Pete Wargent blogspot

Co-founder & CEO of AllenWargent property buyer's agents, offices in Brisbane (Riverside) & Sydney (Martin Place), and CEO of WargentAdvisory (providing subscription analysis, reports & services to institutional clients).

5 x finance/investment author - 'Get a Financial Grip: a simple plan for financial freedom’ (2012) rated Top 10 finance books by Money Magazine & Dymocks.

"Unfortunately so much commentary is self-serving or sensationalist. Pete Wargent shines through with his clear, sober & dispassionate analysis of the housing market, which is so valuable. Pete drills into the facts & unlocks the details that others gloss over in their rush to get a headline. On housing Pete is a must read, must follow - he is one of the finest property analysts in Australia" - Stephen Koukoulas, MD of Market Economics, former Senior Economics Adviser to Prime Minister Gillard.

"Pete is one of Australia's brightest financial minds - a must-follow for articulate, accurate & in-depth analysis." - David Scutt, Business Insider, leading Australian market analyst.

"I've been investing for over 40 years & read nearly every investment book ever written yet I still learned new concepts in his books. Pete Wargent is one of Australia's finest young financial commentators." - Michael Yardney, Australia's leading property expert, Amazon #1 best-selling author.

"The most knowledgeable person on Aussie real estate markets - Pete's work is great, loads of good data and charts, the most comprehensive analyst I follow in Australia. If you follow Australia, follow Pete Wargent" - Jonathan Tepper, Variant Perception, Global Macroeconomic Research, and author of the New York Times bestsellers 'End Game' and 'Code Red'.

"The level of detail in Pete's work is superlative across all of Australia's housing markets" - Grant Williams, co-founder RealVision - where world class experts share their thoughts on economics & finance - & author of Things That Make You Go Hmmm...one of the world's most popular & widely-read financial publications.

"Wargent is a bald-faced realty foghorn" - David Llewellyn-Smith, MacroBusiness.

Saturday, 29 March 2014

Earth Hour - Sydney

Below are two photos I snared at Darling Island this morning (just having a coffee over here).

Now, if everyone is being good, there should be no lights on tonight from 8.30pm to 9.30pm in the CBD, since it is Earth Hour.

Earth Hour is one export that we can be proud of, since, as you may recall, it began as a lights out event in Sydney back in 2007. 

Today, more than 7,000 cities and one billion people globally take part in Earth Hour.

It's a great event, but realistically if companies (and people) were serious about making a difference they'd turn office lights off every night, wouldn't they?

More than that, the future must lie in investment in green technologies.



Friday, 28 March 2014

Tens of billions earmarked for infrastructure

A bit rough on Victoria, perhaps, since the state has already sold off many of its assets, but a significant boost for the Australian economy, and particularly for the states with assets to sell off.

This is what the economy needs as the population booms: infrastructure spending.

States will not be allowed to use proceeds from asset sales to pay down debt. 

Instead, funds must be spent on infrastructure, and spent quickly.

From Business Day:

"Federal Treasurer Joe Hockey says he has struck a ''historic agreement'' with state treasurers that will create tens of billions of dollars of new infrastructure across the country.

The Commonwealth has promised to provide an ''asset recycling pool'' of money that will be used to encourage state governments to sell their public assets and recycle that money into new, economy-boosting infrastructure.

The pool will be used to give states an extra 15% of the sale value of their assets but state governments will only receive the extra money after signing a bilateral agreement with the federal government promising to use the proceeds from privatisation to invest in new projects.
''We need to fill an infrastructure hole in the economy and we need to do it fast,'' Mr Hockey said on Friday.

''The net outcome will be tens of billions of dollars of new additional infrastructure in Australia.''

State governments will need to show the Commonwealth what infrastructure projects they would like to build and the federal government will judge each project on its merits before handing them any money.

''This is a blank sheet of paper for a project proposal but, obviously, there needs to be a net benefit to the economy, it needs to be result in more jobs and it needs to be a good use of money,'' Mr Hockey said.

State governments will not be allowed to use the money to pay down debt.

The 15% bonus from the federal government will only be paid on the amount of asset sales reinvested in ''productive infrastructure''.

Announcing the decision on Friday, Mr Hockey conceded some states would get more money from the pool than others because some states had more public assets to sell.

The decision angered Victoria, which has already sold many of its assets.

Victorian Treasurer Michael O'Brien said his state's previous history of privatisation ought to be recognised.

''We would certainly prefer that there had been some recognition that Victoria, and other states including South Australia, have done a lot of the heavy lifting when it comes to economic reform and asset recycling,'' Mr O'Brien said.

But Mr Hockey said he was not interested in history, saying he had to ''deal with the challenge that lies before us''.

The money will only be available until June 30, 2016, to encourage state governments to start selling assets quickly. 

The money will be paid out over a five-year period, with the expectation that some asset sales will take years to bring to fruition."

Record Australian household wealth

Record wealth

Commsec reported that Australian household wealth has reached a new record high as share markets (and therefore super balances) as well as dwelling prices continued to rise in 2013.


Source: Commsec

At the end of 2013, total household wealth exceeded a record $7,500 billion, an increase of around $250 billion in the calendar year.

That's an average of $322,757 per capita, making Australia an extraordinarily wealthy country.

Household wealth during the financial crisis suffered a little as share markets dived, but Australia had bounced back relatively swiftly by the end of 2013.

Uneven

As in all capitalist societies, however, the wealth continues to be distributed unevenly.

Largely thanks to our compulsory superannuation (a major driver of the high average household wealth figure) most working Australians will have benefited from a strong 5 years on the share markets.

