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
Two years ago, in our Magic Dragon report, we upgraded our housing forecasts even though they were at historic peaks, all because we believed that Chinese capital flows would have an unprecedented effect on the market. Our forecasts were too conservative, as approvals and house prices in the two major east coast cities have boomed. Approvals for foreign purchases of dwellings have risen tenfold in five years and more than fourfold in two years. Chinese residents now represent nearly two-thirds of all foreign applications for such transactions.
About one year ago, we started seeing signs that the Chinese government was restricting capital flows and Australian banks began to tighten credit standards. The former restrictions seem to be having only a limited effect, but bank lending has continued to tighten, particularly for foreigners (major Australian banks now require borrowers to have domestic income), with plenty of encouragement from the regulator. Australian government imposts on foreign investment have also increased, as has regulatory monitoring, enforcement, fines and forced selling.
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.