Opinion: BNZ sees 'long slog to sensibility' for house prices, farm prices and commercial property prices

Bank of New Zealand's economists have published a detailed research report questioning the still-high valuations of residential, rural and commercial property in New Zealand.

BNZ said prices had fallen in some cases since 2008, but remained significantly above their fundamental valuations when compared with inflation adjusted trends, price to income multiples and yields.

"While a good amount of adjustment has been made to date, a greater sense of realism may yet be required," BNZ said in the report available here titled NZ Property Markets Yielding to Fairer Value.

It said property prices last appeared grounded in reality back in 2003 and had become unhitched since then.

However, property buyers were beginning to become aware that conditions had changed and valuations may still be stretched, it said.

"There are signs already that the populace is completely rethinking what constitutes fair value for a property, of whatever sort, especially on the growing realisation that credit channels will not be as open-ended as had become accustomed to," BNZ said.

It said many investors were beginning to consider risk adjusted yields again after years of being blinded by the prospect of capital gains. It warned of a potential for a long grind lower of values.

"As capital-gain pretensions peter, beware a long slog to sensibility," it said.

Here is the full report below.

NZ Property Markets Yielding to Fairer Value

All manner of New Zealand’s property markets have struggled over the last couple of years. What’s going on, where are we in the process and what does the future hold? Well, while a good amount of adjustment has been made to date, a greater sense of realism may yet be required. How will we know when we’ve found a base? Well it will probably be when valuations are based on decent risk-adjusted running yields (remember those?), as capital gain expectations rightly fade from the equation.

Perspectives, Please

To get a handle on what’s playing out we believe it’s essential to step back a bit in time. Indeed, probably back to circa 2003, when property markets last looked well grounded in their fundamentals. From around that point something seemed to be unhitched and everything was pretty much off to the races from there. Just a couple of years ago, of course, the NZ economy was incredibly over-heated. It seems like a distant memory now. But resources of all description – whether plant, premises or staff – were stretched to breaking, meaning core price and wage inflation was bursting its banks. But property prices had become even more inflamed. And we’re not just talking about houses.

Land prices mushroomed. Commercial and industrial property prices soared at double-digit rates. New Zealand’s biggest asset price cycle over recent times, was arguably in farms. Collectively, it was probably the broadest and biggest property price “boom” the nation has ever experienced. It was also, however, mainly bubble and bluster associated, as it was, with a rapid accumulation in debt. So those expecting a reversion to those heady days, even something resembling it, are fooling themselves. What we’re actually aiming for now, across the range of property markets, is a return to reality.

A finding of one’s feet.

While virtually all of New Zealand’s property markets became “richly priced” in the few years to 2008, it’s unclear as to how much of the requisite rebalancing has transpired to date. This opaqueness is essentially because of limitations in the available data. Nevertheless, the following are our general impressions. We can start with oft-overlooked farms. Having burgeoned in price over 2006-08, their subsequent correction seemed an obvious reaction to the way international dairy prices essentially halved between early 2008 and early 2009, during the global recession. However, despite world dairy prices having reclaimed broad robustness over the last twelve months or so, farm prices have failed to rebound much, if any.

In any case, how much of a price cycle have we really seen in farms, and in which farm types? The Real Estate Institute’s rural statistics show the simple median sale price of all farms dropped more than 40% between mid- 2008 and mid-2009, and has gone about sideways ever since. That gives the appearance of a complete pruning of protuberance. However, how much of this is real as opposed to just reflecting the type and size of farms being sold. This is where the Quotable Value NZ rural price index comes into its own, as it attempts to control for farm-type, size and quality. And this index slipped just 15% between 2009 H2 and 2008 H2, to rest comfortably above the level of 2007 H1.

The QVNZ indices also questioned the notion that it’s been dairy farms that have swung and suffered the most. The dairy farm price index (to 2009 H2) fell 15% from its peak – bang in line with the overall rural index. The price of fattening land actually dropped a greater 23%. And while the price index for horticultural land had fallen about 11%, we suspect its viticulture sub-component fell by much more than this (such are the travails of New Zealand’s “overgrown” wine industry at present).

