Slow new household formation likely to dampen residential rental market

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This in turn is likely to dampen aspirant tenant demand for residential rental property. In addition, low interest rates may be working moderately in favour of home buying and against renting, further constraining rental demand growth.

Slower pace of new household formation, and some household “terminations” will likely slow residential rental demand heading towards 2021.

Data emerging from the residential rental market over recent years has pointed to a weakening trend even prior to the 2020 Covid-19 lockdowns, with the second quarter lockdown period increasing the severity of those pressures.

From a multi-year high of 5.68% year-on-year as at September 2017, the CPI for Actual Rentals has seen its rate of increase slow to a lowly 1.8% year-on-year as at June 2020, with year-on-year deflation now appearing a distinct possibility.

The key economic source of pressure on the rental market, we believe, is the long-term stagnation in growth in the South African economy.

This source of pressure constrains the finances of existing rental tenants, thereby curtailing their ability to pay rent timeously and absorb rental escalations. This is reflected in the multi-year trend in TPN’s percentage of tenants that are in good standing with their landlords, which declined gradually from a decade high of 85.95% as at the third quarter of 2014 to reach 81.52% by the first quarter of 2016.

Then came the more severe economic dip of the second quarter, caused by the Covid-19 lockdown period, and by June 2020 the preliminary percentage of tenants in good standing had dropped all the way to 62.43%. This is a severe drop that more than rivals the decline back in the 2008/9 Global Financial Crisis-related recession.

The pressure on tenants, resulting from either partial or full income loss in this recessionary period should lead in certain cases to pressure on pro-active landlords into accepting more moderate escalations and in some rentals, or alternatively risk not having a good paying tenant.

However, the financial pressure can also be expected to reduce the pace of growth in total number of households in the formal housing market, with a dampening impact on demand growth for rental property.

This can work in various ways:

Firstly, in that as the economy curbs job creation, young aspirant labour market entrants may have the timing of their first appointment delayed due to a lack of opportunities. This may translate into delayed establishment of a new household for these young labour market entrants, with a portion of them choosing to remain in their parents' home for longer than would be the case in better economic times.

Secondly, a group of young working people may choose to delay their household formation, remaining in their parents' home until the currently highly uncertain times pass, possibly out of fear of retrenchment or partial income loss.

Thirdly, household “shut downs” can take place too. People losing jobs during this recession, and unable to cover the costs of living as a stand-alone household, could opt to either move back in with their parents, or to merge households with other households, for example two rental tenants or homeowners, previously staying in separate residences alone, choosing to live together in one residence, either ending the rental or the ownership of the other property.

Household “shut downs” need not only be young working people. It can also be elderly people moving into their childrens’ home.

The ultimate result is expected to be lower growth, or even decline, in the total number of households in South Africa, continuing to slow demand growth for residential rental properties.

The impact would also be one of “densification” of living, with a likely increase in the number of people living in a portion of homes. In some cases, this could support the demand for larger homes a little more relative to smaller homes, with some merged households opting to relocate to a larger home. But this effect would not likely totally offset the impact of severe economic weakness on demand, even for larger homes. The current recession would appear too severe for that.

Slowing pace of new household formation as a result of tough economic times slows growth in overall demand for residential property, too, translating into a slower required rate of new additions to total housing stock, thus exerting pressure on new residential development too.

Has there been any evidence of slowing growth in the number of households in recent years? Yes. From a multi-year high of 2.7% in 2015, total household growth had slowed to 1.9% by 2019. And the lowest growth rate in the number of households was estimated by IHSMarkit to have been in 2010, one year after the 2009 GFC GDP contraction, the same year that total estimated employment declined by -2% (IHSMarkit data) in lagged response to that 2009 recession.

Household growth was far stronger in better economic growth times pre-2008, and especially around 2009 where it hit a two-decade peak of 6.2%, corresponding to a two-decade high of 7.7% in total employment growth.