Similarly those who own their own home will have benefited since dwelling prices reached new heights in 2013 as wages and household incomes increased for yet another year.

The losers in today's low interest rate environment include net savers and often pensioners, since fixed interest returns have dived over the past two decades.

The beneficiaries since the financial crisis have included those with profitable businesses, large share portfolios and heavy real estate exposure.

Australian population growth breaks some records

Population booming

The ABS released its demographic statistics yesterday, which showed that Australia's population continued to boom dramatically by 405,446 persons in the year to September 2013 to 23,285,800, an annual increase of 1.8%.

For those familiar with the concept of compounding growth, it was interesting to note that the natural increase (births minus deaths) of 164,428 was the highest figure ever recorded in Australia.

The remainder of the growth of 241,018 was the net result of migration, accounting for nearly 60% of the growth (click chart).


The implication of this is that although natural increase is now at a record level, it is still immigration which is driving most of the growth.

As for where the population is growing fastest, see below (click chart)


The bulk of the growth as usual was seen in New South Wales (+108,100 y/y), Victoria (+110,500), Queensland (+83,700) and Western Australia (+76,300).

This is pretty much as expected while housing markets in the two most populous states remain so strong, although the population growth may tend to slow in those states when prices eventually reach a peak.

Population growth remained significantly weaker in South Australia (+15,300), Northern Territory (+4,300), the ACT (+5,900) and Tasmania (+1,200).

When considered on a percentage basis, Western Australia (+3.1%) remained by far and away the strongest state (click chart).


However, it is noteworthy that the rate of growth in WA has slowed somewhat from its peak (+3.7%), which is an expected effect of the mining construction boom passing its peak.

Queensland's percentage growth was also down a little due to net interstate migration, but this could equally turn out to be noise in the data.

Construction boom

I'm aware that people have suggested that Australia would not be able to stage a residential construction boom due to prohibitive land prices, but with dwelling prices now having experienced an uplift the stage is well set for precisely that.

Dwelling approvals are at decade highs and rising, and the significantly increasing levels of construction in Sydney are already easily visible.

In fact, at a conference in Hong Kong this week, the Reserve Bank Governor Glenn Stevens stated confidently: 

"We are going to have a boom in residential construction over the next couple of years. That is very much on track."

He appears most likely to be right, and while I'm aware that Sydney is not Australia, it's definitely underway here thanks to an uplift in dwelling prices and low interest rates.

While the value of residential construction in itself not remotely likely to plug the hole left by the mining construction boom, the combined effect of low interest rates, rising residential and commercial real estate construction, higher levels of services activity, strong retail sales and booming export volumes all look set to keep the economy ticking along.

The boom in Sydney's construction is already having a tasty impact on the local economy, with retail sales taking off and tax revenues to follow, while building materials companies are enjoying some time in the sun:


Captital city construction and new homes also need new infrastructure: hospitals, schools, shopping centres, cafes, restaurants, service stations and more, so the impact should on our major cities be multiplied over time.

The challenge facing Australia is to keep GDP per capita growing at a fair rate and not only real GDP.

---

As if to re-emphasise the point, I was out at Sydney's Olympic Park yesterday for the first time since the mighty Sydney Roosters won the NRL Premiership, and...yes, yet more construction. 

And more rain.




Thursday, 27 March 2014

Bingo!

Two days ago I blogged a post entitled "Stop the Moats" stating my prediction for what the newspapers would say about Tony Abbott bringing back Knighthoods and Dames.

Sydney Morning Herald article today:


And, for my next trick, Powerball numbers...

RBA sees financial stability

Comprehensive review

I've made the point a few times that when it comes to monetary policy and other regulatory actions it matters rather less what people say on chat forums and rather more what the Reserve Bank of Australia (RBA) and APRA say, since ultimately they are the bodies tasked with making the key decisions.

While plenty of people disagree with the RBA, a couple of hours spent reading yesterday's Financial Stability review should tell you how comprehensively the central bank assesses risk.

Fortunately, I spent the two hours so you don't have to.

The four points you're probably most interested in:

1- Banking sector

The Australian banking industry emerged from the financial crisis relatively unscathed, but events elsewhere showed that if ever there was a time to bolster capital requirements and shore up risk, it is surely now.

The RBA reported that the banking sector got stronger in 2013 - asset performance is improving and bad and doubtful debt charges declined.

Having increased from essentially nil in 2003, bank's non-performing loans are now declining as households enjoy very low interest rates.

Businesses too, are finding the terrain a little easier than they were during the financial crisis, and bank loan books look much healthier for that.




The non-performing share of banks’ domestic housing loan portfolios fell over the six months to December 2013, to 0.6% down from a peak of 0.9% in mid 2011, helped by low interest rates and tighter mortgage lending since 2008. 

The ratio of impaired housing loans has fallen recent quarters with rising dwelling prices helping banks to deal with their troubled assets and being able to report a reduction in mortgages-in-possession.

Those are the bare numbers, but a bit of context here might be helpful:


We have just been through the greatest financial crisis since the Great Depression, so non-performing loans of 0.6% is a very sound result.

2 - Lending standards and bank balance sheets

Low-doc lending continues to represent less than 1% of loan approvals, while the share of loan approvals with loan-to-valuation ratios (LVRs) greater than or equal to 90% has been fairly steady since 2011 at around 13%.

The share of banks’ funding sourced from domestic deposits has increased from about 40% in 2008  to around 57% currently.

That's a good thing.

Australia's major banks (classified by APRA as "D-SIBS) have bolstered their capital and funding structures since the financial crisis and are in fact already well-placed to meet APRA's more stringent Basel III capital requirements which will kick in in 2016.



