On face value it doesn’t appear that Australia’s banking regulator (APRA) has done much to slow credit and house price growth. In December 2014 they imposed a 10% growth cap or ’speed limit’ on investor lending which in July 2015 resulted in the big banks increasing their interest rates on investment loans for property investors by 0.25-0.30% (learn more here). Given the tax benefits of negative gearing this intervention only increased the net cost of finance by less than 0.20% for the average Australian investor.
So why are many Australian property investors now now unable to get a loan? And why have auction clearance rates in Sydney dropped to 72.9% — more than 10% below this time last year, and about 15% down from their peak in May?
The answer is tighter bank credit policies and more conservative property valuations. These issues are discussed less frequently than the higher interest rates for investors, but they are both having significant implications.
Tighter credit policies
When determining who to lend money to, banks assess an applicant’s ability to repay the loan based on their cash inflows and outflows – this is know as ‘serviceability’, or a client’s ‘servicing capacity’. Banks don’t know what the future will bring, so when conducting these assessments it make sense for them to build in a buffer to account for the possibility of higher interest rates. This way they’re protected if interest rates rise because the borrower would be less likely to default on the loan.
What’s happening now though is that the banks are using higher interest rates in their stress-tests for servicing. For example an investor might be eligible for say a 4.5% per annum interest rate, however when the banks assess that customer’s credit worthiness they might assume this interest rate to be 7.52% (previously it was much lower). Similarly, existing loans held by that same customer (not the new one being applied for), may have previously been assessed based on their actual interest rates and repayments, whereas now a 20% premium might apply.
Legitimate income bonuses as well as the cash flow benefits from negative gearing were previously included in the borrower’s income used for assessment as well. In many circumstances these funds are now being ignored.
Pre-APRA, there was also a degree of leniency for the prospective borrower who ‘failed’ servicing. In the situation where a prospective customer fell a few hundred dollars short per month in servicing many business development and credit managers could pull strings to get these deals over the line… those days are gone.
Banks are now willingly turning away business and plainly refusing to go outside of their credit policies. They have to cooperate with APRA because failing to do so could put their banking licenses at risk.
The result is that borrowers are having to prove higher incomes and lower expenses in order to borrow money. Many applicants who previously would have been approved for a loan are now missing out.
More conservative valuations
An equally important part of the borrowing scenario is an applicant’s ability to fund the purchase costs of their new property which are not covered by their new loan(s). These “funds to complete” as they’re called are determined by the value of an applicant’s properties, as determined by certified and independent property valuers contracted by the banks.
In recent months these valuers appear to have become a lot more conservative. Valuations are starting to come in below expectations, and even in situations where a customer has purchased a property, and holds a duly signed contract of sale, there are situations where valuations are coming in lower than the contract amounts, implying that the purchaser has overpaid.
Low valuations make it harder to borrower because the banks only lend against these assessed values — so lower valuations weaken the borrower’s equity position and borrowing power.
If you’re buying a $1M home and borrowing 80% you would need $200k cash to cover the purchase (ignoring additional purchase costs like stamp duty and other transfer/registration and conveyancing fees). But if the valuation on the property comes it at $900k (rather than the $1M), the bank will only lend $720k (80% of $900k, instead of the $800k) meaning that the purchaser now needs $280k cash to complete the purchase, $80k more.
Similarly if the borrower is unlocking equity in their existing properties for completion funds (explained in detail here), there is less equity available if valuations on the existing portfolio properties come in low. Again the borrower will have to find additional funds elsewhere, or buy something cheaper, to complete the purchase. Failing these two options the deal would probably fall through.
All borrowers, in all markets, are being affected
APRA’s intervention was largely in response to price growth in the Sydney and Melbourne property markets (see here), however the consequences described above have generally been widespread. A tight credit policy affects all borrowers, not only investors, as do lower valuations.
It makes you wonder whether other measures, for example restrictions on foreign investment (which have grown rapidly of late and traditionally favour inner city Melbourne and Sydney properties) may have been more suitable in addressing the issues. Remember that house prices throughout much of Australia have been fairly stagnant over the past 12-18 months and in some cases have actually gone backwards.
Non-banks and brokers are becoming more significant
Without being governed by APRA, non-bank mortgage lenders in Australia have not been required to limit their growth in investment lending by 10% per annum like the majors. So non-banks have been increasing their share of the investment lending market by offering competitively priced investment loans to new customers while the majors are making it more expensive and difficult.
At the same time investors who have multiple borrowings all tied up with one of the major banks are being forced to work with non-bank lenders in order to further grow their portfolios. The reason for this is that the non-bank lender will assess the customer’s serviceability more favourably. The non-bank applicant will be assessed on lower sensitised rates for the new debt, and any existing debt not being refinanced will be accepted based on the actual rate the borrower pays, rather than say a 20% premium.
This means that where the borrower may not qualify for a loan at her existing big-4 bank, she is still able to obtain finance from a smaller non-bank lender to fund her next investment.
There was a retreat in non-bank lending during and following the Global Financial Crisis because the credit markets froze and their funding dried up however the dynamics of this current situation are helping the non-banks regain their slice of the pie.
Another consequence of APRA’s intervention is that the need for good mortgage brokers is increasing. There are customers all over Australia researching and walking into bank branches only to waste time with people who can’t help them. A good mortgage broker has access to many lenders and should have the skills necessary to put together a complete lending structure (now often involving multiple lenders) enabling the borrower to achieve their objectives.
In summary
In a banking system such as Australia where property plays a major role, sound lending standards are too important not to be heavily scrutinised. It’s unfair and unfortunate though that APRA’s intervention is disadvantaging parts of Australia that have nothing to do with the problems in Sydney and Melbourne.
Soldier Tom expects investor lending to continue to slow in the months ahead. A lot of sellers are already beginning to emerge for fear of missing out on what’s potentially the peak of the market. Auction clearance rates will probably continue to fall and the pace of house price growth will likely ease in coming months too.
What we don’t know is whether prices will rise slowly, hold or fall, but history does at least tell us that the time it takes for the property cycle to pick up again is longer than the time it takes to reach a peak. But prices will eventually bottom out and then it will become a buyers market again. It is important that readers consider when this might happen, and how they can prepare themselves in advance with the right loan structure and approvals.
