Residential market remains "over-valued"

Residential market remains "over-valued"

The residential market adjusts to affordability challenges in 2 ways...

INTRODUCTION –THE RESIDENTIAL MARKET ADJUSTS TO AFFORDABILITY CHALLENGES IN 2 WAYS – REAL PRICES FALL, OR CHARACTERISTICS OF PROPERTIES CHANGE.

Currently, as implied in recent reports, we remain of the opinion that the residential market remains unrealistically priced, or “over-valued”, but believe that it is not possible to ascertain by how much. We argue that it is unrealistically priced based on our current perception of a weak economy which is not fuelling strong demand, and signs emanating from both our estate agent and valuers’ surveys that supply is very strong relative to demand.

Indeed, since 2008, we have entered a period of real house price decline, and the FNB House Price Index is around 17% down since February 2008 in real terms (average house prices adjusted for consumer price inflation). This is a very normal part of the residential property cycle.

But contrary to the views of some, the market adjustment to real property values does not only take place through a decline in real home values. In our steadily urbanising country, accompanied by increased concentration of economic activity around key urban centres, and along with a slow pace of government infrastructure investment, “effective” land scarcity is mounting over the long term (looking past the property cycles that come and go). By “effective” land scarcity we mean that, while there is theoretically no shortage of land in SA (with a whole Karoo at our disposal), there is a mounting shortage of land located in reasonable proximity to where the economic activity takes place, land with the appropriate level of services and infrastructure required by its owners. Transport infrastructure is key in this regard.

The result of mounting effective land scarcity around urban centres is a long term rise in real property values (again, remember, this is looking longer term than the property cycles that come and go).

This long term rise in real property values will not fully be witnessed in the long term real price growth of an average house price index. This is because a house price index measures the value of the average house that gets transacted. And over time, the average house is steadily changing in size and characteristics.

Yes, the market adjusts in 2 ways to deteriorations in affordability. The first has been mentioned, i.e. through real price declines. The 2nd way is being seen in the long run decline in average stand size, in average home size, in a shift to more sectional title, and in less luxuries such as domestic workers’ quarters and swimming pools.

Indeed, if we could construct an average house price index for the past few decades, that could be adjusted for these changes to the “average home” over time, we believe that one would see more of a long term rising trend in real house prices, than is the case when measuring the average house price regardless of changing characteristics.

We now take our annual look at how these long term changes are unfolding.


HOW THE DEVELOPMENT MARKET HAS BEEN ADAPTING TO INCREASING “EFFECTIVE” LAND SCARCITY

We would contend that effective urban land scarcity began to increase noticeably as from the late-1970s onward, exerting upward long term pressure on real urban property values. This upward long term pressure on real prices would not necessarily be witnessed in the long term real average price trend, as reflected in the country’s major national house price indices. Rather, it would be reflected in the changing long term composition of such house price indices. This is because the residential development sector adapts in various ways to any mounting affordability challenge, which results in stand sizes, building sizes and building features being adapted as affordability fluctuates over time.

Key Macro-Economic factors causing increased urban land scarcity

At what stage of our country’s modern history did land scarcity begin to increase noticeably? We would contend that it was from a stage of the 1970s onward. Whilst urbanisation was already in progress at that stage, it may not have reached the pace that it did in the 1980s, when Apartheid-era “Influx Control” measures began to fail, and were eventually abolished. Rather, the noticeable change in the 1970s was the steady stagnation in general government fixed investment, importantly in the area of construction (civils) projects.

This was due to a general deterioration in the state of government finances as a worsening the political situation caused increasing allocations to defence and national security budgets, while an increasingly isolated economy saw government revenues steadily coming under pressure.

One of the expenditure items to suffer was general government fixed investment, and for our purposes notably in the area of construction projects.

So, while theoretically SA has no great land scarcity, and we could build new Joburg suburbs all the way to Bloemfontein, in reality this has become less practical in recent decades due to limited expansion in urban infrastructure, very importantly, (but not only) in the area of transport infrastructure. This has implied increasing urban congestion to, from, in and around key business nodes.

After a few decades of broad increase, General Government construction fixed investment peaked in 1971/72 at 4.9% of GDP (gross domestic product). Thereafter, the decline was very noticeable, with construction fixed investment bottoming at 1% of GDP in 1998. It has since seen some improvement, but only as far as around 2% of GDP, seemingly insufficient to address the level of backlogs created by years of infrastructure neglect, given that the real level of government and parastatal capital stock had moved almost sideways for about 2 decades.

The resultant pressures are visible, on electricity infrastructure and generation capacity, water and sewerage infrastructure, but notably on transport infrastructure.

During the period of government fixed investment stagnation, the pace of urbanisation picked up

While government infrastructure investment was stagnating, the urbanisation process was set to pick up speed in the 1980s, as Apartheid Era “Influx Controls” collapsed, contributing further to effective land scarcity in South Africa’s cities. Whereas at 1980, the percentage of SA’s population that was urbanised was estimated at 48%, by 2010 this was believed to have risen sharply to 62% (according to World Bank data), and the end is not yet in sight.

Residential Densification, through reducing stand sizes for newly built properties, commenced around the same period that general government throttled back construction fixed investment.

From our FNB valuations data, where valuers note the estimated building date of a property each time they value one, we can glean important information regarding the size and characteristics of homes built in certain periods.

