John Paine: Global View January 2008

The last half of 07 certainly had its share of unpleasant surprises, including the finance company collapses and the global Credit Crunch.

In this newsletter I will give my view of how 08 looks for those involved in the property sector in New Zealand.

As we’re all part of a global economy now, let’s start with a speech given last week in London by Glen Stevens, governor of the Australian Reserve Bank. In his view “the US economy is in a period of adjustment, as is the banking core of the international financial system. Even with the renowned flexibility of both, and good policies, this will take a bit of time.”

He goes on to talk about the affect this might have on the global economy and concludes by saying “All told, it seems likely that, after several strong years, global growth will be noticeably slower in 2008. Much of this slowing will be driven by weaker outcomes in the developed world, particularly in countries facing tighter credit conditions.” It’s a very good speech. To get it all click here http://www.rba.gov.au/Speeches/2008/sp_gov_190108.html

In my view more distress from the Credit Crunch is on its way as large banks and investment banks will be writing off more as the insurers they used to enhance the securities they issued fail to honour credit default swaps they have written. To see an early warning last April about this from the Economist click here http://www.economist.com/business/displaystory.cfm?story_id=9033348

For those of you who are interested in the way in which the crisis started, and the reasons why it is having such an effect on the global economy, at the end of this newsletter I have attached links to articles explaining the causes and effects of the Credit Crunch.

So let’s get back to New Zealand and the issues I believe will affect the economy here – and the property finance market in particular.

 Interest rates.
 Inflation fears here are now a major problem – as they are world wide. Figures released last week show our annual inflation rate, as measured by the Consumer Price Index, rose from 1.8% in the September quarter to 3.2% in the December quarter. The main contributors were transport, food and housing – although with higher interest rates the effect from housing may have stalled. This will make the New Zealand Reserve Bank nervous. And while commentators feel the worries about the international financial markets mean it is unlikely the Reserve Banks will raise the Official Cash rate next Thursday, there is still the chance it will be raised later in the year.
 Do not expect any reduction in interest rates offshore to be reflected in a drop here. Any reduction in the U.S. rates will be to stimulate the economy there – and will probably be accompanied by other emergency economic measures aimed at helping avoid recession. In any event countries like China continue to raise interest rates to combat inflation. Their inflation rate surged to 6.9% in November - the highest since 1996. Odds are the Reserve Bank of Australia will raise interest rates in a few weeks time.
 Banks in New Zealand and Australia maintain they cannot continue to absorb increased borrowing costs that have flowed through global credit markets as a result of the U.S. sub-prime mortgage crisis. Already this year they have been increasing interest rates. Home loan fixed rates here have risen by an average of 0.2%. Non-bank residential lenders have been raising their interest rates too.
Expect high interest rates to be with us for some time.

 Banks deposits have been increasing since the finance company failures last year and the flight from investing in finance company debentures. More cash is likely to flow to the banks as the global share markets feel the pinch. This may mean more money is available for the property sector but don’t expect any easing of credit criteria as a result of this. In fact if anything it’s more likely to be tougher to borrow from banks.

 But banks haven’t been the only recipients of the cash looking for a home. Finance companies backed by private investors, solicitor nominee companies, long established finance companies, finance companies backed by strong parent companies, are a few of the sources of finance that have risen out of the ashes of the finance company failures of last year.

 As far as the residential loan market here is concerned, loans funded by residential mortgage backed securities are only a fraction of the entire residential mortgage market, which is dominated by the banks. Therefore the market has little exposure to residential mortgage backed securities which caused the U.S. sub-prime melt down in the first place. There is only about $1 billion of home loans funded this way here and the proportion of these loans more than 30 days in arrears is at its lowest point in 3 years.

 So the residential non-bank lenders are still out there but loans are now harder to get. As a rule of thumb, for any loans over 70% of the value of the house you need detailed documentation to prove your surplus income remaining after tax, hire purchase, and interest on the mortgage, is sufficient for the family to live on. Bank statements are essential and no longer will a couple of pay slips be sufficient to prove income. Lo-doc loans – where an income declaration is required rather than proof – are still available at 70% or less, but issues such as clean credit history are far more important.