1999 was also the very early stages of a massive housing demand boom, perhaps unsurprisingly given the rate of employment and household growth around that time.

However, more recently, in a lengthy period of economic growth stagnation, we have seen employment growth slow from a 4% high in 2014 to 0.5% by 2019, and 2020/21 is likely to see a noticeable employment decline.

We would thus expect a significantly slower rate of household growth, possibly even a negative growth rate in 2021 in lagged response to a major -8% real GDP contraction forecast by FNB.

Impact of interest rate cuts

The second key influence on the rental market is sharp interest rate cuts, although the overall impact of this is less clear than the GDP recession impact.

There has been a large reduction in interest rates during 2020, with the prime rate declining from 10% at the start of the year (10.25% at a stage of 2019) to 7%.

The impact of this interest rate cutting cycle on the rental market is unclear. On the one hand it has cushioned the blow of lockdowns on the economy, and the magnitude of recession may have been worse had it not been for rate cuts. However, the sharp rate cutting gives highly credit-dependent home buying a greater competitive advantage over the rental option.

Households are required to choose between the home ownership and home rental option, the former option being a far more interest-rate sensitive decision due to the fact that many households use a mortgage loan to finance this. Therefore, all other things equal, a sudden reduction in interest rates makes the home buying option more attractive relative to the rental option.

Many commentators place much emphasis on the average house price/average rental ratio, the argument being that if house prices increase in price at a more rapid rate than rentals, leading to a rise in the price/rent ratio, this at some stage should ultimately lead to the rental option winning greater appeal relative to home buying as home buying affordability deteriorates relative to rentals. This in turn would contribute to a cooling off in the home buying market.

We compile an average house price/rental index to track this trend, and in recent years have found house price inflation not quite keeping pace with rental inflation, which has translated into a cumulative -3.6% decline in this index since February 2016. That that decline is insignificant. However, given that many households utilise mortgage credit to purchase a home, an index that we feel makes more sense to monitor is the instalment value on a 100% new home loan on the average priced home/average rent ratio index.

This second index is thus not only driven by house price and rental trends, but also by interest rate moves. And with the very significant interest rate reduction, it has plummeted by a massive -26.1% since a decade-high recorded in May 2016.

This points to a very significant improvement in the appeal of home buying relative to rental, all other things equal, much of this relative change coming in 2020 due to sharp SARB rate cutting.

However, an unknown in the whole equation is that of sentiment. Does the current recession dent confidence levels to such an extent that many risk-averse households prefer to rent temporarily until a period of great uncertainty has passed, despite very low interest rates being in many buyers’ favour. This is possible. This is the wildcard.

Conclusion

In recent years, we have assumed the likelihood that economic and home buying market “stagnation” would see the home rental market outperform the homeowner market, rental inflation thus outpacing house price inflation, and ultimately rising income yields on residential property.

And since around 2016/17, a mild outperformance of the rental market over the homeowner market has been witnessed. At the current time, however, the continuation of this scenario appears in doubt in the near term, with average rental inflation slowing all the way from 5.7% year-on-year in 2017 to 1.8% in the most recent CPI survey. This 1.8% is now a very similar rate of increase to the FNB House Price Index’s 1.2%, and the rental inflation rate may very soon underperform house price growth.

We say this because while a weak economy causing a slowing in rates of new household formation can equally impact on both homeowner and rental markets alike, sharp cuts in interest rates play, relatively speaking, into the hands of the credit-dependent homeowner market.

And so, while we see severe weakness in rental tenant payment performance, pointing to a rental market under pressure, the anecdotal evidence seems to be that the home buying/ownership market has come back reasonably well after hard lockdowns have been relaxed.

Whether this “mini-recovery” in home buying after lockdown holds remains to be seen in a tough economic environment, but it is possible that the move towards significantly higher and more attractive yields on residential property may be “on hold” in the near term.