A long term acceleration in government infrastructure investment through the 1950s and 1960s to early-70s (much of the urban infrastructure investment admittedly being in and around the highly-traded former “white” suburban areas) corresponded with an increase in the average size of full title residential stands to an average peak size of 1061 square metres for homes built from 1970-1974.

With the onset of steadily declining focus on infrastructure by general government, so too we went into a long term declining trend in the average stand size of a house. This did not even really halt during the respective property booms of the early-80s and 2000s, when purchasing power rose strongly, because the reality was that urban land was effectively becoming more scarce as a result of a lack of new services and important infrastructure, and the long term real value per hectare or per square metre was steadily rising as a result., we believe. In the latest period, i.e. 2010 to date, that average size of a full title stand was 524 square metres, around half the average stand size of homes built in the early-70s.

But the adjustment to land scarcity in more recent times has gone further than merely a reduction in average size of full title stands. Average building size has also declined significantly, from a 203 square metre peak for homes built from 1970-1974, to 146.7 square petres for buildings built from 2010 to the present.

For full title properties alone, the average size declined from 291 square metres to 166 square metres over the same period. However, the decline in full title building size has not quite kept pace with the decline in average stand size. It would appear that households are more happy to compromise on land than on house space. The result has been an increase in the full title land utilisation rate (building size/stand size) from a low of 20.3% for homes built from 1965-69, to 31.7% for the period 2010 to date.

But the adaptation to growing effective land scarcity does not stop there. Since the 1985-89 period, where 94.6% of homes valued were full title homes, there has been a shift to increased sectional title living, where land is far more highly utilised, with full title homes built from 2010 to date amounting to a lesser 75% of all homes built in the period.

Households are also reducing the luxuries in order to address the long term deterioration in home affordability.

A further noticeable way in which South African households are addressing the long term rising trend in real urban property values (if one could measure them on a per square metre basis instead on the basis of average home value), is via the dramatic reduction of certain “luxuries”. Domestic workers’ quarters, an Apartheid Era institution, peaked in buildings built from 1955 to 1959, with 51.5% of homes built in those years possessing this characteristic. For homes built from 2010 to date, the percentage is a far lower 11.5%.

The late-70s appears to have been the Golden Era of the swimming pool, with 40% of homes built from 1975-79 having pools (although admittedly some pools may have been built at a later stage). Thereafter, the long term declining trend set in, and a mere 9.1% of homes built from 2010 to date have such luxuries, according to the significant sample of homes valued by FNB.

Garages are an interesting home feature in that their inclusion or exclusion from homes appears more cyclical than the other features, with an increasing percentage of homes being built with garages in the booms and decreasing in financially tough times. From 2010 to date, only 51.6% of homes valued have garages, down from the 69.5% for the boom period 2000-2004.

Declining fertility rates, and resultant long term declines in average household size, are causing bedroom numbers to diminish

Urbanisation is not the only characteristic exerting pressure on urban land availability over the long term. Households breaking up and establishing new households at an earlier average age, amongst previously-disadvantaged sections of the population, imply that the number of households should be growing faster than population growth. This implies the need for a significantly greater number of smaller units in terms of bedroom number. This is also reflected in a rising percentage of two bedroom homes, and a decline in those that have 4 bedrooms or more.

Conclusion - So how are these long term trends influencing the make-up of the average house price index over time

It is important for users of house price indices to understand what they are dealing with when using such data for analytical purposes, and to appreciate that the composition of such an index changes over long periods of time. Therefore, the average house price in the 1960s or 1970s refers to a significantly different average house to the one that is reflected in the index at the present time.

Recent statements have been made to the effect that real house prices are “mean (average) reverting”, i.e. that they always revert to the long term mean. This implies that if they are currently above the long term mean they are over-valued, and the converse if they are currently below the mean.

Such statements are very much a case of “stating the obvious”, because current real prices influence the mean. So, even should real house prices never decline again, the mean would eventually converge with the average real price (unless we have an unlikely event of real house prices continually rising further).

But it is also important to understand that, when the market has become less affordable, as it did in the recent boom years, there are two mechanisms for market correction. The first is the obvious, i.e. that real prices must decline. This has indeed been taking place recently, and more decline is anticipated in the near term. But the second mechanism is the one that we have demonstrated above, i.e. through adjustments to the stand and home size, and home characteristics, of newly built homes.

The FNB House Price Index has an 11.5 year history, so it is not possible to determine the average characteristics of homes transacted back in the 1960s for instance. However, the changes in characteristics of buildings by building date suggests that the difference would be very significant. Long term urbanisation, along with growing infrastructure constraints are believed to have led to a growing urban land scarcity, in turn leading to this change.

Viewing the average size of stand for full title properties included in the FNB House Price Index, along with the average building size (Note: not by year built but by when the homes were transacted), we have seen a significant change over the relatively short period of just over a decade. Average stand size of full title homes transacted from 2000-2004 was 925 square metres, which declined to 737 square metres for the period 2010 to date. Average building size is more cyclical, and has increased slightly in the period 2010 to date on the preceding period, but at 139 square metres is still significantly less than the 159 square metres recorded for the period 2000 to 2004.

And looking past the current stage of the property cycle, where real property values are indeed in a declining phase for the time being, the long term home densification process is expected to continue as the long term effective scarcity of urban land mounts, and as real land values resume their longer term rise.

* This report was prepared by John Loos, Household and Property Sector Strategist, FNB