Debt – Everyone Pays in the End 3

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Monday, June 6th, 2016
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The current debate on negative gearing is just part of Australia’s credit binge woes that must lead to a correction sometime – one where Australians come to terms with living within their means.

The same will apply for governments. At the heart of this correction will be accounting for the true cost of debt driven by the fundamentals of debt servicing and risk that are unavoidable.

Key issues surrounding this concept include:

  • Basic value for money considerations go out the door when the real cost of debt is put off for another day
  • Governments become inflicted with the same debt consequences as households despite their claiming to have avoided this debt being on their balance sheets
  • Australia is overpriced, over committed, and in the end someone has to pay.

Back in the early 1990s, two terms with equally serious consequences were coined. The first was ‘performing, non-performing debt’ and the second, ‘sexually transmitted debt’ (then jokingly referred to as STDs). Both were the result of debt growing beyond the capacity to pay or where a calamity exposed unanticipated consequences.

The latter was often the unconsidered obligations of the parties who had signed up for credit not being fully aware of the personal responsibilities they were taking on. In the case of marital breakdown, this often left one party with a liability that they were not fully aware of, normally clocked up by one or both parties living beyond their means. The banks were often placed in the difficult position of taking possession of pledged assets and dealing with all of the emotion that attached to those ‘STDs’. How history repeats itself.

Performing, non-performing debt occurs when underlying assets do not generate sufficient cash flow to meet their costs, and where this shortfall is met by another benefactor. This situation lasts until the benefactor is no longer able or minded to make this subscription. That is why residential property investment must be seen as a different asset class to other investments such as equities, because debt in those investments are not supported by financial institutions when they are on such discretionary terms.

Banks mostly learned the lessons of the 1990s and subsequently the lessons that followed the GFC. While the cost of debt has become very low, banks have had to adjust their capital adequacy ratios to mirror their full range of debt and the complexities that these involve.

Australian households now have the unenviable record of having the highest debt levels in the world, at 134 per cent of GDP. Respected economist Saul Eslake argues that Australian dwellings are overvalued on a longer term basis if we assume a normalisation of rates in the future. By year’s end, assuming further RBA cuts, this ‘overvaluation’ will be around 12.5 per cent.

The worrying conclusions of Eslake’s argument are that:

  • RBA rate cuts won’t get the economy moving enough to get back to trend
  • RBA rate cuts will add further upward pressure to drive dwelling prices
  • RBA rate cuts will drive household debt higher than already incredibly high levels
  • RBA policy implies a risk to macroeconomic stability

The upshot, according to Eslake, is that when rates do normalise in the future, this “implies some damaging economic consequences if we assume the wealth effect works as prices decline as is being done (by the RBA) as they are rising.”
construction

While this is going on, governments commit to ever bigger infrastructure projects, and to the long-term servicing costs of those projects.

For example, the provision of Public Private Partnership (PPP) infrastructure has shifted over the last 10 years from the PPP company moving the revenue risk of these projects back to government. PPP companies these days take the ‘availability’ risk and the government takes the ‘revenue’ risk. This is not to say that economic PPP infrastructure projects are not a good thing, but it is hard to determine if they are value for money. It becomes more questionable when social infrastructure is funded using the same model where the advocates of PPPs make the case that one solution can solve all problems. This could be seen as negative gearing by another name.

The expansion of negatively geared residential property development provides a buffer that masks the rising costs of these projects and how they are driving up the baseline cost of all housing. There are some extreme examples of just how absurd this has all become.

A number of recently completed high end multi-unit projects claim as a badge of honour that they have achieved retail prices upwards of $18,000 per square metre. For a 75 square metre dwelling, that means a price tag of $1.35 million. But the average retail prices of new developments coming onto the market are not far behind. Many now exceed $10,000 per square metre, so for the same dwelling, you could expect to pay $750,000. And recent resales on projects such as Barangaroo claim pre-completion profits by early depositors selling out, exceeding $1 million. Net rents before negative gearing on these properties will be lucky to be 2.5 per cent, but that seems normal.

The cost of construction is typically 30 per cent of retail prices. The the cost of sites, demolition, remediation and obtaining development consents is running around 25 per cent of retail prices, leaving the cost of transactions (including stamp duties, finance, marketing, legal and other holding costs) at approximately 20 per cent, and gross developer margins at 20 to 25 per cent depending on how the rest of the costs pan out.

Everybody is happy – land vendors watch in amazement as new records are set for the sale of their properties, governments reap these land prices for surplus assets and the stamp duty revenues from the current speculative property frenzy. Building contractors competing to get trades to meet demand have all adapted to construction prices that are unsustainable into the future, and the unions know there will be little resistance to their ever pressing claims.

The out of control property price contagion is flowing over to the traditional detached housing market. Last week, a new land release to the north west of Sydney anticipated retail prices of more than $390,000 for a 350 square metre site, but others claimed prices were already achieving $1,400 per square metre for new land now over 35 kilometres from the city. While new transport infrastructure is being rolled out to many of these areas, it is inevitable that those facing long road commutes will have to pay the price of more and ever increasing tolls.

