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31 October 2018, Sweden | Mutual Funds | News

Are the real estate jitters over, or have they only just begun?

The housing market downturn has been much more rapid than most commentators realise. New builds have come to an almost complete halt, according to Catella's property analyst Arvid Lindqvist.

The transition from a thirty-year period of falling real interest rates to a stabilisation or increase is also impacting commercial real estate – the gulf between prime locations and non-prime is expected to widen.

The first time Arvid Lindqvist took part in the Catella Fonder podcast was in December 2016, when he identified, among other things, a mismatch between new builds and demand, with the output often too expensive for residential buyers. This is because population growth in the metropolitan areas comes largely from immigrant populations, often with low incomes.

Arvid Lindqvist points to what he sees as a clear correlation between how much is being built and how much is sold on the secondary market. The rule of thumb is that the market is able to absorb new builds corresponding to approximately one-quarter of sales in the secondary market if prices are to remain stable. At the peak in 2017, the level was around half of these sales, which means that in terms of supply and demand the only way was down.

This change has not yet visibly impacted Sweden's GDP, which Arvid Lindqvist sees as natural since there is a lag of around one year between housing prices and GDP growth.

"The impact should come in the third and fourth quarters of this year. Housing investment as a share of GDP has moved from an average of around 3-4.5 percent to almost 6 percent in three or four years. It has become one of the most important economic drivers in Sweden, and housing investment has contributed 0.5 to 1 percentage point in annual growth in recent years," he says.

This driver is now ebbing away very quickly, emphasises Arvid Lindqvist.

"We believe there will be a complete halt, and we can see this in the planning approvals data, which has fallen back very quickly. In Sweden as a whole, we are talking about a decline of one-third in new builds, and that's in 2018. The falling investment will knock perhaps 1.5 percentage points from the annual growth rate over a number of quarters," he says.

According to the Catella analyst, the slowdown is so rapid that the entire financing system for new builds is changing. From a market in which apartments were sold with a small discount two to three years before occupancy, there has recently been no discount at all – new prices have been 15-20 percent above the secondary market.

Since property developers are dependent on being able to sell their housing two to three years before occupancy, and then borrow from banks against the stock of pre-sold apartments, these changes mean problems. It's harder to sell, households are no longer prepared to buy far in advance, and there are more homes on the market. Suddenly, the financing model no longer works – if there are no pre-sales in a project, bank finance is no longer available.

However, he believes that since new production of housing is decreasing so rapidly the imbalances will correct quite quickly. The mix of supply and demand is improving, which means the market will no longer be so oversaturated by the middle of next year.

On the other hand, there are dynamic effects that can be more difficult to estimate. In addition to the fall in housing investment and the weakening growth, private consumption and household savings also strongly correlate with housing prices. When prices fall, households feel poorer and consumption is expected to decline as a result.

"We have very inflated household debt, and there is a risk this could spark a downward spiral," says Arvid Lindqvist.

Housing prices have so far decreased by about 10 percent from their peak, although there are big variations between different markets. Arvid Lindqvist expects the decline to be in the range of 10-15 percent, at most, since a further downward push in prices is expected in the autumn as the over-supply has not yet been fully realised.

However, he says that an important detail is what these developments say about the Swedish growth model. The country's growth has been heavily driven by credit and fuelled by domestic consumption, based on the continuous injection of more debt into the economy.

"Generally, younger households enter and replace older ones, with the debt injected into the system coming out as equity for the exiting households. What we have seen in the past 30-40 years is an 8 percent annual rate of increase in prices. The measures introduced by the Swedish Financial Supervisory Authority place a stop on how much debt households can take on, and this will by definition slow down the rate of increase in house prices," says Arvid Lindqvist.

What are house builders saying? Is it political policy causing the problems?

"It's a demographic development. Population growth in Sweden is almost 100 percent from migration. People are coming from abroad with generally low incomes and cannot afford newly built homes. If you limit the amount of debt that households can take on, this in turn limits people who want to enter the market and becomes problematic if the prices of the housing stock are generally high," says Arvid Lindqvist.

