Housing prices show returns to normality: Part 2

Image: Renjith Krishnan/FreeDigitalPhotos.net

Main implications

With building cost inflation (incorporating builder's margins, building materials and labour) set to rise high-single digit (6-8%) annually, with nominal prices of existing houses likely to rise only low single-digit (0-5%) annually for the time being, possibly the next three to five years still, two things stare us in the face.

Firstly, real values of existing houses may not have stopped falling and may have further to go as building replacement cost inflation keeps outstripping nominal house price gains. Or to put it in numbers, for instance 6% inflation minus 1% nominal house price gain translates into 5% real house price decline per year.

Secondly, a further consequence is that the discount of old existing houses over newly built houses may widen further, from 25% now to something closer to 35%-45% in five years' time if we allow the logic to run unchecked for the moment.

After the 'overshoot' of the boom years (when existing house values rose, eventually overtaking building cost inflation and finally even matching new building costs, causing the discount of old over new to dwindle to near zero) we have since then gone the other way as nominal house prices started to stagnate.

Today, we have re-established a 'neutral' discount of 25% of old over new. Even so, ahead we may still face an 'undershoot' as the discount of old over new keeps widening, with building costs rising steadily, yet nominal house prices mostly stagnating or rising only modestly as described.

In turn, that presumably would create mounting pressure for people to reconsider their 'new build' decision, instead opting for an existing house purchase.

Would this mean that house building activity, which seemingly has stabilised of late at recessionary lows, could resume declining anew to even lower levels?

With newly built houses only a small fraction of the supply of existing houses waiting to be sold, any such further shift away from new build to buying existing houses would not push up nominal house prices enough to undo this effect. Unless something else gives.

Options

The building cost inflation as described is unlikely to slow down much, given observable cost trends. If anything, at least the energy component of these costs could surprise to the upside.

Still, could builders switch to cheaper materials, or shrink space or in other ways surprise in keeping back the rate of building cost increases? It isn't as if all these things haven't been tried before, but the times may become yet more pressing to become yet more inventive.

It would seem unlikely at present that regulators or credit providers are going to change their definition of the new-model borrower to which they aspire.

Even so, there may be refinements to mortgage lending criteria along the way, but the litmus test is the turnover of residential property, with transfer duty paid, one indicator and credit growth by banks, another.

It remains to be seen how quickly potential borrowers succeed in adjusting to the requirements of credit providers, or whether credit providers may in fact relax some of their more stringent criteria as time goes by.

Cost of serviced land

Be that as it may. With the discount of old over new houses likely to still rise further for the time being, there is one more aspect to consider, namely the cost of serviced land.

For the total cost of a newly built house is builder's profit, building materials and labour, but also the cost of the serviced plot. The latter is in a manner of speaking a very volatile shock absorber.

In euphoric times, buyers bidding up existing house prices to undreamed heights are really bidding up the 'value' of the underlying plot/land, for the house is simply what it is - brick and mortar replaceable at a given building cost.

At the cyclical peak, a choice serviced plot might have fetched R1.2 million. By now, its market value may have already halved. However, does it have further to go?

If the discount gap between old and new houses were to widen further in coming years, and potential new buyers in greater numbers opt for buying existing houses as the more rational thing to do, one can see that one way the discount can be kept 'manageable' is to value the serviced land/plot lower and lower.

Eventually, the stock of potential homebuyers and mortgage borrowers will have acquired far more conservative financial profiles than they used to have, mainly because their incomes have kept rising, they now earn more, they have learned how to save more (or borrow differently) and even with unstable sources of income among them can meet credit provider tougher standards.

As house demand improves and matches existing supply better, nominal house price inflation can start rising again. As it does, it can start catching up again with rising building cost inflation, eventually stabilising real house prices but also the discount of old over new houses, and then beyond that starting to shrink the discount anew.

When this happens, the relentless downward pressure on serviced land values can finally ease, and such values can start rising again, depending on the evolving forces of supply and demand.

Slow process

It would seem when going by appearances that the full play out of the adjustment in credit culture following the shock experiences of recent years has some way to go.

In the process, nominal residential property values and building industry activity may continue to stagnate or increase only very modestly, while the value of serviced land is under severe downward pressure.

Only when the country's pool of potential homebuyers and borrowers has sufficiently adjusted to new realities, and nominal house prices start rising again along with improving demand, can the building industry expect rising activity levels, along with reviving values of serviced land.

However, that could still take a few years, according to some in the industry possibly another five years.

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