Australia is now building on average the largest new houses in the world. At 214 square metres, typical construction costs for traditional detached and attached housing are now running at $1,750 per square metre (including site costs). That’s over $375,000 per dwelling. So, when new land prices of say, $1,250 per square metre are added for block sizes ranging from 250 to 350 square metres, the total deal can range between $685,000 and $815,000. It’s not long ago that this package would have been in the $550,000 to $650,000 range, but houses continue to get bigger.

While there are plenty of bureaucrats and some politicians who would like to forget Kevin Rudd’s national stimulus package following the GFC, there are some trailing reflections that are worth revisiting. It was about that time that the public project mantra shifted from value for money being the key determinant of committing new projects, to one of just getting it done. The time imperative became the priority along with carefully scheduled ‘shovel ready’ project launches, followed by similarly choreographed completion and handover ceremonies, photo opportunities and plaques. The public has been progressively wooed into the belief that just getting it done outweighs other considerations.

The average size of BER school buildings under the economic stimulus program was 574 square metres. You would get approximately 2.7 average houses into one of these school buildings. The public got riled about the cost of these projects. This was an area where school communities could form a value for money view.

In essence, they argued that a new house was much the same in construction complexity at these school buildings. In NSW at the time, the cost of a new house was approximately $1,500 per square metre, so they could not see how the average cost of NSW school buildings at $3,448 per square metre represented value for money. This observation was further exacerbated by comparison with the national BER average cost of similar school buildings at $2,333 per square metre, and with Western Australia public schools at $1,980 per square metre. Making this information available in future would serve the public interest.

Another idea could be to publish how many new houses, or school buildings each multi-billion project may equate to. It may help keep things in perspective, and give the public a price indicator that they may be able to relate to. Based on the above numbers, you may get 1,250 houses or 750 school buildings for every $1 billion spent on an infrastructure project.

PPPs offer a perfect shelter for governments to shield the cost of major projects. Despite the claims of due process and competitive tendering, there is little evidence that bureaucrats can demonstrate informed capabilities in driving costs down. As a result, we have the recurrent cost of funding projects that cost too much in the first place. Hospitals are a prime example. Governments are constantly bombarded with PPP advocacy that the private sector can do it better. I challenge this. On the evidence I have seen of PPP price and value comparators, the underlying assumptions of capital cost are shallow at best, and inadequately tested.

There is a case for a rigorous review of the underlying capital costs of all new public projects. These costs should be tested against their potential to achieve better onsite productivity, to be undertaken smarter, to be performed better, safer, faster and most importantly cheaper. The public sector comparators I have seen make skewed assumptions that are never published, and the marginality of most PPP business cases would be very different in my view if the possible capital cost savings were pursued. Such a review would only be valid if it were performed by independent experts free from any conflict of interest. Any such review would have flow on benefits in guiding the lowering of construction costs more widely.

Let’s assume that 12.5 to 15 per cent cost savings are on the table. This is on the conservative side of proclamations of those in industry who know what’s possible, and it accords with Saul Eslake’s view that new residential properties are 12.5 per cent overvalued. A 15 per cent betterment in the cost of new infrastructure could equate to as many as 185 new homes or 115 new school buildings. Simplistic maybe, but something has got to give.

So here we have a situation where both public clients and private sector investors are subscribing to projects which are costing too much. Governments have signed up to long term PPP agreements that lock in these embedded costs for 20 to 30 years. The public subscribes in part to these costs through user pays pricing such as tolls. And for the rest, the public pays because we are charged for these projects through ‘availability based’ contracts where the shortfall in servicing cash flow comes out of benevolent recurrent expenditure. The public pays again when negative gearing is applied. When rental properties are rented out by investors and the cash flows do not cover the costs of outgoings, the debt involved effectively becomes ‘performing non-performing debt,’ and that’s the tip of the iceberg.

These are the costs that go to the heart of getting more for less and lowering both public and private sector non-performing debt levels. According to the ABS the value of lending to investors in new housing construction surged from February’s $1.186 billion – itself a record high – by $642 million to $1.828 billion in March 2016. In NSW, the government is about to embark on a number of very large social housing PPPs. it really is time to take stock.

There is no question that the current infrastructure projects and the residential property boom have helped hold up national economic activity after the mining boom. But, one has to ask, at what price? There are signs that the current investment property boom is starting to retreat. Who knows what calamities await, when they will arise, and by how much residential investment prices might retrace? By then, of course, Australian governments and households will be saddled with record debt levels driven by unsustainable property speculation and construction costs. Someone will still have to pay in the end. I assume it will be the taxpayers.

Perhaps a new and more memorable take on this period will be one of “Government Transmitted Debt” disease or GTDs. Either way, the effect will have similar consequences for households as the STDs of the 1990s. In the end, everyone had to pay in some way. But this conversation will have to wait while any serious consideration and public policy in this space gives way to selective slogans and mudslinging that is electioneering in Australia these days.

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3
  1. Kim lovegrove

    Great Article, well done.

  2. Lee

    An intriguing and frightening article, well written.

  3. Mark Whitby

    Great article David… and at last some real figures to get our teeth into.