As an antidote to there being limited land in desirable locations, residents of Melbourne, and to a lesser extent Sydney, have witnessed an explosion in the number of high-rise residential apartment buildings being constructed in the past decade. Following a similar pattern to densely populated Asian cities, Melbourne especially has been able to grow its population in the inner city, especially the CBD and neighbouring Southbank through the rapid construction of buildings that contain upwards of 250 dwellings.
The developers of these properties are well known — Mirvac, Central Equity, Meriton — and the profits can be substantial. Because apartment buildings use only a small amount of land, the stamp duty payable by purchasers is nominal.
The key to a successful development is the developers’ ability to quickly sell most of the dwellings off the plan. This is because it covers their initial costs and because banks usually won’t lend to fund developments until a certain number of the properties have been pre-sold.
Until recently, the most difficult job for developers wasn’t actually designing or constructing dwellings but selling the units for a price that almost always is far more expensive than comparable, established dwellings. (Buying a property off the plan is not altogether different to buying a new car, with purchasers paying about a 30% premium). Until recently, Australian foreign ownership laws permitted developers to sell half of any project off the plan to overseas buyers. Because overseas buyers generally weren’t permitted to acquire established property, this provided a handy competitive advantage for the large developers, most of whom maintain small offices in cities such as Singapore and Kuala Lumpur.
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Because of their monopoly on overseas buyers, developers had reasonably minimal difficulty in selling half of the stock of apartments in new developments off the plan to easily convinced overseas buyers. Where they tended to have more trouble was in convincing Australians to buy the remaining 50% for prices that generally, were far higher than for similar apartments literally across the street.
However, this all changed though in December 2009, when the Rudd government altered foreign-ownership laws. The major consequence of the changes to FIRB regulations was a substantial contribution to the nation’s house price bubble. This was because the new laws allowed for three major changes. First, holders of student visas (who were previously only able to buy a property that cost less than $300,000) were able to buy property at any price. Second, foreign-owned corporations were permitted to purchase properties for Australian staff and third, developers were permitted to sell 100% of their properties off the plan to non-residents.
The first two changes affected established properties, while the third has caused a dramatic increase in profits, and also in the change in the risks for developers (and potentially lenders).
The higher returns are obvious. Instead of having to struggle to sell to Australian residents, developers can offload 100% of their projects overseas. (Although not all developers are ignoring Australia, this writer last week received an “exclusive” invitation from a property spruiker to attend a Moet Hennessy sales pitch — the spruiker kindly offered “minimal deposit”, “extended settlement term” and “low or no interest”).
But the larger developers, with substantial overseas sales teams have been able to substantially “ramp up” development. For example, in Melbourne, a Chinese-backed group plans to build 2500 apartments in one inner-city block near Melbourne’s Southern Cross Station. Literally across the road, Melbourne-based developer Central Equity is planning a 1000 apartment complex. In Southbank, the Melbourne Council recently approved a 226-metre, 532-apartment complex that was outside their previous guidelines. In all, upwards of 10,000 dwellings are either under construction or being planned for the Melbourne city area or Southbank. Most of those properties will be marketed and many sold to overseas, largely Asian-based investors.
But while developers have experience very strong profitability in recent years as the property market has surged, record prices, combined with high levels of overseas sales, substantially increases the risks.
For most large apartment complexes, the developer will borrow as much as 80% of the development costs (the AFR noted last week that NAB is prepared to lend 70% of developer costs for a project itself, while Westpac has a tougher standard of 25%) — the rest will be contributed as equity. However, lenders will require a specific number of properties in the development to be sold before they will provide even initial finance (usually, about 70% of the apartments need to be sold on an “unconditional basis”). After that, lenders will provide finance for the project in installments as the development is completed.
This all works well in a rising market, but when the value of properties is falling, things can go very awry.
The main reason for this is because the buyers only put down a 10% (or in some cases, 20%) deposit. The rest isn’t paid until settlement (when the property is completed). For local buyers, this isn’t usually a problem as the contract is unconditional and the developer can require “specific performance” of the contract — that is, the buyer can’t wriggle out of the contract simply because the underlying value of the property has fallen below their purchase price. This happened in 2005 when Mirvac successfully sued buyers of its Tower Five building in the Melbourne Docklands.
But while developers are able to enforce contracts with local buyers, the situation is somewhat murkier with overseas buyers — and the risks far more pressing now that developers are legally able to offload all their stock overseas. If the inner-city property markets collapse like they did in 2003 (when Melbourne apartment prices in some areas fell by 40%), overseas buyers ay be somewhat less willing to complete the purchase. For example, if someone has paid a $100,000 deposit on a $1 million property, which, before settlement, drops in value to $700,000, they would be far better off simply forgoing their deposit and saving $200,000 — this is the “jingle mail” scenario that is present in the United States.
While the Financial Review last week noted that “offshore buyers are treated even more toughly with restrictions on certain postcodes, a requirement that income be confirmed in Australian dollars, redirection of all rental income to loan repayments and a maximum LVR of 80%” — none of those restrictions apply if a buyer pays cash for their deposit, or borrows the funds from a financial institution in their home country.
So while the changes in foreign investment rules may appear to benefit developers — they may in reality be creating a new set of unforeseen risks. As Warren Buffett famously noted, you only find out who’s swimming n-ked when the tide goes out — and there may be some very large property developers (and lenders) caught short if the growing supply of new properties leads to lower prices.