AUSTRALIAN HOUSING MARKET REVIEW

AUSTRALIAN HOUSING MARKET REVIEW MARKET DRIVERS, LONG-TERM PRICING INDICATORS AND INVESTMENT IMPLICATIONS November 2012 Arnhem Investment Management Pty Ltd ABN 17 129 606 775 Level 13, 56 Pitt Street, Sydney, NSW, 2000 Tel: +61 2 9016 3633 www.arnhem.com.au

ABOUT ARNHEM INVESTMENT MANAGEMENT Arnhem Investment Management is a boutique Sydney based Australian Equity Fund Manager. Arnhem manages approximately AU$3 billion of institutional and retail funds.* The founding members of the investment team, George Clapham, Neil Boyd-Clark and Mark Nathan were instrumental in the establishment of the Australian equity funds for ABN AMRO Asset Management in 2000. In 2008 they formed the boutique manager, Fortis Investment Partners which became Arnhem Investment Management in 2010. Arnhem is majority owned by the investment team with distributor BNP Paribas Investment Partners having a minority holding. *As at 30 September 2012. ABOUT BNP PARIBAS INVESTMENT PARTNERS BNP Paribas Investment Partners is the dedicated autonomous asset management business of the BNP Paribas Group. BNP Paribas Investment Partners offers the full range of investment management services to both institutional and retail clients around the world. Central to the way we work is the concept of partnership both in terms of how we behave as a family of companies and our relationships with our clients. Around 800 investment professionals work across our network of some 60 investment centres, each specialising in a particular asset class or type of product. With total assets under management of EUR 502 billion*, BNP Paribas Investment Partners is the 6th-largest asset manager in Europe.* * Source: BNPP IP as at 30 June 2012 This document may not be copied or distributed or passed on, directly or indirectly, to any person without the express consent of Arnhem Investment Management Pty Limited ABN 17 129 606 775, AFSL 332484 (Arnhem). This document is produced for general information only and shall not constitute an offer to sell or any type of solicitation or form the basis of or be relied upon in connection with any contract or commitment whatsoever or be taken as investment advice. You should seek your own professional advice in relation to investments in the funds presented. While great care has been taken to ensure that the information is accurate. Arnhem, to the extent permitted by law, disclaims all responsibility and liability for any omission, error, or inaccuracy in the information or any action taken in reliance on the information and also for any inaccuracy in the information contained in the document which has been provided by third parties. Past performance is not necessarily indicative of future performance. 1

OVERVIEW Housing has a major impact on the way we live our lives and the way we spend our money. For most home owners, their house is their most significant asset and is the biggest financial decision most people will make throughout their lives. Fig. 1 Australian housing investment as a % of GDP Whilst residential property investment is only around 5% of Australia s GDP (Fig. 1), it indirectly impacts other parts of the economy and presents opportunities within the stock market. Using the US market as a guide, housing services account for 12% of GDP, resulting in the housing sector in aggregate being a significant driver of the economy. Source: ABS, UBS Notwithstanding the importance of housing to GDP, housing is a topic close to our hearts as home ownership is often considered part of the Australian dream. As shown in Fig. 2, many Australians are home owners, but perhaps surprising to some, compared to other developed countries home ownership is not exceptionally high. Fig. 2 Home ownership rates by country Source: European Mortgage Federation, ABS, US Census Bureau, Japan Ministry of Internal Affairs & Communications, Statistics Bureau 2