A key point here:

Banks are generating imperiously strong, comfortably double-digit returns on equity (ROE) and colossal net profits after tax (e.g. even after tax Commbank cleared a net profit of $7.8 billion in their 2013 financial year - before tax the figure was closer to $11 billion).

Surely then, herein lies a golden opportunity to enforce the strengthening of capital ratios further through earnings retention, reducing dividend payments or scaling back share market purchases in order to offer dividend reinvestment plans (DRPs).

Of course, bank execs will want to continue chasing the golden egg of 15% ROEs through reinvestment and greater expansion of their loan books, but if our major lenders are to receive an implicit government guarantee then, stuff it, make them shore up their capital ratios, I say.

It would be better for everyone over the long term.

3 - Household finances

The overall financial position of the household sector was little changed in 2013 and indicators of financial stress remain low, reported the RBA.

Households continued to manage their finances with greater prudence than a decade ago, household wealth continued to increase, the saving ratio was within its range of recent years and, importantly, households continued to pay down mortgages much more quickly than required.

The household saving ratio remained within its range of recent years, at about 10%.




The proportion of disposable income required to meet interest payments on household debt has now stabilised over the past 6 months, having previously declined in line with the fall in mortgage interest rates in recent years. 

The good news is that households have used lower interest rates to continue paying down their mortgages much more quickly than required.

Remarkably, the aggregate mortgage buffer has risen to almost 15% of outstanding balances, which is equivalent to two full years of total scheduled repayments at current interest rates. 

The RBA notes that therefore households have considerable scope to continue to meet their debt obligations even in the event of temporary unemployment. 

Overall, aggregate indicators of financial stress remain low.

4 - Housing market

As for the housing market, the RBA noted that lending to self-managed super funds (SMSFs) is now being tightened up and remains only a small part of the market, as do purchases by non-residents.

Housing loan approvals are picking up across Australia, but are really firing in New South Wales (read Sydney).




The financial crisis seems to have scared households away from the share markets and towards housing according to surveys. Note how sentiment towards equities hit lows just when share market valuations became cheap and more attractive!

The RBA noted that "the pick-up in investor activity in the housing market does not appear to pose near-term risks to financial stability" but "developments will continue to be monitored closely for signs of excessive speculation and riskier lending practices."

The Reserve Bank is very keen to ensure that lending standards in Australia remain high.

Summary

There is much more besides which you can read here, but that is the flavour of the report.

Lending standards will be monitored but on the face of it the RBA appears to be more focused on aggregate loan impairments and indicators of financial stress than dwelling prices. 

Wednesday, 26 March 2014

London housing market breaking records

The Office of National Statistics released the latest housing market data for the UK here.

Daily Mail almost averaging one article a day on this now.

House prices grew +7.1% y/y in England, +6.9% in Wales, 1.4% in Scotland and +2.7 in Northern Ireland.


The average UK house price hit £254,000 in January, while prices in London topped £450,000

Long-time readers of this blog won't be remotely surprised to hear that (a) UK average house prices are making new all-time highs, and (b) it's London (+13.2% y/y) and the south-east of England (+7.1% y/y) that are driving the gains.

London is powering ahead of the rest of the country, with prices up 13.2 per cent in a year

Gross mortgage borrowing of £11.5 billion was a stonking 47% higher than the same month last year, and the highest level of lending recorded since 2008.

Given the UK's penchant for boom/bust cycles, there are to be no prizes for guessing what happens next: a continued substantial run-up in housing valuations.

House prices are now well above the pre-crash peak, raising fears of a new bubble

March 2014: the biggest month Australian property history?

Goodness, a bold question indeed for a Wednesday arvo.

Whether or not there is any, erm, value, in the concept of daily property values, RP Data's Daily Home Value Index undeniably creates a great deal of opportunity for nerds to play around with charts, and I, for one, am grateful for that.

Until just a couple of days ago the RP Data index was showing national property price gains for March of a staggering 2.3% which, if it were to be sustained, would represent the greatest monthly gain on record for RP Data in Australian capital cities, representing further validation that monetary policy works on dwelling prices.

Over the past year, the home values by city, have increased by 10.51% (click chart).


This is probably easier to see in a bar chart of year-on-year price growth by city (click chart).


Brisbane and Adelaide are now showing some gains in 2014 but, perhaps unsurprisingly, it is Sydney and Melbourne that are really driving values higher.

From what I've heard from Queenslanders who are in the market it appears likely that Brisbane will begin to show some decent gains in the near future.

For 2014 year to date, Sydney prices are up by 3.74% and up by 2.13% in March so far alone.


Meanwhile Melbourne's chart finally seems to have moderated a little, but even so, prices are up by an outlandish 5.67% in 2014 and are still up by some 2.54% in the month of March so far.


Viewpoint?

Is this all important?

Well, I'm not a huge believer in the idea of daily home values due to the obvious limitations on capturing and processing data, but these figures are certainly important in one sense.

If nothing else, the headlines that record or near-record monthly price gains will  doubtless generate and which will be reported next week can themselves fuel a herd mentality.

Moreover, history has shown that where asset markets get away from central banks they can take on something of a life of their own.

The Reserve Bank will be watching all this with great care, of course.

Indeed, the RBA talked a lot about housing today, it's confidence instrumental in sending the dollar all the way up to a 4 month high of 92 cents.

I'll cover off why they seem so relaxed tomorrow, but I think that we can reasonably expect there to be more talk of macro-prudential measures to cool speculation in the market in the absence of actual interest rate hikes in the near future.

Also tomorrow, the ABS releases its demographic statistics for the September 2013 quarter.

Never a dull moment!

