Buy-to-let industry skating on thin ice

07-06-2004

Buy-to-let investors and houses in upmarket suburbs are most at risk should the South African economy be hit by an external shock that causes interest rates to be bumped up.

The reason for the exposure of the buy-to-let market is that this market segment is currently in some geographic areas over-supplied as a result of over-enthusiastic development. The strong investment demand for property follows in the wake of the poor performance of bourses worldwide, the strength of the rand, and latterly the sharp structural decline in interest rates, says Rode CEO Erwin Rode.

He says if interest rates were to climb to former heights of 18% and higher due to, for instance, abnormal oil price hikes, our economy could be in for a rude awakening. Such a shock would severely damage the speculators in the house market.

However, a more likely scenario is that the economy will keep on chugging along at 3% per annum, with interest rates remaining structurally at more or less current levels and house-price increases levelling off.

He says the latest Rode's Report shows that upmarket house-prices are fully priced relative to replacement cost. This means that should house prices increase much above these levels, they would per definition move into a bubble.

Rode defines a bubble as a market in which the prices of newish second-hand properties exceed replacement cost (the cost of the stand plus the cost of erecting an improvement, allowing a reasonable profit margin to the builder). However, lower-priced suburbs are in most areas not fully priced yet, with the exception of the Cape Peninsula.

Replacement cost is a good indicator of the long-term path of the prices of newish second-hand houses, Rode says. "Consumers are not stupid they will not pay more and more for homes ad infinitum. At some stage they will make their sums and realise that it would be cheaper to build than buy. Except of course in places like the Atlantic Seaboard in Cape Town, where there are very few stands available and where demand stays buoyant.

“However, grist to the speculative mill is the fact that in a construction boom, like the present, builders also stretch their profit margins. Thus house prices partially accelerate because house-building costs accelerate.

“But sooner or later this frenzy will come to an end — either through an external shock like exploding oil prices, which would lead to price declines, or gradually through the replacement-cost mechanism or lack of affordability. Indeed, there is already anecdotal evidence to suggest that rental income is decreasing in some areas, which points to an oversupply in rental space."

Rode says for all their talk about the industry booming rather than being in a bubble, banks are already stricter in supplying loans for buy-to-let homes.

In the event of an external shock to the economy, the upper-crust suburbs would suffer most because the buyers in these suburbs will be harder hit, as their incomes are more directly tied to the fortunes of the economy than salaried persons' remuneration. "This also explains why lower-priced suburbs' growth rates are less volatile and tend to lag the economy," he says.