Rate of increase in Melbourne rental levels likely to be much higher in second half of 2020

In May of 2019 we called the bottom of the sales market – subsequent events have shown this to be a good call.

It is our view now that vacancy rates will fall and rentals will rise faster than they have been in the second half of 2020.

Why do we have this view:

Demand growth continues unabated

On the demand side of the market Melbourne’s population growth continues to lead the nation. The latest available data from the Australian Bureau of Statistics has the Victorian population growth rate at 2.1% per annum or 132,800 – predominantly in Melbourne.

The ABS predicts that population growth in Melbourne equates to a demand for an additional 40-44,000 premises per annum.

The rate of additions to supply is likely to fall

 

In the September, quarter dwelling unit (houses and apartments) commencements declined 11.7% on the quarter prior, and 27.2% on the year prior. As there is about a nine month average from commencement to availability this will begin to show in a decline in new stock for lease from around the middle of the year.

 

The balance between supply and demand is quite tight

 

The vacancy rate in Melbourne was 2.5% in December 2019 so quite a small change in the rate of growth in supply can quickly translate into a shortage of available capacity.

 

With a shortage of available stock landlords will be in a strong position to seek and obtain higher rental increases later this calendar year.

 

What is causing this slowing in growth on the supply side?

 

Projects need finance

 

Project developers typically borrow as much of the capital required for a project as they can.

 

Historic financing arrangements

 

For many years the finance available was to a significant extent a function of the pre-sales the developer secured for the product once completed.

 

These sales were contracted and secured by significant deposits paid by the purchasers.

With a substantial portion of the project pre-sold the developer could obtain finance for around 60% of project cost from a major bank and a further 15% from a non-bank or mezzanine financier leaving the developer to put up 25% of project cost in equity.

Changes to the financing environment

Multiple factors have combined to reduce the pre-sales developers are able to achieve including:

  1. Stamp duty concessions for off the plan sales have been significantly reduced – meaning the advantage available from buying off the plan has been reduced or eliminated for many buyers
  2. There is reduced confidence amongst buyers that there will be an immediate profit available from reselling soon after completion as the property market’s long bull run reversed
  3. There is reduced confidence amongst buyers that developers will actually finish projects so they are more reluctant to put down deposits
  4. There is reduced confidence amongst buyers that banks will lend them the amount they had previously assumed or at all at settlement to enable them to complete the purchase

All of these factors combined mean that developers have much lower levels of pre-sales.

Combine this with the banking environment post the Banking Royal Commission and many developers are finding bank finance either unavailable or available to finance a much smaller proportion of the project.

Some of the non-bank financiers are prepared to partly fill the void by offering senior finance rather than mezzanine finance. This comes, however, at a higher interest rate than through a bank and with a loan volume more like the banks were previously lending – say 60% of project cost.

Impact on construction volumes

So developers need to be able to finance more like 40% of the project in equity than the 25% they were historically needing to provide. So the same dollar amount of developer equity will only enable 5/8ths as much building to be carried on as in the previously prevailing environment – that is a 37.5% reduction.

Apart from the increased equity required the higher cost of the finance available pushes some marginal projects into uneconomic territory meaning they will not be developed.

These factors together are resulting in the much reduced building start rates we are now seeing.

Which leads us back to a likely shortage in supply and increased rentals being likely later this year.