Pass me that nail would you

A frequent comment about why “property prices will keep going up” is that:

  1. They aren’t making land any more
  2. Building costs keep going up
  3. Our population is growing

If these points are true, then this would provide a strong force to push property prices up. It still wouldn’t mean property prices couldn’t decline.

  • Citizens still need  funds and financing to purchase houses and may not have them
  • Property “consumption” can be reconfigured. That’s a fancy way of saying you can squeeze more people into the existing houses
  • Informal settlements can spring up relatively quickly. There is plenty of “land” in South Africa, it just doesn’t have services or proximity to employment opportunities.

What’s all this about a nail?

iAfrica has an article on declining building costs in Q2 2008. Wow, the cost of creating a new building is lower now than it was in the first quarter of 2008. This is while Producer Price Inflation (PPI) stood at 12.3% in June. PPI is a measure of the general costs of production and has been leading CPI and CPIX recently. (I think it will typically exceed CPIX due to efficiency gains in costs of production that are passed on to consumers through competitive pressure.)

Property prices are down (according to Standard Bank). If you ask ABSA, they still seem to suggest prices are rising. Decreasing building costs builds the case that Standard Bank’s index is telling the real story. This is another nail in the coffin of ever-increasing property prices.

Tail Wagging the Dog

So building costs are down, which suggests that there is less fundamental support for property prices. Property prices are likely to decline for a few months yet.

Could it be that rather than rising building costs driving up prices of existing houses, rising prices of existing homes increased the price of substitutes (new developments and thus building costs). The “support” that rising building prices were giving to property prices seems to be less real than many thought. What we experienced was rising profit margins for builders and developers.

The long, inevitable property cycle

Increases in the supply of raw materials and companies entering the profitable market didn’t have instantaneously. The delays in supply coming on stream  was part of the cause of the rising property prices. However, the delays in supply coming on stream also means that supply probably expanded more than necessary. New entrants, basing their decisions on the profit margins available at a point in time rather than considering what would happen to those profit margins when hundreds of other similar people were doing the same analysis and entering the market with the same goal in mind.

Plenty of existing builders and developers made money. Plenty of early entrants made money. Probably, given the length and extent of the property boom, plenty of later entrants made money. But the very late entrants probably aren’t going to make money. Worse, the over-supply affects the original suppliers, the early entrants and the late entrants as well. The market is over-supplied, profit margins will drop to below a fair economic return and builders and developers will leave the market.

They will leave, but only after they have completed their current contracts. Some will try to hang in, hoping that others will give in first and leave them a relatively lucrative market. In fairness, some will collapse and leave early with their half-completed developments in limbo. But the general trend will be for a slow demise, possibly with continued oversupply of the property market. Prices will continue to decrease and builders and developers will lose money.

The demand side of the story

Meanwhile, FNB is withdrawing approval for home loans on a large scale. Even as supply continues to grow, demand is declining. Every time any individual thinks hears bad news about property, he or she is that much less likely to want to buy “just at the moment”. This gearing effect on property is much like that created in commodities through ETFs.

What is a sustainable growth rate in property prices

Our economy grows at a certain rate. Careful, the numbers reported are “real numbers” which indicate how much the economy has grown if we keep prices the same. (Strictly speaking, a “GDP deflator” is used rather than CPI or PPI, but the principal is the same.)

Wages may sometimes grow at slightly more than real GDP, either due to productivity gains or efficiency of capital employed. Special fiscal spending on housing aside, I suggest that in the long-term, this should be a pretty close proxy for the sustainable growth in real property prices.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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