Written by A special report by Jupiter Securities Research
Monday, 15 August 2011 11:48
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There is no question that Malaysia’s residential property market had a great run between 2001 and 2011. But property stocks have had a chequered performance record.
A capitalisation-weighted sector index, the Bursa Malaysia Properties Index suggests property stocks exhibit a pattern of returning to the approximate base levels (starting points) after the index completes its rally.
Each successive rally also took the index higher than the previous occasion, that is, assuming the current rally will accomplish the same. This suggests that, in general, property stocks on Bursa Malaysia are purely cyclical and exhibit increasingly volatile retracements with every new upswing cycle.
The upswing portion of each rally cycle appears to last either about 11 months or, if of an extended duration, about 20 months. Given that property stocks began rallying in April 2009, the post-recession rally reached its 21st-month duration in January 2011 and may already be past its approximate end if the January 2011 high is to be taken as a peak.
Given the cyclical nature of property stocks, they are unsuitable for a buy-and-hold approach to investing. Timing considerations then take on an important role in investments in property stocks.
An integral part of investing in property stocks is therefore to also read market trends for signals identifying a peak in the cycle e.g. relying on technical analysis for signals, but we will suggest that there are other ways to achieve this.
Success in direct property investments depends ultimately on the choice of location, but sentiment trends may be discerned from Malaysia’s House Price Index. After staging an excellent run in 2010, particularly in Kuala Lumpur and Selangor, this index dipped quarter-on-quarter in 1Q11.
Anecdotal evidence suggests that speculative activities did play a major role in the initial run-up in prices in 2009 right after interest rates fell with the onset of the 2008 global downturn. In turn, the sharp price appreciation drew in new speculators and resulted in newly formed families bringing forward house purchase decisions.
In the past 10 years, property prices rose steadily, resulting in a proliferation of hitherto rare million-ringgit homes. Based on the national House Price Index, a “representative” residential property costing RM100,000 in 1988 would have risen in value from RM220,694 in 2000 to RM308,066 in 2010, up 40% on the back of a rise in per capita nominal income of 20%.
Property investment became a viable asset class in Malaysia, where it had stayed in a class of alternative investments outside mainstream asset classes in the preceding decades.
What has changed in the past 10 years that has allowed house price appreciation to outstrip income growth without affecting demand? We suggest six main factors:
Malaysia's aggressively young demographic profile has and will continue to fuel rising demand for housing.
1) Malaysia’s aggressively young demographic profile has and will continue to fuel rising demand for housing. There’s an age pyramid showing a jump in the population in the 20 to 29 years age bracket compared with the 30 to 39 bracket.
This means that household formation is set to pick up pace sharply and that sets the stage for a boom in housing demand in the medium term. Our estimates suggest that on a nationwide basis, the rate of household formation implies that the incoming supply can be mostly absorbed.
But demographic dynamics do not permit demand to circumvent affordability issues.
2) Interest rates fell steadily from 1998 highs. From a mean lending rate of 12.1% in 1998, interest rates fell to 5% in 2010. This lowered the monthly interest-only cost of, for example, a RM200,000 loan by 34.5% from RM1,278 to RM837 while nominal incomes rose 20%.
Lately, many developers even absorb the holding cost by offering interest-free periods until completion. This enables property speculators to gamble on potential price appreciation by buying, then simply “flipping” a property to the next purchaser before the need to pay any money at all arises.
3) Loan to value (LTV) or the margin of finance that banks permitted borrowers to take on rose from typical ceilings of about 70% in the early 1990s to as high as 95% to 100% recently.
The implication is that house buyers need not spend as many years accumulating cash resources needed as deposit for a purchase. Consequently, it became possible to buy a residential property very early in one’s career. Purchase decisions brought forward easily in this manner fuelled demand for houses.
4) Loan repayment periods were in the past constrained by the length of one’s working career (up to 55 years of age), effectively limiting anyone who began working immediately after graduation from university to no more than a 32-year loan. But no more. Banks resorted to two-generation loans of 40+ years’ duration at the peak of Malaysia’s 1980s property boom. Malaysian banks have now come full circle to again offer 40-year loans or for periods until the borrowers reach 70 years of age (effectively launching into two-generation loans again).
The average life expectancy for Malaysian males is 73 years, meaning that this measure (lengthening repayment periods) has no further room for play.
5) Multiple home mortgages spread across several financial institutions each still declared as owner-occupied units generate strong demand that is higher than can be inferred from income or demographics. They reduce each bank’s exposure to a given borrower, but mask elevated systemic risks. Generally, owner-occupied residential mortgages find favour with banks because they are thought to spread out risks, and individuals will arguably be loathe to lose the roof over their heads.
Owner-occupied home mortgages also tax the capital base of banks less. They carry 50% risk weight, allowing banks to extend twice the sum in credit on a given capital base.
6) The rise of property as an international investment asset class. The pooling of investor resources via vehicles like local and regional REITs (real estate investment trusts) has telegraphed the up-until-then limited ability of individual investors to invest in large-scale commercial properties. Some property consultants also attribute the purchase of properties by foreigners as an important demand driver, but other than residential properties in a limited number of enclaves, this may not be a major source of property demand.
Applications to take up residence here under the Malaysia My Second Home programme number about 1,500 a year. Some consultants also allude to the repatriation of money by returning expatriate Malaysians. The extent of this inflow and the number of individuals involved is unknown.