However, he believes that the authorities have no choice – they have to limit the accumulation of debt, and doing this depresses house price growth in the long term back in line with incomes. Less debt is injected into the economy, resulting in less consumption and growth. Sweden will therefore become more dependent on global demand and exports, making it even more important that the country has a competitive export industry.

Will the difficulty of selling homes far in advance lead to much more production of rental properties?

"There has been a clear upswing in the supply of new rental properties. More are being built, and condominiums are being converted into rental where possible. What we are seeing among investors is that they are being very selective about location and rent levels – the rents have to be realistic and in good locations. Rents must not be too high or in poor locations as there is a risk of vacancies," says Arvid Lindqvist.

Annual rent levels for new builds are somewhere between SEK 2,000 and 2,500 per square metre, while revenues in the older stock are around a minimum of SEK 1,100-1,200.

Arvid Lindqvist says the trend for older homes may be better going forward, with rents on older properties rising faster than for new ones. This tendency is already apparent, he believes.

"There are a number of companies that focus on buying older rental properties – the older stock is attracting a high level of investor interest and there has been absolutely no upward pressure on the required return. Many of these use the concept of buying unrenovated rental properties and then improving them apartment by apartment before upping the rent," says the real estate analyst.

View of commercial real estate

Two years ago, Arvid Lindqvist's opinion of the commercial premises market was that shopping malls in so-called C locations would have a tough time – and he has been proved right about this as well. In some places, shopping centres are now even being converted into offices. This is part of a wider global trend, with online shopping winning ground and putting pressure on many shopping centres. In Sweden, large malls in the major cities are still doing well, while others are suffering much more.

One apparent trend for offices is that major players like pension companies, which have previously driven the market, have now started to sell. It is mainly office properties in central Stockholm that have been sold, and there have been international interests among the buyers.

The buyers obviously believe that office rents will remain unchanged or rise. What do you think?

"Our view is not as optimistic. There has been enormously strong growth in Stockholm in recent years, with a 55 percent rise in rents over three years, and market rent is now at around SEK 7,300 per square metre. We have recently seen an upswing in coworking providers, and this may have helped to push rent levels up above fundamentals," says Arvid Lindqvist, and continues:

"Going forward, we expect supply to increase slightly. Meanwhile, the economy is hitting a ceiling and unemployment is very low. It is extremely low among educated people of working age, while the unemployment that does exist is mainly due to a mismatch of people with low qualifications. What is happening is that the rate of increase in office-based employment will slow."

Arvid Lindqvist does not anticipate a crash, and he expects the downturn to mainly impact less attractive office locations. There is a rising risk of a correction to rent levels even in the best locations, but this may not happen – what could happen is weak rent growth over a five-year period.

Stefan Ingves, the Riksbank governor, has warned of a rate hike in December or January. What impact would this have?

"Interest rates will not rise substantially, and the environment of low rates will persist. The difference is that we will go from 30 years of falling interest rates to a real rate that will be more stable and will probably be around zero. Companies with the highest risk level have tended to go very short on fixed interest and maturities. Going forward, I do not believe the big companies will be greatly impacted, but high-risk companies with short fixed-interest terms will have greatly impaired leverage," says Arvid Lindqvist.

When it comes to the real estate shares available on the stock market, his view is that property will remain attractive in an environment of very low real interest rates. If the economy weakens, the gap between properties in prime and less-prime locations will widen, which is a typical cyclical phenomenon. But a low real interest rate acts as a floor in the market and means that values cannot fall very far – since new capital is ready to step in.

Arvid Lindqvist expects consolidation of residential property developers. The big companies like JM, Bonava, Veidekke, Skanska and Peab account for a large bulk of output, and companies backed by local authorities and institutions also account for a large share. About 20 percent of developers are what can be classified as high risk, and they have generally had a large proportion of pre-sold homes. The problem for them now is that they cannot launch as many new projects, and this is where the consolidation is expected.

How about the construction companies – they have taken a real beating? Is it time to pick them up, or will things remain difficult for a while yet?

"New builds and ongoing projects have fallen very steeply in the Stockholm region. On the other hand, this is likely to bottom out in the middle of next year. There will be very few new builds on the market in one or two years. It is likely that the worst period for construction companies will be the next nine to twelve months," says Arvid Lindqvist.

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