INSIGHTS: Flat out – why apartments are a good bet in the current climate

1 September 2022

By Andrew Schwartz, Group Managing Director and Co-Founder 

From the CBDs to the outer suburbs, evidence that Australians are abandoning the dream of a quarter acre block for apartment living is all around us in the number of high-rise residential buildings that have sprung up in recent decades.

Of course, this drift to apartment living is not always by choice, with housing affordability and availability playing a significant role. But it is clear that apartments, once considered only a steppingstone for young families or newly arrived immigrants on their way to a house-and-land package, are now the preferred abode for many Australians.

The first batch of 2021 Census results, released in June, clearly identifies this trend. Of the nearly 11 million private dwellings in Australia, 1.7 million, or 16 per cent, were defined as apartments. Another 13 per cent were defined as semis or town houses.

Census after Census show apartments’ share of the national housing stock continuing to grow; Of the nearly one million new private dwellings added since the previous Census in 2016, apartments accounted for more than 30 per cent.

The 2021 Census for the first time also singled out high rises, defined as nine or more storeys. Today, more than 550,000 people live in Australia’s 370,000 high-rise apartments and, in total, more than 2.5 million people, or one in 10 of us, now lives in an apartment.

These long-term trends alone are enough to make residential apartment buildings attractive for developers and investors, underpinning rising prices and rents. But there are other factors that make them an even better investment in the current environment.

The first is the well-documented undersupply of housing around Australia. Demand continues to outstrip supply and this problem will only get worse as the COVID-imposed restrictions on foreign labour and students continue to be lifted. Every person who comes to Australia needs somewhere to live and, for many, apartments are the obvious (or only) choice.

One of the mistakes commentators make, particularly in periods of rising interest rates, is confusing the vexed issue of affordability with the equally vexed issue of undersupply in housing stock. Interest rates and affordability are issues for property ownership; they are not issues that the underlying need for housing. This is driven by the dynamics of demand from natural occupiers versus supply and inventory. Interest rates and affordability affect the rent-or-buy decision as opposed to true underlying demand from natural occupiers.

Meeting this demand will be reflected in continued apartment building, notwithstanding the current problems in major project construction. That’s the volume part of the investment case. Institutional capital will continue to seek ownership of apartments that attract long-term renters with the right offering.

More immediately, however, it’s worth focusing on the value part of the investment case – and explaining why improvement values – the cost of the building, structures and other infrastructure that sit on top of the land value – make apartments a good bet for investors in the current inflationary environment.

When you build an apartment – one of multiple dwellings on one plot of land – 75 per cent or more of the total value is improvement. By comparison, with a house and land, improvement is typically 40-50 per cent per cent of the total value. That’s an important ratio if the value of the improvement – basically, the cost of building – is rising because you’re in an inflationary environment.

Major apartment builders have sounded a warning on these rising costs, saying property developers will be forced to raise new apartment prices by at least 20 per cent in response to the perfect storm of bad weather, high petrol and energy prices, increased labour and building costs. Put simply, if higher costs are not compensated by better planned developments with greater saleable area or an increase in price per square metre of saleable area – or both – apartment building will stall.

The risk is that rising costs mean market values fall below replacement values. At that point, developers stop investing in new development for fear of not being able to sell the end product if market values for existing stock are cheaper than newly built apartments. When this occurs, underlying demand outstrips supply, pushing up rents and returns. Eventually, market values catch up due to the higher rental returns – and a new cycle begins.

Either way, these market cycles are ultimately characterised by rising prices to justify continued building or periods of demand outstripping supply, that drives new apartment building. And underpinning all shorter-term cycles is the long-term structural undersupply of apartments.

With every changing market, there is a need to understand the evolution of risk and rewards. The reality is that when it comes to residential property, it’s not all the same.  As a large provider of capital through real estate debt and equity for residential projects, we recognise that the specifics of each project are relevant to our decision making. In assessing macro systemic risk to the sector, we are gaining comfort from reviewing the imbalance of excess demand over supply for residential apartments.

Technically, of course, we must acknowledge that market values could fall below replacement values due to rising rates or falling sentiment. But it is important to question how long such a cycle would last (if indeed there was a sustained drop in values) in an environment with ongoing housing shortage that would only see rents and yields increase, only further exacerbating the issues of affordability and availability of accommodation.

Disclosure

This document has been prepared by Qualitas Securities Pty Ltd (ACN 136 451 128) (Qualitas Securities), holder of Australian Financial Services Licence number 342242. Qualitas Securities and its related bodies corporate and affiliates constitute the Qualitas group (Qualitas).

The information contained herein is for informational purposes only and does not constitute an offer to issue or arrange to issue financial products. The information contained herein is not financial product advice. This document has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Before making an investment decision, you should read the publicly available information carefully and consider, with or without the assistance of a financial adviser, whether an investment is appropriate in light of your particular investment needs, objectives and financial circumstances. Past performance is not an indicator of future performance.

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