Building fixed investment slowing down

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By Cees Bruggemans

Mid-quarter fixed investment round-table participants:

Cees Bruggemans, Chief Economist FNB
Charles Martin, Senior Economist, BER
Erwin Rode, Property Economist, Rode & Associates
Pieter Laubscher, Chief Economist BER

Bruggemans: The news coming out of the building industry appears to be increasingly grim. Fixed investment in new structures is slowing down, with apparently more downside ahead. These are enormous ‘Winds of change’.

Martin: We have in recent weeks seen an avalanche of poor news coming from especially real estate agents. Activity levels in the property market are way down, potential buyers moving to the sidelines even as more buyers come to market. Properties are spending longer time on the market. Negotiated discounts have widened. The number of estate agents is shrinking as people leave the industry.

Rode: We need to distinguish between the secondary and primary housing markets and their price trends.

Historically there is quite a good correlation between secondary transactions (house sales) and nominal prices. Currently the number of transactions is volatile, but heavily trending down. House prices are less volatile, more stable, in fact resistant.

Bruggemans: Do you believe the comments from estate agents about the current situation?

Rode: Oh yes, they are very much describing reality as experienced by them. If we accept the integrity of the ABSA house price index, nominal house price changes are still increasing but are very close to zero.

Martin: Their latest reading (for May 2008) was +6.8% on a year ago, but giving the impression of sitting on the edge of a cliff. This is the lowest price gain since November 1999 and it is still slowing.

Bruggemans: That price index can be expected to turn negative year-on-year in coming quarters?

Martin: Prices are already negative in real terms and nominal declines are quite possible, if interest rates jump another 1% and real disposable incomes get eroded by rising fuel and food prices.

Bruggemans: So what does that suggest about residential building activity ahead?

Rode: Given the strong correlation between real house price trends and residential building activity, the news for new house building is terrible. Building activity is going to drop heavily. The evidence is already there.

Martin: The signs are that the drop is accelerating.

Rode: Yes, there is quite some way to go. The degree of the fall-off is worse than foreseen on account of interest rates, rising higher for longer than expected.

Laubscher: Nationally?

Rode: Yes, nationally, basically everywhere, interest rates being nationally. Latest cement sales in April are down 1% in volume nationally (and -5% in Gauteng). This is despite strong demand coming from construction (infrastructure).

Bruggemans: I notice that the Cement Institute reported a 4% volume decline in cement sales during 1Q2008.

Martin: Construction doesn’t take too much cement. It is especially residential and non-residential building activity that absorbs a lot of cement. But there are infrastructure activities looming (roads?) where more cement is likely to become absorbed.

Laubscher: Erwin, are you worried about house prices?

Bruggemans: Are we in an American situation, facing a 20%-25% decline in nominal house prices?

Rode: Not close. With a 15% prime interest rate as we have it currently, I expect ultimately a 5% decline in our house prices as reflected in the ABSA price index.

Bruggemans: But if we face 16% prime, with a 0.5% increase in June to 15.5%, and another 0.5% increase in August or October to 16%?

Rode: Prime 16% could translate into a 10% decline in house prices as per the ABSA index.

Bruggemans: Is this a unique experience for us (as it is for the Americans who haven’t seen house price declines since the 1930s depression)?

Rode: Yes. Very unique. The irrational exuberance in recent years has been exceptional. House prices have been overcommitted, as I have been saying these past two years. So they are now cyclically correcting.

Martin: By 1998 house building and the property market had not yet taken off properly, with real prices still low, when both were shocked by the rise in the prime interest rate to 25%. So we were coming off a low base as we entered the new millennium, and were then given rapid interest rate cuts. People simply went overboard.

Rode: What we see now playing out is normal, real house prices reverting to their long-term mean after a period of deviating to the upside. The model I use is simple, deflating nominal house prices by the BER building cost index. Normalisation of that trend suggests a 10% decline in house prices from their peak level.

Bruggemans: The driving forces are the usual suspects?

Rode: We are currently still enjoying very high real prices. Household debt burdens have increased by more than half to 80% of disposable income. The higher interest rates have increased the debt-servicing burden already to over 11% in line with 1998. That has reduced affordability. To this we must add further purchasing power losses through food and petrol price increases, further shrinking affordability.

Laubscher: If we get 10% house price declines, we will see spreading negative equity in the housing market.

Bruggemans: Could our downside get to be as bad as what is happening in America?

Rode: We didn’t have the extreme excesses in our home building as they did. Therefore the downside in our prices is also not the same as over there. What is happening now is what traditionally happens, properties moving from weaker hands into financially stronger hands.

Laubscher: Do we have evidence of empty houses?

Rode: No, not anywhere close to what the US is experiencing, except at the upper end of the price range (over R2 million), for example in the Golden Mile in the Strand, or CBD apartments in Cape Town.

Bruggemans: There are also more empty, up-market, houses in parts of Johannesburg. But why not more empty houses?

Rode: There is a shortage of housing stock, given the inflow to the cities as urbanisation proceeds. Rentals are rising strongly, which can be taken as proxy for no excess houses.

Martin: Even so, the house price downside should not be underestimated and could be more severe than has become expected.

Rode: The 1984 situation was similar to today. Very high real house prices, sharp interest rate spike (prime reaching 25%).

Martin: But today’s experience could be worse.

Rode: Current interest rates aren’t as high as they were then, but the debt load is much bigger. Also, there are many more people who haven’t gone through such a cycle.

Martin: Many more people with small or non-existent capital bases, with little to fall back on to absorb such a shock.

Bruggemans: How is this playing in the building trade?

Martin: There is still considerable denial in the broader building trade as to what is playing here, and more importantly what is looming.