In this paper, we examine some of the key drivers of the housing market including supply, demand and credit availability. We address the question of whether there is a housing bubble in Australia and draw on this insight to identify micro-industries and stocks which may be impacted. HOUSING DEMAND DEMOGRAPHICS AND AGEING POPULATION Australia s demographic trends are very important long-term drivers of housing demand and in turn prices. In fact, one of the better indicators of long-term house prices in several countries has been the growth in people aged 20-44. This age group is the key house purchasing segment. Figs. 3-6 show a strong correlation between this age group and house prices over the long-term. Note however that changes in the number of people aged 20-44 does not necessarily imply housing bubbles and busts will not occur as evidenced by the US experience from 2000. It does however provide a useful guide to longer term price trends. Fig. 5 UK house prices and population aged 20-44 Source: Credit Suisse Fig. 6 China house prices and population aged 20-44 Fig. 3 US house prices and population aged 20-44 Source: Credit Suisse Source: Credit Suisse Fig. 4 Japan house prices and population aged 20-44 Hence, looking at the 20-44 year old population band in Australia may give us some idea about the long-term direction of house prices in Australia. The UN (as part of its 2010, World Population Prospects report) has prepared population pyramid data for 2010 and 2050, which shows (Figs. 7-9) that the economies of countries such as Japan (and most of Western Europe) will be negatively impacted by an ageing demographic. Australia, the UK and the US due to higher fertility rates and immigration will be less affected by the ageing demographic. Source: Credit Suisse 3

Fig. 7 Japanese demographic pyramid - population by age groups and sex (% of population) 2010 & 2050 Source: United Nations World Population Prospectus Report 2010 Fig. 8 United States demographic pyramid - population by age groups and sex (% of population) 2010 & 2050 Source: United Nations World Population Prospectus Report 2010 Fig. 9 Australian demographic pyramid population by age groups and sex (% of population) 2010 & 2050 Source: United Nations World Population Prospectus Report 2010 4

Analysing the Australian demographic trends, we can observe that there has been a surge in the key household formation age band of 20-44 year olds. The 2011 Australian Census revealed that the 20-44 year old cohort expanded at an average of 4.6% per annum (including immigration) in the five years to 2011. This compares with the overall growth rate of the Australian population of 1.4% per annum. In contrast, the ABS forecasts that growth in the 20-44 year old age group will slow to 1.2% per annum (including immigration) between now and 2020, just below forecast total population growth (including immigration) of 1.5%. This implies population growth factors will moderate as a support factor for house price appreciation over the next 20 years. IMMIGRATION ASSISTING DEMAND Australia has experienced strong population growth, which has in part been driven by net migration (see Fig. 10). This has contributed to household formation and housing demand. Some forecasters suggest this dynamic could continue for the next 40 years. The United Nations expects Australia s growth to exceed many of its peers over the next 40 years (see Fig. 11). While this is superficially positive we caution against placing too much emphasis on this because in part this is already captured in the demographic pyramids above. Fig. 10 Australia s population growth components Fig. 11 Selected country population growth forecasts Source: United Nations PERSONS PER DWELLING Since the first Census was conducted in 1911, the number of persons per dwelling has consistently fallen. In 1911, there was an average of 4.5 people in every home. By 2006 this almost halved to 2.4, impacted by smaller families, higher divorce rates and pensions allowing older people more financial independence. As the Census is only produced every five years, the ABS now estimates that the number of people per household has increased Source: ABS, Arnhem Investment Management 5

to 2.66 in the last few years (see Fig. 12). What is unclear is whether this reversal is caused by a shift in demographics and/or a fundamental shift in preferences or whether it is purely motivated by affordability. If it is the latter, it is somewhat more positive for housing as it suggests that there may be latent demand at lower prices. It is worth pointing out that the most recent ABS forecasts point to a continuation of the long-term downtrend in this ratio. If however, it is a fundamental shift in demographics and preferences, the outlook for housing demand will remain subdued. We suspect the change in trend is partly driven by affordability, which will help moderate any house price retracement. Fig. 12 Australia: people per dwelling is forecasting housing starts to recover from 134,000 in 2012 to 152,000 in 2014 (Fig. 13). Our contention therefore is that housing demand in Australia, while likely to increase modestly, may well disappoint most market forecasts. For market forecasts to be correct, the people per household ratio would have to revert back to its previous downward trend. This disappointment in starts would have negative implications for the earnings forecasts and valuations for companies operating in the Household Construction, Building Products, Department Store, Household Goods, Mortgage Lending, Electricity Retailing and Home Insurance micro-industries. Fig. 13 Market forecasts for Australian housing starts Source: ABS, Brokers Source: ABS, CommSec SUMMARY OF DEMAND In summary, population growth will be robust, but this is partly offset by deteriorating demographics. With Australia s population increasing by approximately 350,000 per annum and approximately 2.66 people per household, it is easy to see that underlying housing demand growth is approximately 130,000 per annum. However, this underlying demand comes at the same time that people per household has seen a reversal in long run trend. Housing demand is very sensitive to this ratio, for example a 0.01 change from say 2.66 to 2.67, would result in a reduction in underlying housing demand of approximately 28,000. The market HOUSING SUPPLY BUILDING CYCLE Housing starts peaked in 1994 and have remained volatile since. While there have been several claims that we are underbuilding as a nation, we are less convinced given in the past we have experienced extended periods of oversupply and there is an underlying shift from houses to multi-dwelling apartments, consistent with the reducing number of people per dwelling discussed earlier. In fact, Credit Suisse analysis suggests most recently completions have exceeded demand (see Fig. 14). We remain cautious about the demand side numbers 6