It is also difficult to get a good fix on commercial and industrial property price adjustments to date. While there has been plenty of anecdotal evidence of big price falls (especially in lower-grade premises), the last “official” nationwide data point we have is the QVNZ indices for the second half of 2009. And these registered an 11% fall in respect of commercial property and 13% for industrial, from 2008 H2 peaks. Residential property price indices have also not looked as bad as some of the stories, and earlier prognostications, were pointing to.

Again, with reference to the quality-controlled QVNZ measures, we note that their reading for the March quarter of 2010 was about unchanged from the previous quarter, to be 6.4% higher than a year ago. The most recent level was down just 4% from the late-2007 peak. So, can we really say there has been a generalised property price slump across homes, business premises and farms in New Zealand? Not by the look of some of the key evidence available.

But might this simply mean we’re not getting a clear read from the data (perhaps because of sales illiquidity?) such that a more noticeable correction is yet to be registered? That is the question.

Ongoing reservations

Accepting the accuracy of the QVNZ property price indices at hand, as a good example, what’s clear is they still look high when set against their long-term trends. As an expositional device, the various indices in real (inflation-adjusted) terms show that property prices in the latter half of 2009, although down, were still well above any reasonable trend, having last looked “about right” back in 2003. Incidentally, we can even throw residential land (“section”) prices into the analysis here.

While we’re not aware of any QVNZ measures on such, we do note that the REINZ median sale price measure took off like a rocket from about 2003. And while it has come off the boil over the year to July 2010, it remains well north of trend (which, by the by, is part of what’s stymieing a bigger recovery in new home building activity in our opinion). We get a similar impression of over-altitude by looking at other rough valuation metrics. Farm prices, for example, while off a bit, still seem lofty in relation to pastoral export receipts (especially when excluding the less-stretched looking dairy farm valuations). Commercial property prices appear high compared to the rents they are getting. And home prices are still very much on the high side relative to household disposable income and rentals.

Groping for Decent Yields

This, of course, is another way of saying that property investment yields remain implicitly low (albeit not quite as low as they were at the height of the property froth).

Sure, yields of all description, including wholesale and retail interest rates, are cyclically depressed. However, it is inaccurate to say that they are low, absolutely. And interest rates, as a general rule, can only tend to rise in line with (presumed) economic recovery. It’s all about normalisation. So those wanting to guard against miscues in property markets over the coming period will do well to;

• Take Government/Rating Valuations (which are only ever crude historical distribution devices) with more than just a grain of salt If one must use historical comparisons, try to go back a number of years – with, say 2003, serving as a much sounder reference point than two or three years ago, when things were frothy

• Most importantly, bring everything back to yields – explicit or implied – and risk-weight these yields for things like tenancy duration/health and renegotiation risks on rents. \

• Compare these risk-weighted yields to market “riskfree” interest rates (recognising the latter are probably biased to rise over the coming years, meaning debt rollover issues need thinking through).

• Benchmark these yield-based valuations to what has “normally” prevailed since the early 1990s (the approximate start of New Zealand’s inflation-tamed environment, following the inflation blow-outs of the 1970s and 1980s).

This general emphasis on (risk-adjusted) yield is only reinforced by the likelihood that capital gains will be far from assured over the coming years, with even ongoing risk that further price correction might be needed in some property markets before a solid footing is found. We would certainly put housing in this camp. This, of course, will be a complete reversal from the “boom times”, when many property buyers would seem to have been tolerant of unusually low yields (and negative net returns in the case of many housing investors) in the presumption of strong capital gains.

Sure, this strategy, worked out for a while – for houses, for land, for commercial and industrial premises, and for farms. But it’s now reversing, as such things invariably do. Easy come, easy go – but the higher debt loads remain. Indeed, there are signs already that the populace is completely rethinking what constitutes fair value for a property, of whatever sort, especially on the growing realisation that credit channels will not be as open-ended as had become accustomed to. In the rural area, for example, it’s interesting that there are few signs that farm prices have bounced back to any discernible degree, even though commodity prices certainly have. In the realm of commercial and industrial property, effective yields are backing up.

And while home sellers are holding out to achieve “recent valuations” buyers are only prepared to pay what they think is a “reasonable price”. There’s a big gap between the two. This price-discovery process will continue. It could yet surprise people in how drawn-out it is and where it gets to in the end. There are some big questions rightly being asked. While we can’t be sure of the results, and timings, we do think the best compass will be a decent risk-adjusted yield in respect to whatever property market you are dealing in.

See PDF version of this report here.