Small contractors are already feeling it firsthand. Building activity is coming to an end for subcontractors.

Large building contractors are starting to feel it, but are still very unsure as to where this will lead. Townhouse activity is feeling it strongly. Single-house building as yet the least, going by building plans passed.

Bruggemans: You see considerable downside, Charles?

Martin: The debt load. The already high interest rates going still higher in coming months. These will push the debt-servicing burden (mortgage payments as percentage of disposable income) even higher than what it already is.

There are today many more households owning houses, but with little asset backing. Especially the emerging market doesn’t as yet have much asset backing. This is going to create negative equity. It will encourage more selling. It will put more downward pressure on house prices.

Rode: Especially at the lower end of the housing market. The R200 000 to R500 000 bracket, where there are today many more new entrants, of which many are exposed to negative equity (having 100% to 108% bonds).

Martin: That applies especially to those households who bought prior to the new National Credit Act coming into force in mid-2007.

Bruggemans: Can we shift our attention to non-residential building activity, especially retail space, industrial and offices?

Martin: Throughout we have been very confident about non-residential building activity, as reflected in our BER opinion surveys of the trade. There was reason for confidence, with vacancies falling, rentals rising.

But then the 1Q2008 gave us a surprise, with confidence and activity falling off already, way ahead of expectations. The office and retail space data are already turning negative. It looks like non-residential building activity isn’t going to escape the downturn.

Rode: I have been most surprised to see the data turning. We know shopping was getting overbuilt, and is now slowing. But the office space decline already also starting to come true was a surprise. Indeed, it makes no sense, given the low vacancies and strongly rising rentals.

Martin: Yes, but building plans passed are slowing. Interest rates have been rising for two years already. Then there has been the political environment, and its early stirrings of changes coming. Eskom hit hard this January, but problems were already apparent from late last year, as it apparently became more difficult to gain approval for new projects.

Rode: Confidence has been failing since late last year. Despite good fundamentals (rising rentals), sentiment has been fading. It may explain an early downturn.

Bruggemans: It suggests heightened sensitivity out there already for some time to straws in the wind, especially interest rates and politics. Can’t say that confidence surveys registered such early hesitancy on the non-residential side, but building plans passed tells their own story. People weren’t ultimately blindsided. Even as activity reached peak levels, new projects were apparently starting to be approached more cautiously.

Laubscher: Will we crash the economy this year and next with too high interest rates? If we do, we risk building interest rate volatility into the system, having to ease aggressively again to revive the economy down the line. There is also a risk of capital outflows in the event of substantially weaker growth over the short term.

Bruggemans: I agree that our policymakers are certainly shaping that way at present. But I am far from convinced that we will get ambushed over the capital account, with so many corporate assets in play (MTN, possibly Billiton) and billions of dollars potentially still flooding in, and this before taking into account the higher interest rates boosting carry interest. But then I also wonder whether the policy rules (inflation targeting, fiscal surpluses) will be relaxed within the year on political grounds and what that will do to our playing field.

How does the BER see this year and next?

Laubscher: We expect a sharp further slowdown in 2H2008. Real fixed investment growth of 7.5% this year and 6.5% in 2009, compared to 15% last year.

Excluding infrastructure, we see private non-residential fixed investment doing 3% this year and 1% next year (basically nil).

All of this is a substantial deceleration in the growth momentum of fixed investment. From elevated growth as recently as 4Q2007 to almost flat by early next year.

Bruggemans: I suppose the essence is price discovery and builders gradually discovering a changing environment.

Laubscher: So far it is a cyclical change, a dip.

Bruggemans: But is the dip shaped like a V, a U or, heaven forbid, an L? Is recession looming?

Rode: Is this a structural change?

Laubscher: The BER is more in favour of a moderate adjustment to the growth outlook. There are positives, such as that we will be removing the overhang of imbalances (savings and trade shortfalls, overutilising available capacities). Also, certain producers are being favoured (manufacturers) by the weaker rand.

Martin: Tourism, infrastructure, agriculture are all positively influenced.

Rode: There is no real sign of despondency, at least not in the non-residential secondary market. But then they don’t feel the signs as quickly as in the building trade. Confidence is still pretty high, going by explosive rentals growth in the non-residential property market.

Martin: Sure, but small subcontractors in the building trade are showing a gut-feel sense that things are changing.

Bruggemans: It seems that after the unflagging upbeat conditions still dominating last year, there is a major downshift under way this year. It is most pronounced in the secondary residential property market, with estate agents reporting a major change for the worse to be under way. The residential building trade is also feeling the headwind with especially small subcontractors already seeing the workflow ease. Larger contractors are probably still mostly in denial as to what could be looming. Prime 16% and Erwin Rode’s expectation that house price levels could drop 5%-10%, traditionally a reason to expect a sharp fall-off in building activity also, suggest the worst may still lie ahead.

Non-residential building activity has so far been shielded, also due to low vacancies and healthy rental growth. Building plans passed here also have started to drop off, hinting at an early cyclical downswing. But then interest rates have been increasing for two years, and political stirrings have also for some time been hinting at changes ahead, with Eskom coming strongly onto the scene only these past seven months. It may have made people of late more cautious to commit longer term.

Instead of seeing total fixed investment steaming on unchanged from last year’s fast growth, there seems to be a halving of the pace under way to 6%-7%. While infrastructure fixed investment is likely to continue strongly, possibly even speed up in some areas, private fixed investment commitment may be going through a bit of a rethink as spending is slowed down, possibly in search of new clarity as to what precisely lies ahead.

Source: Cees Bruggemans, FNB, May 26, 2008.


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