It is clear that easier and cheaper credit availability for both residential as well as commercial properties were major factors fuelling a decade-long upswing in property prices. Between 2000 and 2010, nominal GDP rose annually at 4.6% a year Banking system housing loans in comparison, grew far faster annually, averaging 16.8% a year.
This translated into increasing levels of household debts relative to income. During all periods when GDP growth stalled in the past decade, loans growth merely slowed briefly, only to see, on recovery, an acceleration to a pace faster than prior to the slowdown.
The resultant relentless rise in household debts became possible mainly via a loosening of lending standards in the manner described above.
Is further leverage even possible?
The precise upper limit of sustainable household debts is a matter, of some conjecture, but Bank Negara Malaysia (BNM) has begun to turn its attention to the matter given the role played by unsustainable household debt levels in inflating a housing market bubble in the US between 2002 and 2006 and given an alarming number of cases of individuals (140,000) seeking assistance from AKPK (the Credit Mediation Bureau).
How far away are Malaysian households from the famously high debt levels of US households at this point?
The chart sets out the household debt-to-GDP ratio for the US from 1952 to 2011. Note that the 2010 household debt-to-GDP ratio for Malaysia stood at 76%, approximating US household debt-to-GDP levels in mid-2002, when the housing bubble in the US began unfolding.
It would therefore be prudent that BNM quickly install measures to head off an involuntary deleveraging process that would accompany any subsequent bursting of an asset bubble (e.g. requiring banks to test repayment means using net, not gross, income as is usually done).
That the current US household debt-to-GDP ratio of 88.6% is still an unsustainable level is best indicated by the still ongoing nature of the US household debt deleveraging process.
In our opinion, the comfortable aggregate household debt to financial assets ratio at 238% for Malaysia is an unreliable buffer because currently high asset prices (e.g. unit trust prices) may also rapidly deflate in a deflationary environment that typically accompanies the onset of any deleveraging process.
Also, such aggregate data masks the true extent of the pervasiveness of over-extended households where income disparity is very wide (a small number of extremely wealthy households with no leverage in combination with a large number of over-extended households will result in a comfortable aggregate ratio still).
Anecdotal evidence hints that this may be increasingly the case. In a systemic crisis, it will be the number of households in the weakest financial position at the margin which determines the incidence of inability to meet financial obligations.
While the precise timing of peak conditions in the property market is as always unclear, we see clear implications from the tailing-off of the credit impetus to the housing market.
The large-scale township development model is clearly behind us. The lack of large plots of undeveloped land in the proximity of mature urban areas means developers must realistically focus on smaller developments, thus robbing property developers of some economies of scale.
The strategic response has been to move upmarket, into “niche product”, higher-margin developments.
In order to justify higher prices, product innovations such as gated communities, “landed strata” communities, SOHO (and variant) residential developments with commercial possibilities, and inner-city high-rise developments have been explored.
First-mover advantage can be quickly lost, so innovations such as these have been followed up by rapid-fire launches across a number of locations.
To maintain the earnings momentum, the gross development values (GDVs) at property developers have had to be quickly built up. To ease the process, these developers have also increasingly turned to commercial developments that involve higher GDVs, but which are more vulnerable to soft patches in the economy.
This is of particular concern as our view is that in a “new normal” world economic order, business cycles will be of a shorter duration.
A clear consequence is the spring/summer soft patch in the US and developed economies that has already weighed on property prices in export-dependent Penang.
Valuing property companies will become measurably more difficult in 2012 as new accounting standards in accordance with IC Interpretation 15 of FRS118 are to be observed in respect of income recognition beginning from 2012.
The present method of first estimating the total development profits and then progressively matching the estimated profits with the percentage of completion is thought to be unreliable, as the risk of failure to carry construction to completion will go unrecognised and project cost overruns may not be reckoned with until the completion, skewing reported quarterly earnings away from reality.
As a strategy, we have deliberately focused our attention on property companies with a small current base of ongoing projects measured by their GDV but which have a strong pipeline of relatively affordable properties, particularly in the Klang Valley.
Considering the following:
1) The interest rate cycle has clearly bottomed and is on the upswing in the face
of inflationary pressures;
2) Beating means test constraints through lengthening repayment periods has reached a practical limit with the latest 40-year loans;
3) Demand from investors is being choked off by restricted access to high LTV loans for second and subsequent home purchases;
4) The price dynamics have turned less friendly and may turn unfriendly in several major states; and
5) The ratio of the price of a representative house to the nominal per capita income has reached 1996 (eve of Asian crisis) levels and Malaysian consumer debt levels are unsustainable.
Our preferred approach to stock-picking in the property sector is to focus on companies with projects involving ongoing GDV of less than RM1 billion. These tend to be lower capitalisation stocks but those which we eye as candidates for promotion into the big league.
The drawback is, with a smaller even if growing pipeline of projects, these companies will report a more volatile stream of earnings when income recognition becomes restricted to the completion stage beginning 2012.
We have also become more wary of property developers with a high exposure to the shop unit, shopping complex and purpose-built office properties segment in Putrajaya, Kuala Lumpur, Selangor and Johor.
There is anecdotal evidence that the surge in launches in this property segment was to an extent made possible by the loosening of bank credit standards. In the past, drawdowns of bridging loans were, as a rule of thumb, subject to projects exceeding the 60% sold mark.
This has apparently been lowered to 40% in many instances, raising risk levels for banks and also for developers.
This article appeared in The Edge Financial Daily, August 15, 2011.
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