given the recent change in the person per dwelling trend set out above. We note also that any latent demand implicit in the persons per dwelling trend has to be at the appropriate house pricing points if we are to see this theoretical demand translate into the actual purchase of houses. Fig. 15 Australian state housing starts relative to history Fig. 14 Australia housing supply and demand balance Source: ABS, Deutsche Bank APARTMENT BLOCKS Source: Credit Suisse The long-term build rate in Australia has been around 140,000 dwellings a year. Presently we are constructing at around 5% below this rate. However, the micro dynamics at a state by state level differ dramatically. NSW has been depressed for some time, whilst Victoria is coming off a period of very strong activity. Victoria has been adding almost twice as many dwellings (units and houses) as NSW, despite having a smaller population. To some extent this has been driven by better transport infrastructure, affordability and also higher subsidisation for first home buyers. First home buyers continue to receive subsidies or grants which on average are about $7,000, but are capped at price levels between $450k and $750k depending on state. Today almost one in two dwellings approved is an apartment compared to one in four 20 years ago (see Fig. 16). The shift away from single family homes to apartment living is expected to continue if the long-term downtrend in the people per dwelling ratio resumes. Apart from the better affordability of apartments, demographic factors have previously driven this trend. Baby boomers are downsizing and younger people are more comfortable living in apartments close to the CBD. One major implication of this shift in living establishments is a reduction in the intensity of use of certain building materials (eg. fewer brick homes, fewer tiles, windows, garages). This is not good for companies like Boral, CSR, Brickworks or James Hardie. We are also seeing this trend in the United States. Fig. 16 Australia apartment approvals as % of total approvals Queensland and NSW have been underbuilding relative to long term average approvals (Fig. 15). However Victoria has been building at a rate well in excess of long term rates. It is worth noting that Victoria s first home buyer subsidies were the highest across all states. These grants have since come down. Source: ABS 7

HOUSE PRICING While we have discussed supply and demand, we have not yet looked at the other factors that may be driving Australian house prices. Firstly looking at how house prices have moved over the last 25 years, with the exception of recent history, they have been largely a one way bet (see Fig. 17). Fig. 17 Australia house price growth HOUSE SIZES Most analysis on the relative affordability of the Australian house market fails to make an adjustment for the different quality or size of houses. Adjusting for size, Australian house values at around US$25,000 per m2 (see Fig. 19) compare favourably with other nations. It is interesting that excluding many Asian countries where population densities have forced people into smaller housing, some governments (the UK and Ireland for example), are forcing the size of houses downwards. Interestingly, Britain s new homes are the smallest in Western Europe with an average three-bedroom house being 76m2. This compares to the average Australian house at 243m2 (when averaged with apartments it is 214m2) and Denmark at 137m2 (which are the biggest sized homes in Western Europe). Fig. 19 House prices per m2 (US$) Source: ABS A substantial part of the increase in house prices up until the GFC mirrored that experienced by other developed economies (see Fig. 18). This suggests that in part, the driver of Australian house prices must be global in nature. Some of these factors are financial deregulation, improved global stability and availability of credit. Putting to one side these global factors, one factor that has been specific to the Australian market has been increasing house size. Fig. 18 House price to income ratios Source: IMF/OECD In 2008/09 the average new Australian house hit a peak area of 248m2 and has since fallen to 243m2 in 2011 (see Fig. 20). Fig. 20 Average floor area of new homes Source: OECD Source: ABS, US Census Bureau, CommSec 8