US consumer confidence highest in 6 years

Global news has been a bit mixed of late, but here's some good stuff: 

The level of US consumer confidence has hit its highest level since more than 6 years ago when the global financial crisis was just beginning.

The Consumer Board's confidence index hit a reading of 82.3 up from 78.3 last month.

That's the best reading since all the way back in January 2008.

This is very important, since, after all, in a consumer economy like the US, consumer spending ultimately accounts for about 70% of all economic activity.

US employment increased by 175,000 in February as well - great news, there is nothing better than seeing jobs created.

Aussie share markets will probably follow Wall Street a bit higher. 

Lower north shore lift-off

Aha yes, very timely.

As I noted yesterday, our property pick for this year in late 2013 included a few key suburbs with great transport links on Sydney's lower north shore.

I covered off the reasons why we favour the lower north shore here, and added some more detailed thoughts in our summer edition of the Buyers Eye here.

Weekend results

From APM's weekend wrap:

"The hot Sydney weekend auction market continued on its merry way at the weekend recording its eighth consecutive clearance rate above the 80 percent. 

Clearance rates have been remarkably consistent over the past month fluctuating between these weekends’s 81.5 percent and the months high of 82.7 percent recorded on March 1st.

Vendors are keen to take advantage of Sydney’s best ever autumn selling conditions with strong competition for properties amongst buyers in most region and prices brackets."
Lower north firing
The lower north shore is really getting going now. Continues APM:
"After a quieter weekend last weekend the lower north bounced back this weekend with a stunning clearance rate of 92.5 percent.  
Next best was the city and east with 89.7 percent followed by the inner west with 86.8 percent, the south 83.7 percent, the south west 82.4 percent and the upper north shore and the northern beaches each with a clearance rate of 80 percent."
Wrap
And, APM wraps it up:
"Sydney’s super autumn home auction market continues unabated with frenzied activity from buyers and sellers set to continue over the next three weekends to the Easter break. 

Next weekend is likely to present the market with its biggest test for year so far with nearly 800 properties due to go under the hammer. The pre-Easter rush is on."

What if inflation takes off - stocks or property?

Moderation

I noted the other day that we are living through a period of low interest rates, and in some countries at least, relatively low inflation (click chart).


Let's have some fun today considering what might happen if inflation takes off, and how that might impact investors.

Stocks

Conventional wisdom says that stocks are a good hedge against inflation, since the investor continues to own a part claim on the assets of the company, and over the long term this may indeed be true if you are owning shares in outstanding companies.

There is no escaping however, that a jump in inflation can eat away at the dollar value of dividends.

Buffett would always say you should try thinking of stocks in the same way as you would a bond: you buy the investment to receive a "coupon" (dividends), but you also hope that a quality company will increase its earnings and therefore market capitalisation or valuation over time. 

Even though that "coupon" from the company is not fixed since company earnings tend to gyrate, over time the returns on equity in the market may be more consistent than you might expect.

Of course, stocks are quite different from bonds in lots of ways.

For one, thing companies and stocks are perpetual while bonds eventually fall due and can be renegotiated, and thus stockholders are kind of stuck with corporate returns. In that sense, stocks are considered to be riskier. 

There are other differences too, in particular the vast swathes of traders and speculators in the stock markets who, in aggregate, don't achieve a great deal except for making brokers happy through transaction costs.

Can companies increase returns in times of higher inflation?

Well, let's think about it logically. If I remember what I learned accountancy college correctly (by no means a given) there are basically five ways in which companies can increase their returns, those being:

1 - Boosting the turnover ratio?

Turnover may increase with inflation, but can it increase in relation to the assets employed by the business?

Hmm, not so sure about that. 

Receivables (what we used to call debtors), for example, just tend to increase in proportion to sales. 

I suppose turnover could increase over the short term in relation to the company's fixed asset base if the assets are being replaced slowly, but the impact of this is likely to be muted, and over the long term companies will probably have to replace their property, plant and equipment at higher prices anyway.

As for turnover in relation to stocks or inventories, this relationship can tend to jump around a bit depending on what's actually happening in the business, such as supply bottlenecks and so on.

Over the decades the beancounters have used accounting trickery such as last in first out accounting (LIFO) to reduce corporate earnings and therefore tax payments. But over time, there is unlikely to be much of an improvement here either.

So, what about...

2 - Improving profit margins?

If you're an optimist you might argue that in times of inflation companies can improve margins by simply increasing sales prices ahead of costs. 

Yeah, well...maybe.

Ultimately, though, there are only 100 cents in the sales dollar, and company costs - which include the cost of sales or raw materials, staff wages, utility bills or energy costs, and admin expenses - are most likely heading north too.

Moving down the income statement...

3 - Cheaper debt or leverage?

Lower interest expenses might improve returns? Pretty unlikely. If inflation goes up, interest rates probably will too. 

Racing inflation tends to cause companies to require stacks of capital to keep a business galloping along, but lenders tend to become less trusting in long-term borrowings and thus the cost of debt will more likely be higher.

4 - Using more leverage?

A possible option, but more leverage tends to equivalently increase company-specific risk, and lower credit ratings can also see the cost of debt increase.

5 - Lower corporation taxes?

Well, we live in hope. Never say never, but I wouldn't bank on it.

The problem with stocks and inflation

Considering all of the above, it seems likely that higher inflation may not necessarily afford companies the opportunity to increase corporate returns, and this can present a bit of a problem.

If a company makes a return of, say, 10%, pays out 5% as a dividend (effectively taxed by inflation as well as income taxes in the hands of the investor) and 5% is reinvested in the business in times of higher costs...the impact of higher inflation now seems less than rosy for the world of stocks.