 The commercial property market here has been showing considerable strength for several years now and through the turmoil of the last 6 months. Values were up 22.3% in the year to September 07. Some economists predict the growth in new commercial building will exceed residential over the next 6 months. In the year to November 07 new non-residential consents were up 4.7% on the previous year. Dwelling (residential) consents seem to be moving in the opposite direction. But most of the decline is in apartment consents, which indicates this is a story about the apartment market rather than the housing market as a whole.

 However I do have some concern about commercial property values here. As commercial property has been one of the beneficiaries of the plentiful supply of cheap money, cap rates and yields reached ridiculously low levels. In my memory the rule of thumb for commercial property was 10% - with a mid city office block leased to long term prime tenants maybe 8%. Industrial property was 12% - and those with average location/leases 15%. The other rule of thumb we had was rental yield needed to be 2% above the average borrowing rate. Current borrowing rates would indicate commercial property is overvalued.

 The diary industry continues on a roll and farm prices reflect this. The recent high forecast payouts to farmers means more money should flow into the greater economy. Rural loans have always been based on proven productivity and serviceability and we expect there to be no change in the ability to get these. However prices for dairy farms have hit record levels and this is of some concern.

 Finance for property development and commercial property investment is there - but the criteria needed to get it are tougher. Much of the non-bank lending secured over wide range of commercial properties and developments will fall due in the next 6 to 12 months. Developers have taken short term loans to settle properties while resource consent issues, pre-sales, and other regulatory and commercial requirements are sorted out. In the past if there were delays the lender was normally happy to roll the loan. However in an environment where the lender is conscious about their own liquidity position, refinancing is no longer a certainty.

 And, hey, it’s election year. With tax relief? That’s always a positive for the economy.

As far as all forms of finance are concerned, as I’ve said in the last two newsletters, the focus has changed. No longer are simply low loan to valuation ratios enough to attract finance. Sustainability of cash flow to service loans has become the focus and some lenders are demanding higher interest cover than before. Developments and subdivisions are almost impossible to finance without presales.

There are however “asset” or “security” financiers out there. These lenders are not seeking serviceability but are looking for a take out from an event like a sale, or another financier replacing them once certain criteria have been met

These financiers are now far fewer than before and many are private lenders. To make matters worse, those lending one week can be quite different from those the next. And as they have a multiple of choices as to whom they will lend, a proper and full presentation to the financier is essential for your proposal to be accepted.

There will however be some projects that will be in difficulty as a result of it being harder to raise finance. This has and will continue to bring up opportunities for buyouts, joint ventures, and equity and quasi equity participation in commercial ventures.

Email or phone me if you’d like to know more about any of the above.

Cheers

JP

John Paine B.Sc. Dip BIA
Global Pacific Corporation Limited
112 Gladstone Road, Parnell,
Email john.paine@globalpacific.co.nz
Web site www.globalpacific.co.nz

P.S. Articles explaining the causes and effects of the Credit Crunch.

1. A bulletin issued by the Reserve Bank of Australia entitled The Asset Backed Commercial Paper market explains the technicalities of the market and the implications for banks. It’s good in that it compares the differences between the U.S. and Australian Banks (which own the New Zealand banks). To read this click here http://www.rba.gov.au/PublicationsAndResearch/Bulletin/bu_jan08/Pdf/bu_0108_1.pdf

2. The international Monetary Fund article explains how it was lax loan and underwriting practices that led to the sub-prime debacle and how the structure of the mortgage market amplifies these losses into the financial markets as a whole. To read it click here http://www.imf.org/external/pubs/ft/fandd/2007/12/dodd.htm

3. An article from out of the U.S. would be hilarious if it wasn’t true. It illustrates how investors and Wall Street, in their efforts to keep a lucrative market going, took a good idea too far. It’s called “Along came Norma”. To read it click here http://forums.marketocracy.com/general/posts/list/67592.page

GLOBAL VIEW is an email newsletter reporting on the New Zealand Economy with a bias towards how it affects the property and business finance markets. It is a regular commentary delivered to you by email every month.

Disclaimer: Please note that all opinions and statements expressed in this email are indicative of our opinion only. Both the author and Global Pacific Corporation Limited issue no invitation to rely on the information contained in this email and intend by this statement to exclude liability for any such opinion and statement.

ENDS

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