Aside from the size of houses, the number of bedrooms has changed in the 2006 Census around one in every 3.5 homes had four or more bedrooms whereas 20 years ago the ratio was one in every six homes. Further, once wages and the size of houses are taken into account, Australia compares favourably with its peers (see Fig. 21). Fig. 21 House price to wage ratio adjusted for house size *Housing loan repayments calculated as the required repayment on a new 80 per cent LVR loan with full documentation for the nationwide median-price home; based on capital city house price data prior to 1990; household disposable income is before interest payments; RBA estimate for June quarter 2012. The bearish perspective usually shows affordability based on prices to wage ratios, without adjusting for the interest rate environment. When viewed on this basis, the results do look frightening (see Fig. 23). Fig. 23 Australian house price to wage ratio Source: IMF/OECD AFFORDABILITY Affordability is in part a driver of demand, but we considered it to be of sufficient interest to review as a standalone item. While we often hear that prices have become unaffordable, the fact that we have not experienced a significant price correction would go some way to disprove that argument. There are several ways to judge affordability. Probably the most pragmatic way is to look at repayments as a percent of household income (see Fig. 22). At present, this is very much within the range of the last 30 years. Fig. 22 Repayments on new housing loans as a % of disposable income* Source: CSFB To balance the arguments, we would observe that household indebtedness peaked around seven years ago, and has moderated since then (see Fig. 24). While not directly addressing the issue of whether houses are affordable, combined with the price trends, it does not appear that there is much appetite to push prices substantially higher. Fig. 24 Australian household debt to income Source: ABS and Deutsche Bank Source: RBA 9

Recent reductions in mortgage rates have certainly led to improving home investor sentiment and affordability (see Fig. 25). Indeed affordability is pushing back up to levels not seen since the emergency rate settings during the GFC. Fig. 25 Australian housing affordability index However we are concerned that other costs associated with home ownership are rising such as council rates and utility charges, which may limit price appreciation in the short term. Source: HIA-Commonwealth Bank Affordability Report RELATIVE TO OTHER COUNTRIES Those that argue that Australian house prices are excessive often do so with reference to international comparisons. There are numerous arguments to rationalise why Australian house prices are relatively high: Table 1 Coastal city house price to income ratio 1. As discussed above, Australian housing stock is high quality and larger than its international peers. 2. Australia is a highly urbanised society by international standards, with a cultural preference towards living close to central business districts and coastal cities. This limits desirable land area in an otherwise large land mass country such that Australia s capital city house price to income ratios are comparable with coastal city metrics globally (see Table 1). Source: Deutsche Bank, CBA, 2010 10