In any case, this is all working on the basic assumption that you are buying shares at the equivalent of book value, which in most markets is not possible, so this is a consideration for future shareholder returns too.

Over-arching all of this is that if inflation spikes then interest rates will likely also increase, and the perceived higher risk of shares is likely to see investors bombing for the exits in order to seek safer returns from bonds or fixed interest investments (which would now be generating more attractive returns due to the higher interest rates).

Of course, in aggregate, investors can't all exit the stock market at once, so the likely result is transaction costs as investors turn over their portfolios more frenetically, and much lower stock valuations all round.

This is why the best bet for most average investors can often be to try to think as stocks as being more like a bond, and continue to receive those increasing "coupons" (dividends) over time, worrying less about trying to jump in and out of the market ahead of the herd.

Real estate as an inflation hedge?

Conventional wisdom also tells us that property is a great hedge against inflation.

It's true that inflation reduces the value of mortgage debt. What is inflation, after all, if a transfer of wealth from creditors to borrowers?

And, over time, inflation might see wages increase which can eventually push property prices higher. 

All very neat, and a win-win for property then?

Well, maybe, but it's not really that simple at all. 

As noted before, if inflation goes up, then so too will interest rates, and this may impact property prices adversely due to reduced demand, particularly where real estate valuations are already considered to be high.

And, of course, when you eventually come to liquidate your investment, you'll find that the cost of living is much more expensive thanks to the silent thief of inflation.

This, incidentally, is why many investors in remote locations don't experience the level of success that they might feel they have: if the rate of property appreciation doesn't beat the inflation rate, then the returns will necessarily be stunted.

In fact, if you start playing around with a few numbers in a model which variously considers possible rates of inflation, interest rates and expected capital growth outcomes (I wrote a short piece about this topic here), you'll often find that the internal rate of return (IRR) on property as an investment doesn't change very much at all, regardless of what the inflation rate is doing. 

In summary, higher inflation would surely inflate away the value of debt, but you'll likely be clobbered with higher interest rates, and your money will be worth less when you liquidate.

The implication of this, then, is that the specific choice of asset is vital in determining returns.

Simply put, you need to find a property investment which increases in value (or price) ahead of the inflation rate if you want to get ahead.

Summary

It's far from all bad news, however.

Just flicking back through what I've covered above, it seems to me that most investors in shares and property should probably hope for a bit of inflation, but not too much. Moderation is best.

The good news is that over the past two decades the Reserve Bank has introduced an inflation target and has largely been achieving this with the odd blip, and interest rates have not been very high for a couple of decades either.

So, try to remember all this when the first interest rate hike inevitably comes. 

Rather than groaning, remember that the RBA targets inflation and price stability for a good reason, and one which ultimately is for our own good!

Monday, 24 March 2014

6 places to invest money and 4 rules for doing so

You can't escape gravity

In economics, interest rates act a little like gravity.

Any changes in interest rates, anywhere in the world, changes the value of financial assets.

Of course, this is blindingly obvious when you are looking at bond prices shifting, but the rule also applies to all other classes of financial assets, including equities, farmland, commercial and residential real estate or commodities.

Simply put, if interest rates are at 10% then the present value of each dollar you receive on any investment is much lower than when interest rates are at 2.50%.

Evidence?

Interest rates impact financial markets.

Famously, Warren Buffett, who knows a thing or two about investment markets, provided the empirical evidence for this in a speech in 2001.

He noted that in the 17 years between December 1964 and December 1981, the US Gross National Product (GNP) increased by a whopping 373%, yet the Dow Jones index essentially went absolutely nowhere, from 874.12 to 875.00.

A major driver for this was that long-term bond rates ran from 4.20% in 1964 to an eye-watering 13.65% by 1981.

In the next 17 years from December 1981 to December 1998, GNP in the US only increased by less than half as much at 177%, yet the Dow Jones went on a bonanza run from 875 to 9,181.43, a truly staggering increase.

Why? Largely because interest rates altered the landscape for financial assets by falling from 13.65% to 5.09%, and this changed the way people invested their money.

We're seeing it happen again now, with rock bottom interest rates in the US firing the Dow from below 7,000 to well above 16,000 since the financial crisis.

Given that investors must contend with inflation, and with interest rates at rock bottom, bonds and fixed interest investments have about-faced as an investment choice from offering "risk free return" to practically guaranteeing "return free risk".

A decade of low rates

You didn't have to be a genius, then, to work out that very low interest rates across the globe would cause a shift in the way people invest their money.

Below I've charted the rates trend in Australia, the US, the United Kingdom, the Eurozone and Japan from 1990 until today (click chart).


The thing about money is that there is an awful lot of it around the world and all of it has to find a home. 

Here are the six of the main places people might choose to put their money.

1 - Cash/fixed interest

Lending investments range all the way from cash in your bank account, to term deposits, government bonds, inflation-linked bonds, corporate bonds, notes, debentures, or hybrid investments, subordinated debt, and a stack of other stuff. 

The basic principle is that the lending of money is exchanged for interest payments.

Clearly with interest rates at historic lows, fixed interest returns are presently very low. High yields are generally only obtained from low grade or perceived riskier investments.

As a result, lending investments are far less popular than they have been and this is seeing a huge shift of global capital towards other asset classes, in particular...

2 - Equities

When my first book Get a Financial Grip was published, I put forward the opinion that if financial freedom is your goal, then the best means of achieving it for the average investor in Australla could be (1) to get broad exposure to (certain suburbs of) Sydney real estate for the long term, (2) to continue building a diversified portfolio of dividend-paying equities, and (3) keep a very healthy cash buffer.

For long-term investors, assets which bring income and the potential for capital growth tend to beat the cash/fixed interest investments. 

