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Too many new apartments may squeeze bank profits

Australia is facing an oversupply of new apartments in its three largest cities leading to a suggestion by the central bank that possible defaults may put pressure on lenders – especially Chinese ones – and put a brake on economic growth.

The risk was set out by the Reserve Bank of Australia in its latest Financial Stability Review. The new governor, Dr Phillip Lowe is expected ro provide more details at a keynote speech at Monday’s Citi Australian investment conference in Sydney.

The RBA notes that housing price growth has slowed, and the share of high loan to value and interest only loans has fallen, but points to mining regions where many households  are in stress because house values have fallen below outstanding mortgage debt. Repossessions in Western Australia have edged higher.The RBA points to a large supply of new apartments coming on stream, particularly in the inner-city suburbs of Brisbane and Melbourne.

“One risk associated with the large volume of construction underway is that off-the-plan purchases fail to settle. Liaison with the property industry points to some concern that this will become more common in Brisbane, Melbourne and Perth”, the RBA states. “Liaison with banks and industry suggests that in Melbourne, and increasingly in Brisbane, valuations for off-the-plan apartments are often below contract process”. Many of these buyers are either offshore, or Australian residents dependent on overseas incomes, including pensions, which Australian banks, astonishingly, will no loger accept.

The likely outcome of this potential oversupply is that banks will be called upon to maintain higher reserves, which will put further pressure on profits, and accounts for the poor performance of bank shares lately. Faced with a profits squeeze, the banks will have the choice of increasing interest rate margins for home loans and business, or cutting dividends.

The RBA has an interest comment on this: “

“Higher capital levels are expected to have a persistent effect on ROE. Indeed, analysts’ expectations are for Australian banks’ ROE to remain on average around 121⁄2 per cent over the next couple of years. While this is high by international standards and appears to be above banks’cost  of equity, it is lower than the returns to which Australian banks and their investors have become accustomed.

In theory, investors might be expected to accept the lower ROE that results from higher capital levels. This is because the reduction in leverage reduces volatility and risk in returns. If investors do accept lower returns, banks could adjust their target ROE lower. However, investors’ expectations may not adjust immediately and banks may feel pressured to maintain historical levels of ROE. “