3. The Australian taxation system is unusually generous with respect to residential dwelling investment (the family home is the only asset exempt from capital gains tax), reinforced by a cultural investment bias towards residential real estate. A BUBBLE? PROPERTY BUBBLES ARE BAD The consequence of a real estate bubble collapsing is profound as recently seen in offshore markets. There is a strong two-way feedback loop between house prices and financial stability. Housing market booms followed by busts have been associated with financial system instability historically, including in Sweden in the early 1990s, as well as the USA, the UK, Ireland and Spain during the current global financial crisis. The IMF highlights that house price gyrations can carry a significant cost to macro economies, reflecting the importance of housing to the construction industry, household budgets and overall wealth, but that the degree to which house price boom-bust episodes have spilled over to create more widespread financial system instability has varied across countries, in turn partly reflecting differences in housing finance systems. The IMF notes that, since house price busts weaken household and financial sector balance sheets, housing-linked recessions are on average two to three times more severe than other recessions; further, housing busts tend to prolong recessions (averaging 18 quarters, compared with four quarters for other recessions). However, the IMF has also noted that not all house price busts resulted in a financial crisis (e.g. Hong Kong during the 1990s) with the likelihood of a financial crisis emerging following a house price bust perhaps depending upon whether the preceding housing boom was driven by a deterioration in credit underwriting standards, the degree of leverage, or whether solvency and liquidity buffers were strong enough to sustain the financial system through the bust. A BUBBLE IN AUSTRALIA? We have addressed many of the factors that lead us to think that Australia is not going to experience a property bubble collapse (current build rates are supported by population growth, credit standards have been appropriate and affordability is acceptable on at least some measures). It is worth highlighting a few other points that support our view that Australia s current house prices do not represent an imminent bubble. In some US states, a contributing factor to the crises was non-recourse lending. In Australia, full recourse provisions in bankruptcy laws provide discipline over mortgagee repayments and therefore limit the incentive/incidence of tactical mortgage defaults. In Australia, the non-deductibility of interest payments on owner occupied home loans incentivises rapid accumulation of housing equity (in turn, diminishing the loss incurred by the mortgage lender in the event of default). In Australia, national consumer credit legislation seeks to prevent predatory lending practices, and maintain minimum underwriting standards from bank and non-bank providers alike. We have already discussed supply, but in the context of considering whether we are likely to experience a bubble, it is illustrative to compare the level of residential investment as a percentage of GDP with other countries, particularly those nations that have experienced boom conditions. Australia housing investment share is not excessive at 5% of GDP (Fig. 26). 11

Fig. 26 Selected country residential investment as a % of GDP turn back to the traditional deposit market for funding as well as a move away from short term funding to long term funding to lower their rollover risk. Thus this risk factor has substantially reduced. 3. An extended period of low policy rates, inasmuch as subsequent monetary tightening can lead to liquidity problems for households and lenders. Australia has not experienced a sustained period of relaxed settings. Source: CSFB The IMF stated that in the past, three factors were associated with both housing busts and banking crises: Finally, it is worth noting that Australia is in a far better economic position than most of its peers (see Fig. 27). Fig. 27 Selected country GDP and unemployment 1. Excessive competition and aggressive lending, often in the wake of financial sector deregulation which prompts financial intermediaries to compete for market share through lower credit underwriting standards. The IMF stated that relaxed lending standards and increased household leverage were associated with greater house price inflation and, in turn, with stronger house price declines and financial stability problems during the bust. Given that Australia has been a stable banking oligopoly for well over 10 years with market share relatively stable, this factor has not really been present in Australia when accompanied by the above mentioned consumer credit controls. 2. Capital inflows that sustain the supply of credit to households, whilst also leading to vulnerable funding for mortgage lenders and borrowers. This was a growing issue up until 2009, inasmuch as Australian banks were sustaining high and rising levels of housing credit as a percentage of GDP which was being funded by an increasing quantum of and reliance upon term wholesale debt. The RBA has stated that in 2006 the major banks collectively issued $60B of senior unsecured debt, equivalent to 3% of the global pool of available funding at that time, whereas in 2009 this was $150B (equivalent to 10% of the global pool). When credit markets froze, the banks were forced to Source: RBA 12

THE LENDERS Since 2003, a continuing theme for the Australian bank stocks has been the interplay between banks and the Australian housing market, including the perceived vulnerability of bank solvency in the event of an Australian house price bust. Australian banks are largely retail banks and, as a result our banks are levered to the fortunes of the Australian housing market. As shown in Fig. 28, Australian banks have increased their loan exposure to housing from 22% of total lending in 1992 to around 50% in 2011 (however, it must be remembered that this has been partly due to contractions in business credit in the recession of the early 1990s as well as the contraction in business credit following the GFC in 2008). Australian banks have grown their mortgage book as this has been an attractive business for them. We estimate the return on equity for the Australian mortgage portfolio held by the big four banks is in excess of 25%. This is assisted by a loss rate on residential mortgages that has seldom risen above 2-3 bp. MORTGAGE ASSET QUALITY When looking at mortgage asset quality, it is important to distinguish between losses and non-performing loans (NPLs). Up until now only a fraction of loans that were NPLs resulted in losses, due to the conservative nature of Australian banks. The increase in NPL s in the last several years has been relatively greater amongst non-banks although there has also been a deterioration in bank mortgage asset quality as well (Fig. 29). The RBA has suggested that very recent past dues have declined partly owing to some banks implementing more concerted collection processes. Fig. 28 Major bank composition of lending 1992-2011 Source: Company data, Credit Suisse 13