Buffett stated that only certain asset classes fulfil these criteria from his perspective: profitable businesses, equities and real estate.

I noted that my suggestions were particularly so given the low interest rate environment (which would likely see funds flowing away from cash and fixed interest and into share markets).

Low interest rates have been very kind to share markets in Australia of late, while investors continue to derive annual benefit from tax-favoured dividends which come with franking credits attached.


Source: ASX

3 - Real estate

Even last year people were still arguing that Australia's housing markets aren't interest rate sensitive.

Remember, though, that all financial assets are in some way sensitive to interest rates.

Questioning of the effectiveness of monetary policy tends to be a part of every economic cycle, of course, but monetary policy generally does work and, like all financial assets, housing markets are ultimately responsive to changes in the cost of capital.

What may have wrong-footed commentators was that there tends to be a lag in effect, with the full impact of interest rate cuts on occasion taking up to 18 months to be seen in full. 

A dramatic turnaround in the tenor of online comments from schadenfreude to snarky has been a fairly reliable indicator of the property markets having moved into a new phase.

The chart below shows what has happened since the most recent trough in mid-2012 which includes a very strong rebound in Sydney and Melbourne (click chart).


4 - Commodities

The most popular for average investors are gold and silver, which don't pay yield but can represent a hedge with a portion of a portfolio. 

It's been a rollercoaster ride for the precious metals over the last year or two. 

Who knows where to next?


Buffett sees gold as a barren asset, since it pays no income or yield. 

In 2011, he drew the analogy that the world's gold stock of 170,000 tons (about 68 square feet) had as great a total valuation at $9.6 trillion or $1,750/oz of all the cropland in the US, plus 16 Exxon Mobils (the world's most profitable company in 2011, generating net profits of $40 billion annually) and around $1 trillion of walking around money. 

When put in those terms, of course, Buffett explains that the choice is a no-brainer, since farmland will continue to produce income and growth over the decades. 

The price of gold tends to peak at times of fear and so can represent a worthwhile hedge for some investors with part of their portfolio. 

Buffett's main gripe is that if you hold a bar of gold for 50 years, at the end of the process you still have that same gold bar, and it still pays no income. Thus, he argues you are hoping for more speculators to push up the price in times of fear.

5 - Collectables

Investing in collectables such as art or antique coins tends to be handy...for experts.

6 - Get rich quick schemes

There have been a lot of these over the years, from pyramid schemes to exotic new diamond mines and emu farms. 

Get rich quick schemes tend to be very suitable for people who have some money and want to rid themselves of it quickly.

4 rules for investing

Rule 1 - Diversify

Don't put all your eggs in one basket - you should have your business, property, shares and cash.

It's easy enough to get diversification in the share markets through using Listed Investment Companies (LICs) or index funds, but one of the problems with real estate is that the leverage involved sees you quickly gain exposure to only a handful of correlated assets in one asset class.

For this reason, while it's not for everyone, I invest heavily in UK property too.

The beacon of truth that is the Daily Mail reported over the weekend that house prices in Britain had increased by as much as £50,000 to £100,000 in only one month, particularly in London and the south-east.

While I certainly don't make a habit of believing everything I read in the Daily Mail, as an active participant in the London market, I can tell you that well-located and in demand property may easily have seen a 5-10% price uplift in recent months. 

In a separate article, the Mail also reported that a surge of investors using their savings and retirement funds could push UK house prices up by 30%. Why? Because the UK's zero interest rate policy (ZIRP) has crucified the value of annuities. 

Just like gravity, you can't get away from interest rates.

Rule 2 - Investment is not about luck

Successful investment is not about luck. It is about patience and discipline. 

Rule 3 - Markets are cyclical

In every cycle, people argue that this time will be different. But corrections follow booms and markets slump before booming again. Cycles continue. 

Investors need to have an awareness of whether asset prices are near their peak or nadir and plan accordingly.

Rule 4 - No free lunches

Very high returns tend to be achieved only through riskier ventures. If something sounds too good to be true, it probably is. 

This is true in bonds where high yields often come with a high risk. In equities, the opportunity for doubling your money quickly tends to come with an equivalent chance of halving it (or worse). 

And high yields in residential real estate are frequently found in areas of lower demand.

When it comes to property, my view has always been while you may certainly start small, you ultimately need to play in a big pond. 

Just like Buffett's point on barren assets - if you invest in a cheap property in a cheap location, then at the end of the process you will still have a cheap property in a cheap location, and the returns adjusted for inflation will likely be lacklustre. 

On the flip side, I know of Aussies who invested in London's Mayfair years ago who have achieved returns that are almost beyond belief - both in terms of capital growth and in terms of income. 

See how much a 2 bedroom apartment might let for in W1 today and you'll get an idea of why property in high demand areas tends to outperform massively over the long term. 

That's why I've tended to look for properties with an 'X factor' that will be in demand for decades to come, such as properties close to the City of London, or in Australia located in Bondi, or on the Sydney harbourside. 

Cheap regional properties can perform reasonably well over short periods of time, but over the long term well-loated capital cit properties outperform.

Sunday, 23 March 2014

Sirius to be sold

Was down the harbour today for a coffee at the Opera Cafe and thought I'd grab a quick snap one of Sydney's most famous eyesores (Sirius) since it's about to be sold off.


The sale of 300 social housing dwellings is to raise hundred of millions of dollars. Sydney Morning Herald reports here.

Prime position: Housing commission flats in The Rocks.

Photo: Fairfax Media

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For this weekend's $11 movie at Broadway, I watched George Clooney's Monuments Men. Not bad and mostly fairly entertaining. 6/10.

Tumbalong

Indian food festival this weekend. Yes please.


