demand-supply pressures are offsetting the effects of rising interest rates.

However, the effect of high interest rates and prices generally on households, both directly and indirectly, are still working their way through the system. For example, about 45% of the low-rate fixed mortgages are going to reprice in the nine months ending this year, and another 30% will reprice next year.

As a result, we expect overall house price growth to slow in the second half of this year but continue to increase, followed by flat or sideways movement in the first half of next year. House price growth should resume a positive trajectory by the second half of next year, due to strong population growth, fewer new dwellings, and limited increases in the cash rate.

The property sector faces a "triple whammy" of influences, according to AMP. What does this entail?

Shane Oliver:  the property market generally is enduring a triple whammy: higher interest rates; increased supply and less demand for office and retail space; and potential recession. Commercial property is worse off than residential property.

Despite a rebound in property prices earlier this year due to an influx of immigrants and tight rental markets, the risks are on the downside from here, with the possibility of another leg down and significant price drops. Some indicators are already starting to get shaky. AMP puts the risk of recession at 50%.

An unseasonal rise in property auction listings may also indicate an increase in distressed selling. The number of borrowers switching from fixed to variable loans will be a major stress point.

On mortgage performance, are there any borrowers in which S&P Global Ratings see signs of distress?

Erin Kitson:  The mortgage arrears rate is currently low, but there is some divergence in performance across areas within capital cities.

Our data on residential mortgage-backed securities (RMBS) shows the top-10 areas with the highest levels of loans more than 30 days in arrears across the capital cities. Many of these areas are on the fringes of capital cities where housing is typically more affordable for example, Northwest Melbourne and Sydney Outer Southwest, and therefore more likely to attract first homeowners, who often have higher debt-to-income ratios, and lower savings buffers, given their stage in life. Census data for 2021 shows that in several areas with higher arrears, the percentage of households with a weekly income greater than $A3,000 is below the national level of about 5%.

This contrasts with those areas in capital cities with lower arrears, where the proportion of households with higher weekly incomes is much larger. Borrowers in these areas are more likely to absorb higher mortgage repayments. Overall, there is a divergence in mortgage arrears levels as you move from areas close to CBDs further out.

When will arrears peak?

Kitson:  We think that mortgage arrears are likely to peak toward the end of the first half of next year. We base this is on our current interest rate forecasts.

To what extent has there been a shift in lending standards among nonbanks in the residential property sector?

Kitson:  We are seeing some incremental shifts in lending standards, which is not surprising because of the competition, particularly around reductions in serviceability buffers for refinanced loans. The non-banks seek to be more opportunistic, given they don't have the funding-cost advantage of larger lenders. When competition increases, you will start to see nonbanks shift to new or different lending segments.

We are seeing more lending to self-employed borrowers with more complex income streams, self-managed super fund-type loans, and non-resident loans. Nonbanks will typically gravitate to higher-credit risk lending, given they are specialist lenders--larger loan sizes, higher loan-to-value ratio (LVR) lending.

And are the banks altering their standards?

Jain:  In the past 12 to 18 months, some mortgage-lending characteristics have strengthened. The proportion of new mortgages written at high debt-to-income and high LVR ratio has diminished. Obviously, that doesn't cover the full picture. The big one is the interest rate paid on the new mortgages, and that's also reported by the regulator. The average rate for new variable loan mortgages is roughly double what it was 12 months ago. So that does affect lending characteristics.

A key point is the serviceability buffer or exception to the serviceability buffer. It's important to note that that exception isn't something new; that exception has always been allowed under regulatory standards, but on a truly exceptional basis. It remains a small proportion of the mortgages written by banks, and we expect it to remain so.

How do the banks' mortgage portfolios look?

Jain:  Strong. We expect the banking system to weather the stresses from rising interest rates very well. There is, however, no question rising interest rates will mean a segment of borrowers will struggle to service their mortgages. The effect of higher interest rates and prices, including the transition from low fixed-rate mortgages to much higher variable rates, is yet to fully play out.

Particularly vulnerable are households who borrowed at high leverage; those who borrowed when prices were near peak; and, most importantly those who risk losing their employment or income. We consider that segment to be small at the overall system level as well as the individual bank level for most banks.

