The Housing Crisis - Where Are The Cranes?
tl;dr – not enough cheap financing available to develop new homes – no economic incentive
2/3rds of attendees at a conference I was at recently stated that the housing crisis is the biggest issue facing Australia today.
Media frenzy (rightly so!) feeding into fear and concerns, a push for rezoning, advocacy groups such as YIMBYs and even religious groups all calling for greater density. From the latest AFR article on housing supply:
"The supply of new homes will crash to the lowest level in over a decade by 2026, worsening housing and rental affordability, and leaving the federal government far short of its goal to build 1.2 million homes by mid-2029. Across capital cities, 79,000 new homes will be finished in 2026, a drop of 26 per cent compared with last year due to planning bottlenecks, labour shortages and soaring material costs."
What do we need to increase supply of housing in Australia? And this is not a Sydney/Melbourne issue, it permeates across the Australian landscape.
Econ 101 - Demand and Supply
We have a market where there is sufficient demand and I take the view that even if you resolved the 3 stated supply issues (planning bottlenecks, labour shortages and material costs), that there will be no step change in supply overnight. Planning bottlenecks improving isn't going to magically bring about more supply, labour shortages are easing up and material costs are passed through to the buyer.
This is a market of the capitalist, so I ask, where is the capitalist? If there is such high demand and such little supply, should there not be an automatic supply response?
Some of the proposed solutions have been forcing (sorry, encouraging) industry super to build housing – political motivation in large pools of capital to take on risk to subsidy housing - I am not a fan of this...
How do you expect me to afford a new home?
Does anyone remember back in 2017 when APRA reduced credit availability, house prices fell? And as covid came in, all those changes were wound back, and credit availability was increased (along with ZIRP) leading to an increase in house prices.
Credit availability has great influence on the price of homes. And it isn't unreasonable to think credit availability influences the (non-existent) supply response of home construction.
What do we need for a supply response? More credit availability in the right areas!
Basel III – First Blood
The bank doesn't hold dollar for dollar for each loan they originate, it is a combination of balance sheet assets (equity) and other sources of capital (debt).
- For each loan a bank originates, they need to hold a particular level of capital.
- The riskier the loan, the more capital they must hold.
- Residential home loans (already built shelter, basic human necessity) has a low "risk weighting"
Corporate loans are different, lending to a business that has cashflows only and no assets - something you have no recourse over if there is a default - is risky. For unrated corporates, the risk weighting is 100%. (ie you need to hold a dollar for each dollar you lend out)
Property development is once again a different beast, depends on how much you borrow, but for simplicity's sake, let's call it 100% risk weighted.
Okay this makes sense right? A bank is forced to hold more assets for a risky loan to make sure that if something goes wrong, there is sufficient capital buffer.
What is the cost of my capital?
Return on Equity (ROE) is an important number for banks. It reflects how capital efficient a bank is and is a constant measure of returns for shareholders.
Now I am sure someone will argue with me that bank ROE is not the banks cost of capital. The banks cost of capital is the weighted cost of debt + equity (WACC).
I will die on this hill, earning a "market risk premium plus cash rate" is not realistic target for business earnings. An index maybe, but not a business. That is economist talk. A banks cost of equity is their ROE.
A bank will NOT make a loan out below ROE, why would they contemplate accepting a lower return on their capital? The board will look after shareholders, therefore places pressure on management who place pressure on their employees - don't make a loan out below ROE, it is not commercial and dilutive to earnings. Bad for share price.
What does this mean?
Risk weighted assets (RWA) and ROE matter.
The banks have regulatory motivation to:
- Issue home loans all day long (need to hold less than $1 of capital per $1 lent)
- Not issue construction loans (need to hold a dollar for a dollar lent).
The higher the risk weighting, the more capital a bank needs to hold, and it makes things more difficult from a ROE perspective to justify lending to property developments.
Basel III along with APRA restrictions changed the lending environment in Australia. Permanently.
At current RWA rules & ROEs, banks can barely lend to developers of residential property (among all other types of property) for a greenfields project. The ROE for CBA is approximately 14%, so why would CBA charge less than 14%pa for a construction loan that has a risk weighting of 100%?
The banks have pulled back from construction lending and the non-bank market has stepped up to close the funding gap.
The cost of capital at non-bank lenders is what investors such as you or me are willing to accept as a return on our capital. And most of private debt lending for construction loans is done at 10%+ in today's environment.
The cost to develop more housing
Equity on a residential development would generally earn approximately a 20% IRR (pre-tax & fees) before the 2016 restrictions. That equity IRR relied on cheap bank financing.
But house prices and land prices continue to rise while the ability for developers to access cheap capital (debt) is restricted. Realised equity IRRs for developments is no longer 20%, it is closer to 10%.
If you are an investor, why would you fund the building of new homes to increase housing supply when the lender gets paid just as much as an equity holder for taking on a lot less risk!
Basel III: Endgame
This is not to say there is no lending by the banks, there is still some lending going on today. And helpfully, APRA have recently improved the conditions for lending by amending some of the risk weights to make it more palatable, but it is simply not enough.
A question I have is whether we have gone too far in light of "banking stability".
I am going to make an insane suggestion, should we contemplate having a bit more potential instability within our banking system with the guardrails of QE if things go really wrong to try and improve credit availability?
Those that make these decisions (economists) are cold hearted, they have no concept of what is at stake here. I am going to sound insane saying this aren't I?
But the reality is housing affordability is not going to improve unless financing becomes easier, and the non-banks are not the solution to our financing issues. Reasonable financing needs to exist within the system, it is the only way to encourage economic incentive.
Yet we continue to tighten the belt, this is shadow monetary tightening.
The argument for real assets
It is not about supply or demand today, but instead the balance of where things will end up in the future.
- Land availability is going to reduce on the back of increased density.
- This stuff is better than bitcoin because believe it or not, there is only a fixed supply of land and by rezoning we reduce single dwelling land.
- Immigration isn't going to stop (higher income earners coming in through skilled migrant programs)
- Credit availability is going nowhere which means little gets built, the supply response is non-existent for some time.
I don't think I am too wrong here – the missing piece is credit supply which now is largely influenced by globally unified regulatory response (ie Basel III) and our regulators are not going to step out of line.
Heads I win. Tails, I don't think I lose?
Is this the solution?
As simple as increasing credit availability for developers?
Hell no, this is a multifaceted problem - zoning, lack of approvals, credit availability, construction bankruptcies, labour, materials. What I cover is one issue within a much larger set but I feel like I'm the only one who's talking about financing and economic incentive.
Until credit availability increases for the construction of new homes, the economic incentive for a supply response is not going to exist.