9 reasons developer costs jumped...and what they're planning to do about it

Rising construction costs

Last year, the Reserve Bank of Australia (RBA) released independent analysis which determined that the overwhelming share of costs relating to greenfield and particularly infill property development sites relate to construction and financing rather than the respective land value per dwelling.


As you'd expect, rising land values have certainly played a part in increasing dwelling prices as the capital city populations increase rapidly. But in mature capital cities elevated developer construction costs on infill sites have contributed disproportionately to the expensive nature of new multistorey apartment developments, as the RBA's research concluded:

"If land availability were the problem, we'd expect land costs to dominate the costs of producing a new home at the city fringe. But that's not what we see. Neither do government charges dominate total costs. Rather, it turns out that construction costs are the largest contributor to the total costs of production, and they seem quite high compared with the total cost of a newly built home in some other developed countries."

Today, I'll consider in some detail why that has happened, but will also explore what Australia's major developers are now planning to do in order to combat expensive construction costs.

Supply response

I put forward the opinion some years ago when Australia's residential property markets were soft that I did not believe that dwelling prices would continue to fall over a prolonged period of time in a mature capital city with booming population growth such as Sydney, since housing supply would collapse until such point in time when upwards pressure returned on dwelling prices. 

The clearest evidence in support of this is how quickly and dramatically dwelling approvals dived in the New South Wales capital after dwelling prices peaked in early 2004. 

It is important to recognise that the executives of Australia's major property development companies are responsible for representing shareholder interests and thus where developments can be completed profitably, so they will be. 

From 2005-2011, however, unit dwelling approvals in Sydney essentially died a death despite the rapid growth in the city's population. 


Source: RP Data

In this context, it was critical that dwelling prices rose in order to stimulate supply, and with median prices having jumped by more than 20% in Sydney since 2012 in concert with a material easing in financing costs, this has resulted in a strong supply response presently unfolding, which is clearly visible across the harbour city. 

This will please the Reserve Bank, since last year it mused:

"It takes longer to build a block of apartments on a brownfield site than the same number of dwellings as detached houses at the fringe. Dwelling investment has already become less cyclical in the past 10 years than it was in the previous 20 years. It might well be that construction lags – and concerns about supply – will become even more acute."

Developer gouging?

Contrary to what some folk believe, there is scant evidence of price gouging by developers. If there was then this would very quickly show itself in the reams of publicly available information of the major development companies available on our securities exchange.

This is important, since tight profit margins add weight to the argument that a prolonged easing in prices would quickly kill off supply.

The large Mirvac (ASX: MGR) property group has a ROIC hitting at ~10%, and its residential developments have been recording extremely weak average gross margins of only 18%. 

You certainly don't require a master's degree in accounting to know that there is not a shred of evidence of price gouging on residential developments happening there.


Land developer Stockland's (SGP) underlying profit in FY13 was hampered by weak housing conditions, with that financial period encompassing the period from 1 July 2012 when sentiment was still in the process of picking up. 


Stockland's Australian residential development division secured an operating profit of only $60m in FY13 due to what the company termed "the prolonged downturn in the Australian residential land market" (Source: Stockland Annual Report 2013) recording an EBIT of  only 19.9% and a ROA of just 5.5%. 


The residential results of Stockland had been propped up in FY12 by sales in Victoria where a very strong uplift in Melbourne dwelling prices from 2006 resulted in respectable margins to the company's residential division. 


Meanwhile Lend Lease's (LLC) Australian geographical segment is recording EBITDA of only $500-$600m and NPAT of around only $400-$500m from colossal annual revenue streams of  $7.5 billion+. 


However, Lend Lease's FY14 H1 results for its Australian geographical segment have disappointed as development and construction profits have once again slipped.


One could continue analysing developer's financial data until kingdom come, but the conclusions would remain the same. Developers are making satisfactory margins in the current environment - particularly now that prices have picked up and financing costs been cut to near record lows - but no more than that. 

The implication of that is this in the face of a drawn out downturn in dwelling prices (or significant rises in the cost of financing) multistorey apartment construction would quickly dry up.

9 reasons construction costs have increased (and what developers plan to do about it)

Construction costs have leapt dramatically in Australia over the years. I could list 90 reasons why this has been the case, but here are just 9 of them:

1 - Good and Sales Tax (GST)

The GST value added tax of 10% was introduced in Australia on 1 July 2000, and since "developers are price takers not price makers", the additional GST costs levied on materials, insurance, consultancy fees...in fact, practically everything...were duly passed on to the end consumer, a once-off increase in dwelling prices

2 - Land remediation

It's important to note than rising developer costs are not merely related to the cost of materials - the relatively shallow increase in the cost of project homes is proof enough of that. Moreover, reflective of what we have seen in London and elsewhere, as our cities mature the cost of preparing infill or brownfield sites for construction and subsequently developing them has escalated. 

Challenges facing developers today's infill and brownfield sites include anything from heavy metal or lead contamination, to pesticides, hydrocarbon spillages, the removal of asbestos...even uranium contamination on Sydney's north shore. 

One could perm any one of a thousand examples, but let's take the new Barangaroo South project as a case study for today. 

The main sources of contamination on the Barangaroo site are waste tar and underground structures including gas tanks (due to the Hungry Mile area being the former home of the famous Millers Point gasworks), not to mention the unwelcome presence of "polycyclic aromatic hydrocarbons (PAHs); benzene, toluene, ethylbenzene and xylenes (BTEX); total petroleum hydrocarbons (TPHs); ammonia; phenol and cyanide.". 

The city desperately needs more major developments to come online, yet there will be "no cost to taxpayers for remediation. Barangaroo South developer payments will cover any state liability for remediation.". 

