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The rise and rise of new Melbourne units has continued unabated for the best part of five years but now that it’s valuation time, many aren’t stacking up price-wise.

Developers seem to have a habit of getting over-excited and pushing out unit product until the market is saturated and suffers price falls. It’s happened before in Melbourne and it will happen again but the big difference today is that many of the overseas buyers have reportedly done a disappearing act on their contracts.

The cycle

The experts agree that there’s nothing overly unusual about what’s happening in Melbourne’s off-the-plan market at the moment – albeit with the new variable of foreign investors.

Melbourne-based chair of the Property Investment Professionals of Australia (PIPA) Ben Kingsley has been watching the booming new unit sector and waiting for the inevitable slide because he’s seen it before.

“It’s not uncommon for this to be occurring at the top of the cycle. If we look at historical cycles, where we’ve seen significant price growth, which then leads to lots of pre-approval, building, getting the critical pre-sales, to get them under way in a moving market,” he says.

But with reports of valuations regularly coming in 20 per cent under contract price, it’s clear that some buyers have bought into an unrealistically upbeat market.

“In general, it’s something that can probably happen about 10 per cent of the time where people have been sold into an artificially inflated valuation,” he says.

“That would happen in a balanced market but now we’re starting to seeing up to 50 per cent, so this is a real indicator that these developers have taken advantages of market conditions to believe that their properties what they’re worth but the valuers acting on behalf of the banks are being more conservative around that and that’s why we’re seeing these results starting to come through.”

A similar thing happened in Docklands in Melbourne about 20 years ago and in that circumstance investors had to wait years to achieve any capital growth. Today, however, they’re probably the pretty happy owners of a desirable piece of real estate that has matured nicely over the years.

But it’s important for investors to understand, Metropole Property Strategists’ Michael Yardney says, that the off-the-plan sector in Melbourne is not the full story of the market.

The established house sector is performing well and our second largest city continues to attract strong population growth.

The issue with new unit development, he says, has always been the length of time it takes for the projects to be completed.

“Let’s be clear: it’s a submarket,” he says.

“Every time, eventually, the market catches up. This is the pendulum over-swinging and it’s related, in part, to the fact that these bigger projects have a five-year life.

“It’s often two or three years to get development approval, and a couple of years for construction, and that’s the reason why it was a good idea at the time but a lot of other people had the same good idea.”

Valuation woe

There are rumours circulating amongst Melbourne’s property people that up to 50 per cent all new units are not achieving valuations that match their original contract prices.

What this means is that many investors – both local and foreign – are having to tip in more of their cash to settle or some are even forfeiting their deposits altogether and walking away.

Such a strategy, however, may not always work as investors do still have a legal responsibility to settle and some cash-strapped developers may take action to recover any other costs, including if they have to on-sell the unit for a lower price than what was originally agreed.

Herron Todd White Melbourne managing director Tony Kelly spoke to API and admitted that valuations were coming in lower but that it’s nothing new. It’s been happening for a few years, he says.

“Valuations have been coming in under contract prices for the last four years. That hasn’t changed,” he says.

Valuations has been coming in under contract prices for the last four years

“The banks are asking us: ‘What price can you get for it in the secondary market when your Ray Whites go and sell it?’ and it’s a different number and the evidence shows that there’s that discount being applied and that discount is becoming a little bit more evident and a little bit deeper.”

Kelly says that the new unit market has been “unnatural” for a while now because of the additional influence of foreign investors. Developers have been creating and promoting product for overseas buyers because they understand that demand remains strong offshore.

And even though Australia banks have tightened up their lending criteria for foreign and local investors of off-the-plan units, he says that the majority have still been settling. That may be about to change, however.

“They’ve hardly ever fallen over. It just means that the foreigners…they just don’t care because they still see it as getting the money out of the country and that’s a lot safer that leaving it in the country,” he says.

