January 29, 2005

By Charlene Clayton

Prices of residential property (see table <http://www.persfin.co.za/html/persfin/bubble_table.html>) have rocketed over the past four years – so much so, that the question now is whether the boom is really a bubble on the verge of bursting. Everyone’s had their say on the subject, with the prevailing mood probably best described as cautious optimism. But what can you believe? We sum up the situation.

Can you go wrong with property? Most certainly yes, as Lindy James (not her real name) knows only too well. She was 22 in the early 1990s when she inherited money and began to speculate in property.

"I was like a property magnate," she says. "I would buy flats off-plan from developers and on-sell before having to take transfer. At one point I had five properties on the boil."

But then trouble hit. Lindy managed to sell two flats, but couldn’t find buyers for the other three. She struggled to pay the bonds on the three properties for six months and eventually managed to sell one flat, bought for R145 000, for R142 000. She took a loss of R4 000 on the second property, after paying R89 000 for it. And then the buyers dried up completely. It took her a year to sell the third property for R125 000 – the price she paid for it.

If Lindy’s foray into the property market sounds chilling, it should. It’s hard to imagine losing money on property at the moment.

Hardly a dinner-table discussion goes by without stories being told of people asking or paying astronomical prices for property. Some greedy sellers turn out not to be satisfied with the asking price they have set, and anxious buyers, caught up in the hype, are upping their offers in response.

One Port Elizabeth businessman made an offer R20 000 higher than the asking price of R230 000 for a plot at Betty’s Bay on the southern Cape coast, and felt confident of getting it. Imagine his dismay when the seller turned his offer down after being told by her financial adviser that she would get R400 000 for the property by the end of the year. When the businessman upped his offer to R400 000 in his eagerness to acquire the property, the seller decided not to sell.

Facts and figures
According to research commissioned by Absa, house prices climbed by 22.7 percent in the year to the end of March 2004 compared with the previous year – the biggest annual increase in more than 20 years, and the highest increase worldwide for the period, according to ResearchWorldwide.com’s Worldwide House Price Index.

Australia, with 18.9 percent growth in home prices for the last-recorded 12-month period, was placed second, and the United Kingdom, with 16.7 percent growth, came third.

Of the 20 countries monitored in the survey, all but four recorded positive increases in house prices over the 12-month period. Interestingly, Japan was bottom of the list with -5.7 percent.

According to Jacques du Toit, a senior economist at Absa Group Economic Research, the price of an average house in 2003 was R427 600, compared with R282 300 in 1999 – an increase of about 84 percent. Absa’s research is based on loans granted by the bank for houses of between 80 and 400 square metres in size, valued at R1.6 million or less.

Du Toit says this four-year period of relatively strong growth in both nominal and real (after inflation) terms came after a long period of mediocre growth in house prices from the mid 1980s to the end of the 1990s.

The excellent performance of the property market lately can be compared with the boom experienced in the early 1980s when property prices increased for four consecutive quarters in real terms, he says. The subsequent decline from 1984 was caused by factors such as a significant increase in interest rates, poor performance of the economy and political uncertainty.

By contrast, Dennis Dykes, the chief economist of Nedbank’s Economic Unit, says the current boom has been supported by lower interest rates, good growth in incomes, a growing middle class and lagging supply after many years of relatively low prices.

Lower interest rates have played a particularly important role over the past year, Dykes says. The prime rate falling from 17 percent to 11.5 percent in the second half of 2003 increased affordability and therefore demand. This echoes the situation internationally, with interest rates in key economies at their lowest levels in decades and house prices at historical highs.

Thanks to wage and salary growth that has consistently exceeded inflation and personal tax breaks in 2002 and 2003, there has been a real rise in personal disposable income, Dykes explains. And demand for property has been further fuelled by the changing socio-political environment, which has helped create a growing middle class, he says.

Boom or bust?
The big question on everyone’s mind is whether the boom can last indefinitely, or whether it is an ever-more fragile bubble that will burst sooner or later.

