Real Estate: on the verge of correction or still in good shape?

While there are those who consider the Real Estate sector on the verge of a correction, just as many contend that it is still in good shape. Certainly, there are few industries that attract as much speculation in Australia – in large part due to its high visibility.

The number of cranes on the horizon, visible to everyone, newspapers telling people there’s a potential oversupply and prices racing ahead. The front page of newspapers cites people talking about prices going crazy and clearance rates at auctions.

In our recent analysis of Distance to Default (D2D)an indicator that shows how close a company is to insolvency, Real Estate is the furthest from default of all sectors, with a D2D rating of 4.39 in the second half of FY 2016.[1] Meanwhile, Real Estate Investment Trusts (REITs) were a particularly resilient portion of the sector, their D2D rating remaining above 4.3 for the past 3 years. The REITS are very strong, due to a number of factors. In the years following the Global Financial Crisis (GFC), REITs took measures to minimise their exposure to risk, shedding non-core assets. Domestic properties tend to underlie REIT portfolios, which are fortified by the underlying strength of the domestic economy.

The whole REIT sector is well-capitalised. The banks also play an important role. The banks have been judicious in their lending to the sector with commercial investment institutions at a particularly low risk of default.

However, the other segment in the sector – Real Estate Management and Development – is significantly more vulnerable. The industry’s D2D rating has stayed around 2.5 over the past 3 years, although it rose to 3.82 in the second half of FY 2016. Part of its underlying fragility is due to new entrants who have been attracted to Real Estate’s recent price growth. There are those people who join the industry because they feel that these are good times and may not have the same amount of experience.

A novice developer, for instance, who was encouraged by positive media headlines about property and perhaps a recent success, may not recognise the movements of the property cycle. They may start to get into trouble because they bought land at the wrong time and they are up against it in terms of funding and require increasing levels of equity. Plus, because they’re not as experienced, things take a lot longer. Issues of timing can be costly, particularly when they quickly spread from unsophisticated developers to builders.

The developer may not pay the builders on time; they may withhold the last payment; they might have all sorts of delays on the contract which causes angst for the builder’s cashflows. If the contractor has a number of these exposures across different projects, they could find themselves in a cashflow problem very quickly. Experienced contractors are likely to limit their exposure to a certain pool of developers, choosing to spread their contracts across projects in both residential and commercial markets. But those who are less experienced may find themselves with cash flow issues and has a disproportionate number of inexperienced developers on their books.

New entrants from foreign markets can also introduce an added element of risk to the industry. Australia is still very attractive to Asian investors. While Sydney and Melbourne may not be global cities today, there’s no doubt overseas investors see Sydney and Melbourne as global cities of the future. It means they are willing to invest money now, ahead of that curve. The problem is well-capitalised and less risk-averse Asian investors may introduce disequilibrium into the market. Foreign investors, for instance, may have enough capital to begin large-scale developments without presales. If there is a downturn, those developers may add to the oversupply causing a compound negative effect in the market.

However, for now, it appears that real estate remains one of the more robust industries in the country. The story is always more complex than the headlines however and risk still remains.

[1] What emerged from the analysis is the comparative distances from default across sectors measured against the ASX. Sectors with an average D2D score closer to zero, and companies with a D2D score below 0.5 (when compared to other sectors, are considered to have weaker corporate health and may attract higher default risk among their constituents (sector companies). Of the 183 companies with a score above 3.0 (considered to be less at risk than those below) at June 2016, 27 percent were in the Real Estate sector, compared to 14 percent as at December 2013, indicating the Real Estate sector has moved further away from default.

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