“We’re definitely hearing and seeing that settlement dates have been pushed out… Developers are happy to give them longer and longer to settle as they see it as a better outcome than having to try to put product back on the market.

“They’re better off to persist with someone they’ve got on the line rather than take the risk of going back into the market. They’re giving them more and more time to find the money.”

Offshore impact

The unusually strong demand from foreign investors means that the final outcome is difficult to call.

What is likely to happen, if overseas investors don’t settle and do simply disappear, is that the local inner-city new unit market will be even more exposed than it needed to be.

Eventually, the supply will be soaked up by local investors, but that could take quite a while.

And that will likely leave investors who could settle, and developers with any financial troubles, exposed.

“It’s likely that some developers will go broke because they’ve counted on settlement sums at the end of the project and that’s the time when developers’ interest bill is the highest,” Yardney says.

“So, that’s not good for confidence, for consumer confidence, for the real estate market or for jobs. It’s quite possible we’re going to have a very difficult time.

“Some people are going to be waiting at least a decade before they get any capital growth.”

The impact of potentially AWOL foreign investors is likely to drive unit prices down further, Kingsley says, which will make it difficult for investors to recover their position if they need to sell.

He says that if investors dispose of their new units in the short-term then it’s likely they may sell for even less than what the valuers had conservatively valued the property at before settlement.

The key to avoiding this type of unappealing financial situation is to do your research before you even buy a new unit.

“It’s very concerning and it highlights the need to – when you are working with developers and these sales agents who work on behalf of the developers – drill down into the detail in terms of other projects that they’ve done and to approach it traditionally like you would approach doing any comparable analysis
on any type of property that you buy,” he says.

“So you identify comparable properties and you look at what they’ve been selling for. Not just by the developer, but you’re also looking at other properties located close by of a similar quality of build, and if there’s any uniqueness or lack thereof.”

What’s ahead?

The word “oversupply” has been bandied about a lot, especially in media reports about the Melbourne, Sydney and Brisbane inner-city new unit markets.

But it’s a term that may not mean what you think it does.

According to Kelly, the Melbourne off-the-plan sector is not oversupplied. That’s because properties have been settling, even with conservative valuations.

Of course, there may well be an oversupply of new unit product in the rental sector, but the sales market has keep its head above water.

That is likely to change, Kelly says, with 2017 looking like the year that the new unit market tips well past the equilibrium point into oversupply territory.

“Right here as we sit, there’s not an oversupply. We can look on the horizon and we’re pretty sure there’s problems on the horizon, there’s storm clouds. How soon will they get here? We’re not sure but there are signs that it’s starting to sprinkle or to rain and the storm is likely to hit next year, unless something corrects itself,” he says.

The intensity of the storm, however, will be dependent on foreign investors and whether the Chinese cash machine that’s been firing on all cylinders is abruptly switched off.

If that happens, Kelly says, that storm could easily turn into a cyclone.

“That’s the real risk, that we’ll see significant drops in values because the local buyers are not there to fill that void. They’re not there, particularly in this environment,” he says.

So it appears that a rough ride is ahead for the Melbourne new unit market but investors can take heart in that it has (kind of) happened before.

Supply runs ahead of demand, then the market catches up, and everything is hunky-dory once more.

It’s the period of time between those two market ups and downs that can be the tricky part to navigate.

Kingsley says investors can protect themselves by being realistic about the returns they are likely to achieve between now and then, and remembering that property is always about the long-term horizon, not the temporary impact of approaching storm clouds.

“They’re going to have provision in their calculations, potentially, for some higher levels of vacancy and that they wouldn’t have done in the past,” he says.

“When you bring on high levels of stock, it’s not just automatic that they’re going to be consumed by tenants very quickly. There’s always a lag period and they should factor that into their calculations.

“Property is a long-term investment. That’s true. That’s why doing your homework to see the level of supply, and future supply, that’s coming into those markets is also something that they’re going to have to consider.”

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Australian Property Investor , November 2016,  p82-85