Consequently, we consider that most borrowers should be able to absorb the higher interest burden. Reflecting this are asset quality metrics. The level of nonperforming mortgages is beginning to rise, but we expect this to remain low in historical comparison.

The ultimate risk to the banking system from mortgages is the credit losses (bad and doubtful debt expenses) that go through the income statements of the banks. We forecast total credit losses will remain very low in the next two years, at about 15 basis points (bps) of customer loans, and broadly in line with the losses at pre-COVID levels. Similarly, we forecast nonperforming loans to also remain very low. These forecasts cover all sectors, including home loans, although mortgages form more than 60% of bank loans in Australia.

Our expectation of a limited rise in unemployment is key to our base case scenario in which we hold a benign outlook of the banks' asset quality performance.

The risk of an alternative scenario remains elevated: a scenario in which nonperforming loans and credit losses spike rapidly. That could happen if the economic outlook worsens much more meaningfully than our current forecast.

What are the key factors you are watching in terms of mortgage performance?

Kitson:  First, refinancing activity. A slowdown in refinancing activity could add to further arrears pressure in the months ahead because refinancing is a common way for borrowers to self-manage their way out of financial stress. But ultimately when it comes to mortgage performance, the employment story is key. Low unemployment should limit the levels of distressed selling in our opinion, despite rising arrears.

Second, rising interest rates could prompt a rise in demand for apartments, given their lower pricing point than homes. A resurgence in immigration, strong rental growth, and low vacancy levels could also entice more investors back to property markets. Offsetting this are higher mortgage repayments and regulatory uncertainty around limits on rental increases, property taxes, etc.

In terms of debt serviceability, investor arrears are still lower than owner-occupier arrears, which is a longstanding trend given their often-higher debt-servicing capacity. Investor behavior toward property is more opportunistic than owner-occupiers though, given their property is not a primary place of residence. The motivation for selling a property in this type of market for an investor could be multifaceted, and quite household-specific, given the number of private property investors in Australia.

A longer-term structural trend to watch is household formation. It will be interesting to see if the pandemic trends of reduced household size due to the desire for more space unwind as housing unaffordability starts to bite. This may mean more share accommodation or adult children living at home for longer.

In AMP's view, how does this monetary policy tightening cycle compare to past cycles?

Oliver:  It's the biggest tightening cycle since the late 1980s. We are now 400 bps from about January 1988 to late 1989. Rates went up from just above 10.5% to just about just above 18%, so almost 800 bps. But in those days, we didn't have a regularly reported target cash rate. So you've got to look at the overnight rate, which is comparable.

And that's when mortgage rates went up to 17%. The problem this time around is that household debt-to-income ratios are about three times what they were back in 1988. Roughly speaking, a 6% rate today is equivalent to 17%. The question is how could we have been so resilient? Maybe last year's fall occurred earlier than normal and prompted a knee-jerk reaction. House prices normally don't respond to higher interest rates until there are multiple interest rate hikes, then they come down when unemployment goes up. So if you go back to the 1982 recession cycle, and to the 1988-89 cycle, it took longer for house prices to come down. Buffers accumulated.

Nor have we ever had this number of people on fixed rates. At the start of this tightening cycle, we had 40% of mortgages with fixed rates. That degree of protection was absent in past tightening cycles. The question is whether those protections are now starting to run down, whether the so-called revenge spending and revenge travel are starting to wane because of the cost of going abroad. The buffers are contracting, and the fixed-rate reset is happening. So therefore we're entering a more uncertain period.

And of course, the RBA is in a difficult position. It knows that more people will be upset with high inflation than unemployment. Even if we enter recession and reach 10% unemployment, 90% will still be in a job. You'll feel more uncertain about things. But if we get much higher inflation and real wages retreating or just higher inflation generally, everyone suffers. So the RBA is trying to protect the broader community from a return to conditions like those of the 1970s and 1980s.

The RBA faces a tough task. We are going down this narrow path; the risk is increasing with each rate hike that we get knocked off the narrow path into recession.

Writer: Lex Hall

Related Research:

• Credit FAQ: Australian Property Spotlight: Commercial Sector At A Crossroads, Aug. 3, 2023