Jeremy Gardiner, a director at Investec Asset Management, says there is money to be made and lost during bubbles, so it is vital to identify them before it is too late. All financial assets go through periods of weakness and strength, he says, simply because of supply and demand. But bubbles develop when supply and demand reaches extremes: either everyone wants something or no one does. A bubble is simply a period of exaggerated strength or weakness which must eventually correct to more realistic levels, he says.

Most market commentators do believe a correction is due in property prices. The current growth rate cannot last forever, they all agree, but most of them stop short of calling it a bubble. Property is still a viable long-term investment for the future, they insist.

Ryan Jamieson, the head of investment markets and funds research at Momentum, advises extreme caution, especially if you are buying speculatively. Speculators can make money in any kind of market, he says – for instance, you could buy a property at a high price and make money by selling it to somebody who is an even bigger fool than you are. But the danger signal is that interest rates are thought to have bottomed out, so the next move may well be upwards.

The residential market in South Africa is generally expensive and definitely shows signs of the bubble effect, he says. Prices may yet increase further, but, once again, caution is vital in the light of a possible increase in interest rates.

Another factor at work in the market is a shortage of tenants. With construction and the take-up of mortgage bond finance at long-time record levels, it’s inevitable that a high proportion of buyers need tenants. The number of "to let" boards appearing all over cities and suburbs is proof of that.

Jeremy Gardiner puts the high demand for investment property in the buy-to-let sector down to investors having been disillusioned with soft equity markets over recent years and being lured by rising capital values and attractive rental schemes. But having snapped up investment properties, owners are finding them increasingly difficult to let, he says, and rental income is falling. If and when interest rates rise, investors may struggle to pay their monthly borrowing costs, and that could lead to a flurry of selling. If more properties come onto the market than there are buyers, property prices will drop.

Absa’s Jacques du Toit does not expect a major downward correction in the near future, but says prices seem to be peaking, as the novelty of lower interest rates wears off and the probability of an interest rate increase grows stronger.

According to him, the housing market is expected to record strong performance well into 2005, but with growth in both nominal and after-inflation terms expected to slow down. The slow-down in growth will result from higher inflation, as well as higher interest rates towards the end of the year, he says, and a rising trend in the ratio of house prices to income levels.

Bryan McLachlan, the general manager of strategy, innovation and marketing at FNB Homeloans, has no fears of a general price bubble in the market.

"Our economists are predicting only a one percentage point increase in interest rates towards the end of this year and another one percentage point [increase] next year. But long term, the interest rate cycle is still expected to be down," he says. Based on interest rates and inflation rates internationally, which are substantially lower than those in South Africa, he expects local interest rates to decrease to single digits over the next three to four years.

On that basis, he expects property prices to continue to grow in South Africa, although at a slower rate compared to the price increases experienced over the past few years.

Saul Geffen, the managing director of bond origination company MortgageSA, says South African property values might be rising at the highest rate ever, but, taken in the context of other countries, what we are experiencing is not so much a bubble as a situation of "organic growth". We have experienced prolonged economic growth, he says, and that flame has been fanned by low interest rates, increased interest from foreign players and the housing needs of an emerging black middle class.

The country is still a long way from meeting the demand for housing, which shows no signs of tapering off, he adds. And demand for housing exists countrywide – even in the smaller regions of the Eastern and Northern Cape, as well as Limpopo Province.

He agrees with Dykes that increased disposable income as a result of the strong economy is another positive influence. With more disposable income, South Africans can afford to buy property. And household debt levels are lower than they are in households in the United States and United Kingdom.

Then there is the fact that access to and financing of property is in good health, he says. "The government has turned its focus to this sector and is putting regulations in place to ensure access to property and finance across the spectrum, with a particular focus on the lower end of the market."

While he concedes that property price growth will eventually slow and interest rates will begin to rise, he expects these changes will be gradual and manageable.

Mike Bester, the chief executive of Realty 1 Elk, agrees that a dramatic price correction in house prices is not likely. He says the rate of growth in value is levelling out because of diminishing affordability.

