Slow new household formation is a likely dampener for the residential rental market in the near term, and in a low interest rate environment a rise in yields could perhaps be delayed, according to John Loos, property sector strategist at FNB Commercial Property Finance.
The pace of new household formation is likely to slow during and shortly after the current recessionary period, constrained by a lack of new employment creation and widespread household financial pressure, the analyst said.
This in turn is likely to dampen aspirant tenant demand for residential rental property. “In addition, low interest rates may be working moderately in favour of home buying and against renting, further constraining rental demand growth,” Loos said.
Data emerging from the residential rental market over recent years has pointed to a weakening trend even prior to the 2020 Covid-19 lockdowns, with the second quarter lockdown period increasing the severity of those pressures, FNB said.
From a multi-year high of 5.68% year-on-year as at September 2017, the CPI for Actual Rentals has seen its rate of increase slow to a lowly 1.8% year-on-year as at June 2020, with year-on-year deflation now appearing a distinct possibility.
“The key economic source of pressure on the rental market, we believe, is the long term stagnation in growth in the South African economy,” Loos said.
This source of pressure constrains the finances of existing rental tenants, thereby curtailing their ability to pay rent timeously and absorb rental escalations.
This is reflected in the multi-year trend in TPN’s percentage of tenants that are in good standing with their landlords, which declined gradually from a decade high of 85.95% as at the 3rd quarter of 2014 to reach 81.52% by the first quarter of 2016, the lender said.
Then came the more severe economic dip of the second quarter, caused by the Covid-19 lockdown period, and by June 2020 the preliminary percentage of tenants in good standing had dropped all the way to 62.43%. “This is a severe drop that more than rivals the decline back in the 2008/9 Global Financial Crisis-related recession,” said Loos.
“The pressure on tenants, resulting from either partial or full income loss in this recessionary period, should lead in certain cases to pressure on pro-active landlords into accepting more moderate escalations and in some cases rentals, or alternatively risk not having a good paying tenant.
“However, the financial pressure can also be expected to reduce the pace of growth in total number of households in the formal housing market, with a dampening impact on demand growth for rental property.”
According to FNB, this can work in various ways:
Firstly, in that the economy curbs job creation, young aspirant labour market entrants may have the timing of their first appointment delayed due to a lack of opportunities. This may translate into delayed establishment of a new household for these young labour market entrants, with a portion of them choosing to remain in their parents home for longer than would be the case in better economic times.
Secondly, a group of young working people may choose to delay their household formation, remaining in their parents home until the currently highly uncertain times pass, possibly out of fear of retrenchment or partial income loss.
Thirdly, household “shut downs” can take place too. People losing jobs during this recession, and unable to cover the costs of living as a stand-alone household, could opt to either move back in with their parents, or to merge households with other households, for example two rental tenants or home owners, previously staying in separate residences alone, choosing to live together in one residence, either ending the rental or the ownership of the other property.
Household “shut downs” need not only be young working people. It can also be elderly people moving into their childrens’ home.
“The ultimate result is expected to be lower growth, or even decline, in the total number of households in South Africa, continuing to slow demand growth for residential rental properties,” Loos said.
What about interest rates?
It isn’t clear if interest rates do much to support rental market strength, Loos said, following large reduction in interest rates during 2020, with Prime Rate declining from 10% at the start of the year (10.25% at a stage of 2019) to 7%.
“On the one hand it has cushioned the blow of lockdowns on the economy, and the magnitude of recession may have been worse had it not been for rate cuts. However, the sharp rate cutting gives highly credit-dependent home buying a greater competitive advantage over the rental option.
“Households are required to choose between the home ownership and home rental option, the former option being a far more interest rate sensitive decision due to the fact that many households use a mortgage loan to finance this. Therefore, all other things equal, a sudden reduction in interest rates makes the home buying option more attractive relative to the rental option.”
Many commentators place much emphasis on the Average House Price/Average Rental Ratio, the argument being that if house prices increase in price at a more rapid rate than rentals, leading to a rise in the Price/Rent Ratio, this at some stage should ultimately lead to the rental option winning greater appeal relative to home buying as home buying affordability deteriorates relative to rentals.
This in turn would contribute to a cooling off in the home buying market.
“We compile an Average House Price/Rental Index (Jan 2008=100) to track this trend, and in recent years have found house price inflation not quite keeping pace with rental inflation, which has translated into a cumulative -3.6% decline in this index since February 2016,” said Loos.
That that decline is insignificant, he noted. “However, given that many households utilise mortgage credit to purchase a home, an index that we feel makes more sense to monitor is the Instalment Value on a 100% new home loan on the average priced home/Average Rent Ratio Index.”
This second index is thus not only driven by house price and rental trends but also by interest rate moves, the analyst said. And with the very significant interest rate reduction it has plummeted by a massive -26.1% since a decade high recorded in May 2016.
“This points to a very significant improvement in the appeal of home buying relative to rental, all other things equal, much of this relative change coming in 2020 due to sharp SARB rate cutting.
“However, an unknown in the whole equation is that of sentiment. Does the current recession dent confidence levels to such an extent that many risk-averse households prefer to rent temporarily until a period of great uncertainty has passed, despite very low interest rates being in many buyers’ favour. This is possible. This is the wildcard,” said Loos.