Fig. 29 Australia non-performing loans portion (less than 2%) have all of the following risk factors: high loan to value; issued to people with high debt servicing ratios; issued to people who are not ahead of schedule (Fig. 31). Clearly unemployment is a key concern around debt servicing but we believe that this will remain at a manageable level. Fig. 31 Australian households that are vulnerable Source: APRA While NPLs have ticked up, actual losses remain miniscule as seen in Fig. 30. We remain confident that bank losses from mortgages will be small. This comfort is derived from the fact that only a small Fig. 30 Loan losses as a % of bank loans and advances Source: HILDA Release 10.0 Source: ML 14

MORTGAGE INSURANCE Banks also have some protection from property losses due to mortgage insurance. There are regulatory incentives to use lenders mortgage insurance. Typically the major banks require mortgagees with an LVR >80% on a standard mortgage or an LVR >60% on a Low-Doc mortgage to take out mortgage insurance. This is because in Australia APRA imposes a higher capital charge for mortgages with an LVR >80% that are not insured. House prices may look expensive on an international basis but less so when viewed on a square metre basis or with comparable cities. Prices also appear more reasonable when price-to-wage ratios are included. Whilst Australian banks are more reliant on the mortgage market versus peers, the market is protected by its structure, regulation and prudent lending practices. Further, mortgage insurers are regulated by APRA and they are required to be capitalized for up to a 40% decline in house prices. KEY FINDINGS Whilst Australian house prices peaked in 2007 and have either declined or tracked sideways, this has been far better than most of our international peers and unless our economy receives a large external shock that increases unemployment levels, Arnhem does not foresee a housing bust in Australia in the near future. Based on the areas explored in this paper, Arnhem s key findings are: Long term demographics are very important and Australia looks relatively well placed due to immigration and a fertility rate of around 2. China and Japan look particularly bleak based on this measure. Australia has not experienced a high level of overbuild. Australian houses are among the largest in the world and number of persons per dwelling has increased for the first time since 1911 (currently 2.66 persons per dwelling). If this is a structural not cyclical trend it could have a major negative impact on demand for several micro-industries. While expensive, Australian house prices will remain stable (although not expand) if unemployment remains stable and there is no external shock to the economy. Even then, we would expect the market to demonstrate a degree of resilience. MICRO INDUSTRY IMPLICATIONS There are nonetheless, several micro-industries which are impacted by changes in the demand for or supply of housing, both directly and through second degree effects. Following on from the identification of the key micro-industries we then determine which of these microindustries have the most attractive industry structure and how they will be impacted by a subdued property outlook (see Table 2 on next page). The implication of our conclusions for building products, developers and retailers exposed to housing is the most negative. We see the building products and home ware retailing suppliers suffering from reduced demand for products in the medium term despite expectations of a near term recovery. We note also that participants in the home ware retailing supply micro-industry are subject to several structural challenges (competing with imports and online retailing). While negative for mortgage providers and insurers at the margin, companies in those micro industries make significant profits from servicing existing housing stock so are less negatively affected. Where we see attractive industry structures, these micro industries still offer attractive investment opportunities. 15

Table 2: Micro industry implications Micro Industry Companies Industry Structure Mortgages CBA, NAB, ANZ, WBC, BEN, SUN, BOQ, MOC Good Property Services (i.e. Insurance) IAG, SUN, AUB Good Property Advertising Services REA, FXJ Online - good, Print - weak Property Trusts SGP, MGR, ALZ, GPT Average Building Products BLD, JHX, CSR, FBU, BKW, GWT, DLX, BSL, REH, ABC Weak Developers LLC, AVJ, FKP, DVN, FRI Weak Retail - hardware, furniture and appliance, electricity GUD, HVN, FAN, WES, WOW, MTS, ORG, AGK Weak 16