Adjusting to Risk: Capital Controls to Coronavirus

Well before the Coronavirus (COVID-19) started to impact economic sentiment, the Australian CRE sector was already factoring in a slow-down, notably in high density residential development.

Foreign Investment Review Board (FIRB) statistics indicated a 58% decline in foreign investment in the fiscal year 2017/18, falling from ~$30 billion to ~$13 billion. A significant portion of this reduction came from Chinese sources.

According to global real estate firm JLL, pre-sales that were heavily underwritten by mainland Chinese investors peaked in FY2015 and have since slowed considerably.

Residential development site values have consequently declined during the last six months. The yardstick, acquisition price per developable unit, has reduced on average by ~6% across Australia.

Major construction companies are expecting their short-term pipeline to reduce by up to 45% as new towers scheduled for completion in 2020 are followed by fewer new projects.

Opportunities

While this sounds relatively grim, there is a resurgence in alternative uses. Design and planning is well advanced. The long running bull market for apartments actually caused relative undersupply in other uses such as office, hotel, and metropolitan light industrial. Development margins were higher with residential use, justifying higher site acquisition prices.

Given site values have fallen slightly, the alternative uses have tended to prop up valuations, and forecast long-term demand, particularly in Melbourne and Sydney, means developers continue to seize new site opportunities.

Following the absorption of existing stock, and the development lag created by the 2019 slowdown, together with the imminent economic effects of COVID-19, high density residential development is likely to rebound strongly into 2021-22.

In the meantime, medium density apartment developments in inner metropolitan areas have emerged with stronger pre-sales performance anchored by a greater proportion of domestic owner-occupiers. Demand for townhouses appears to be even stronger during February. These projects are typically undertaken by experienced domestic developers funded by local sources.

The ongoing low interest rate environment is driving activity with both Melbourne and Sydney auction clearance rates hovering around 80% again; with higher volumes being an important factor.

Capital Controls: China

In August 2019, China’s State Administration of Foreign Exchange (SAFE) extended currency controls to further restrain outbound capital by individuals and companies.

Specifically, the new set of controls limit the ability of real estate investors to raise funds via foreign currency debt; previously a favoured method of funding foreign developments and acquisitions.

While many property observers generally cite capital restrictions, few have commented on this form of currency control as being the ultimate step-change negatively affecting growth in CRE markets in Australia.

Earlier in 2019, China’s Supreme Court introduced jail terms for operators of “underground banks” which sought to assist capital flows offshore. Chinese authorities were clearly constraining outbound direct investment, notably into what was often regarded as irrational overseas real estate projects.

Nevertheless, ~14% (approximately US$15 billion) of outbound Chinese investment still flowed into countries along the Belt and Road initiative last year. Strategic importance; an imperative yet to be properly understood.

Interestingly, several Chinese backed developers active in Australian property markets have begun to seek domestic non-bank debt to commence construction and, in some cases, complete projects.

By necessity, increased leverage may be required, potentially opening up additional opportunities for non-bank financiers and joint ventures in 2020.

Coronavirus – Current Impact on Construction

COVID-19 has ostensibly spooked global equity markets during the last week. The CRE sector is bracing for delays to the supply chain.

Procurement strategies have been complicated over recent weeks as a backlog of materials including facades, and mechanical and electrical equipment are delayed arriving to Australian sites.

The temporary shutdown of Chinese factories, many of which are in the effected Hubei province, and more recently in northern Italy, means that several Australian construction projects will be feeling pressure to meet key milestones and programmes.

Sequencing in construction is critical for project deadlines. For example, if a fa?ade installation is delayed, the knock-on to other internal trades can be substantial.

Cost implications are yet to be properly assessed. Quantity surveyors and independent superintendents are facing an interesting set of circumstances in the coming months.

Senior debt providers are generally insulated by conservative LVR’s, coupled with construction programme buffers within loan facility agreements.

Conversely, equity investors (the highest risk part of the capital stack) will be observing the situation very closely in an effort to preserve margins.

Apartment Settlements 

Although it’s unlikely to cause material losses in the short term, developers scheduling apartment settlements over the coming weeks may find it difficult if foreign purchasers are caught up in travel bans and quarantine.

The cost of servicing a proportion of the debt during this period may erode developer margin and profitability.

In some cases, developers may need to extend loan facilities, and / or pursue residual stock facilities to repay construction loans on time.

Senior debt will continue to provide the best risk adjusted returns for investors in the foreseeable future. The lowest risk part of the capital stack, underpinned by a registered first mortgage, at reasonably conservative LVR's.