"In the past, people were encouraged to buy an address before a property. In other words, the area in which they bought was more important than the actual house. But now people are compromising, and affordability is key when it comes to home ownership," he says.

Bester predicts that many previously unpopular areas will come into their own over the next few years as more and more desperate and frustrated buyers begin to recognise the value for money they offer.

"Provided that a suburb offers relatively low crime levels, a reasonable infrastructure and access to major routes, first-time homebuyers, particularly, will buy into it and redefine its image by upgrading and renovating the homes."

He remarks on the current trend towards converting CBD commercial buildings into residential properties. Hugely successful developments in Cape Town and urban renewal projects in Johannesburg have shown, Bester says, how property developers and buyers are confident enough to expand into new areas and create new markets.

Danger zones
The buy-to-let market (in which investors buy properties for the purpose of letting them) and other fast-growing developments, such as the security complexes and residential golf estates that have been springing up at a phenomenal rate, are areas of concern.

As Geffen explains it, the excellent performance of property as an asset class means that many people have begun to buy property to let as an investment. At the same time, people who previously rented have found they can afford to buy, resulting in an oversupply of rental property that is becoming more and more widespread. It is important to realise, Geffen says, that property price increases are not occurring across the board. While prices in the middle- to upper-priced sector continue to increase, growth rates in the low-cost sector have not been as significant.

Lindiwe Kubeka, the head of Nedbank Homeloans, says the dramatic price rises and increased speculation in the buy-to-let market have raised concerns that prices may be in a bubble phase. She believes some of the market could be vulnerable in the short term, particularly if interest rates rise unexpectedly quickly and the current upswing is cut short.

According to Steve Mills, the head of portfolio management at Sanlam Investment Management, there is a bubble in certain types of property, such as residential golf estate developments.

A bubble develops where speculators buy several properties in the hope of selling them before taking transfer and making a quick buck. If most of the investors in developments like golf estates are speculators, and they all want a quick turnover, there is going to be an oversupply of these properties at one time. If there are not enough buyers, they might have to sell at reduced prices.

McLachlan says the key, when buying property for the purpose of letting it, is to make sure you can service your loans even if you do not have a tenant. Already rentals have been pushed downwards because of oversupply, he says.

Two years ago, a typical property in the buy-to-let market achieved a monthly rental of about one percent of the purchase price. So, a R250 000 property could have achieved a rental of R2 500 or more. Now, due to the increased supply of properties to let, the same property may only achieve a rental of about R1 800. However, the same property today could cost the buyer R300 000 or more. The buyer would therefore achieve a rental of R1 800 a month on a property costing R300 000, which equates to a yield of 0.6 percent. This illustrates just how far rentals have fallen.

McLachlan’s advice to investors buying property to let – or even a holiday home – is to make absolutely sure you can afford the loan if interest rates increase.

Protect yourself
Price bubble or not, you need to exercise caution when buying property. Consider these tips:

Buy at a reasonable price
The adage buy low, sell high applies to property as to any other asset class. The more you "overpay" for a property, the lower your profit is likely to be, if indeed you make any profit at all, and the longer you will have to hold onto the property before you break even.

Opportunities to acquire property at a reasonable price will always crop up because of the changing circumstances of individuals. There will always be somebody who is forced to sell a property quickly and hence at a reasonable price compared to similar properties on the market.

Don’t over-borrow
The bigger the deposit you are able to put down on an investment property, the smaller your monthly home loan repayment. If you can afford the monthly repayments on the property without having to rely on the rental from a tenant, you will not be under financial pressure if you cannot find a tenant for a few months.
Factor in interest rate increases
While lower interest rates are good news for potential buyers, "stress test" your budget before taking the plunge. You should ensure that you are not over-committing yourself financially while rates are low and that you will be able to take the heat when interest rates bounce back up as they are expected to do later this year.
Diversify
Consider taking some profits out of property and spreading your investment risk by investing in equities or other assets.