Although the figure won't require disclosure, you can read this as meaning that Lend Lease will be required to pay very substantial fees to the government. Who'd be a developer?

3 - Environmental ratings

In 2003, the Green Building Council of Australia introduced its environmental rating system for buildings in Australia. 

Lend Lease's new Barangaroo South project will be awarded a full 6 Star Green Rating: it will have lower greenhouse emissions, use significantly less potable water, far less electricity and will recycle almost 100% of its construction demolition waste. 

All incontrovertibly great news for the environment. And expensive. 

4 - Durability and sustainability

Today's developments must be durable. To again perm one of a thousand examples, typically in Millers Point developments are of high density and retain storm drainage facilities built to withstand only a 1 in 5 year event. 

Approval for Barangaroo, on the other hand, was dependent on the provision of a wide area public space in the guise of a headland park, to be developed with the site requiring stringent drainage and other durability requirements of 100 years.

The benefits will surely be realised over the long term, but in the short term this comes with a cost premium attached.

5 - Insurance, health and safety, training

In today's increasingly litigious society insurance premiums continue to increase, but disproportionately so in the world of construction.

Actuarial calculations of employment risk unsurprisingly showed that construction worker compensation have increased more quickly than industry norms. Consequently, construction premiums jumped yet again in July 2013.

The costs of health and safety compliance and training for Australian construction firms have also increased dramatically, which is perhaps not altogether unexpected given where construction workers and tradespeople tend to feature on the lists of serious incident claims.




6 - Design

Almost everything about today's project design has become more expensive, from complex planning, architect and legal fees, to expensive European kitchen appliances, stylish bathrooms or marble kitchen surfaces.

Consumers have been willing to pay top dollar for new developments, but they fully expect and demand quality products to be shipped in in return. 

It's not only consumers that are more demanding today. Approvals tend to come with challenging hurdles attached. 

In the case of Barangaroo, for example, Lend Lease is accountable for the designing of an Integrated Travel Demand Management Plan and the Design of a Transport Square. 

An entire new ferry wharf has been planned for the suburb by Lend Lease, and a City Walk bridge is to be constructed, also by the developer.

More than this, if you've ever seen the basement area of a major new development under construction, you'll be familiar with the tremendously sophisticated and technological nature of today's developments.  

Lest there was any doubt about the complexity of today's major developments, the Barangaroo project team was compelled to construct a prototype tower in western Sydney as a practice or dry run before commencing work on the structures proper. 

Leveraged developers operating on tight margins cannot afford unforeseen delays or to make costly mistakes and therefore plans are carried out in meticulous detail. 

7 - Marketing costs

Architects prepare magnificent three dimensional designs for new projects today, which can subsequently be used in sophisticated and compelling marketing campaigns by developers in order to secure offshore sales. 

8 - Key worker and affordable housing requirements

New development approvals today tend to require considerable key worker and/or affordable housing components which are likely to be provided at a net loss for the developer. 

In Barangaroo South's case, 2.3% of the housing must be sold at a significant discount for key worker housing, adversely impacting project returns.

9 - Community requirements during the construction process

More stringent than they used to be, requiring that construction activity may only take place between agreed upon times, with disruption from heavy plant to be minimised for the benefit of local residents. 

I could go on, but I think that will suffice for now...

Not all doom and gloom?

Does this mean we are doomed to ever-more expensive construction techniques which outpace inflation as wages and associated costs increase in perpetuity? No, not necessarily so.

Remember, developers and their management teams are incentivised to maximise shareholder returns, and thus are duly motivated to seek out cost savings (this is already underway through the subtle, gradual reduction of average plot and dwelling sizes) and efficiencies from the development and construction process. 

An example of changes me might see? 

Although many of us associate the hyphenated words "pre-fabricated" with cheap post-War housing, the future of Australian construction appears likely to lie in a process that is not dissimilar.

Due to our extreme climate and relatively small population (and equivalently small average development sizes), and thus also due to a lack of economies of scale, Australia has been slow to embrace the concept of pre-fabricated construction on its major developments. 

However, Australia's largest developers, including Lend Lease, are now actively looking towards pre-fab as a key growth sector within the construction industry and one which may assist developers in bringing average construction cost per multi-unit dwelling under control. 


Acceptance of pre-fab techniques on standalone dwellings is understandably likely to be a slow burn, but on some multistorey apartment developments - with appropriately detailed ple-planning - the use of pre-cast concrete may afford the opportunity to shave 5-10% from the real cost of conventional construction techniques, presenting potential advantages in terms of time, cost and quality. 

However, it is unrealistic to expect that developers will simply pass on any savings or cheaper costs of construction to the end user, being motivated by maximising return on investment as they are so compelled to be.

More realistically, efficiencies in construction would initially manifest themselves in improved developer margins and thereafter in more competitive tender processes. 

In other words, as price takers not price makers, competing developers may slow the increase in the prices of new multistorey apartment dwellings over time, rather than reducing sticker prices.

Implications for affordability

In terms of providing more affordable housing supply, the RBA's research implies that this may be achieved to some extent in outer suburbs by forcing the release of more land in order to bring average and median lot prices down. 

In inner suburbs, however, the combined costs of land remediation, development and construction present major obstacles to providing cheaper supply, although in theory of course building more supply in aggregate may ultimately help to ease the pressure on inner ring prices. 

If I sound sceptical, it's because in my experience most Sydneysiders appear to have a diminished interest in living in outer capital city suburbs, variously due to to poor transport links, diabolical city traffic, inferior infrastructure, a desire to be located close to work and the coast, and near to friends, among a whole host of other reasons.