Research Residential

Slow pace of new household formation likely to hinder residential rentals

Rental / Residential Generic

Slow new household formation is likely to dampen the residential rental market in the near term and in a low interest rate environment, a rise in yields could be delayed. This is according to FNB Commercial Property Finance’s latest ‘Property Insights- Residential Market Pressures’ report.

The pace of new household formation is likely to slow during (and shortly after) the current recessionary period which is constrained by a lack of new employment creation and widespread household financial pressure.

This in turn is likely to dampen aspirant tenant demand for residential rental property” comments John Loos, FNB Property Strategist. “In addition, low interest rates may be working moderately in favour of home buying and against renting, further constraining rental demand growth.”

The slower pace of new household formation and some household ‘terminations’ will likely slow residential rental demand as we head in 2021. Data emerging from the residential market over the recent years has indicated a weakening trend prior to the national lockdown with the second quarter lockdown period increasing the severity of these pressures.

From a multi-year high of 5.68% year-on-year as at September 2017, the Consumer Price Index (CPI) for ‘actual rentals’ has seen its rate of increase slow to 1.8% year-on-year as at June 2020 with year-on-year deflation appearing as 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” says Loos.

This source of pressure constrains the finances of existing rental tenants, curtailing their ability to pay rent timeously and to absorb rental escalations. This is reflected in TPN Data in the multi-year trend in the percentage of tenants that are in good standing with their landlords which declined gradually from a decade high of 85.95% as at the third quarter of 2014 to reach 81.52% by the first quarter of 2016.

Following this, the more severe economic dip of the second quarter occurred. Caused by the Covid-19 lockdown period, the preliminary percentage of tenants in good standing had dropped to 62.43% by June 2020. This severe drop more than rivals the decline in the 2008/2009 Global Financial Crisis-related recession.

Pressure on tenants from partial or full income loss in this recessionary period should lead to pressure on pro-active landlords into accepting more moderate escalations in some rental cases or, alternatively risk not having a good paying tenant. However, the financial pressure can be expected to reduce the pace of growth in the total number of households in the formal housing market with a dampening impact on demand growth for rental property.

In a recent survey conducted by digital rental specialists, HouseME, 28% of tenants indicated their income had already been impacted by the lockdowns and a further 21% said they were concerned about their income security in the next six months.

This could cause movement in the rental market” comments Tamira Gunzburg, chief marketing officer of HouseME. “With 62% of tenants confirmed they would move for a better rental deal. Landlords are already beginning to feel the tension with a quarter of all landlords surveyed listing ‘non-payment of rental’ as their biggest worry going forward, followed by vacancies (19%) and late payments (16%)”.

Not only are tenants able to afford less rent, the supply side has also been bolstered by holiday rentals seeking long-term tenants as tourism is interrupted by global lockdowns. Tenants are therefore spoiled for choice which adds further pressure on rental prices” she says.

Loos notes that household shutdowns could 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.

Household shutdowns need not only be young working people. It can also be elderly people moving into their children’s’ home” says Loos.

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.

The impact could also be ‘densification’ of living with a likely increase in the number of people living in a portion of homes. This could support the demand for larger homes compared to smaller homes with some merged households opting to relocate to a bigger space. However, this will not likely offset the impact of severe economic weakness on the demand for larger homes with the current recession appearing too severe.

The slowing pace of new household formation slows growth in the overall demand for residential property which translates into a slower required rate of new additions to total housing stock which exerts pressure on new residential developments.

There has been evidence of slowing growth in the number of households. From a multi-year high of 2.7% in 2015, total household growth had slowed to 1.9% by 2019. The lowest growth rate in the number of households was estimated by IHSMarkit to have been in 2010, one year following the 2009 Global Financial Crisis contraction. That same year, the total estimated employment declined by -2% (IHSMarkit data) in lagged response to this recession.

Household growth was stronger in better economic growth times pre-2008 and around 2009 where it hit a two-decade peak of 6.2% corresponding to a two-decade high of 7.7% in total employment growth.

1999 was the early stages of a massive housing demand boom surprisingly, given the rate of employment and household growth around that time.

More recently, in a lengthy period of economic growth stagnation, employment growth has slowed from a 4% high in 2014 to 0.5% by 2019 and we are likely to see a further employment decline for 2020/2021.

We expect significantly slower rates of household growth, possibly even a negative growth rate in 2021 in lagged response to a major -8% real GDP contraction forecast by FNB” says Loos.

The report goes on to state the second key influence on the rental market; sharp interest rate cuts although the overall impact of this is less clear than the GDP recession impact.

There has been a large reduction in interest rates this year with prime rate declining from 10% at the start of the year (10.25% at a stage in 2019) to 7%.

The impact of this interest rate cutting cycle on the rental market is unclear. 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” Loos notes.

Households are required to choose between home ownership and home rental options. The former option is far more interest rate sensitive due to many households using a mortgage loan to finance this. A sudden reduction in interest rates makes home ownership more attractive relative to renting.

Adrian Goslett, Regional Director and CEO of RE/MAX Southern Africa says the experiences of their network reflects that the first-time buyers’ market is growing because of the interest rate cuts that have made purchasing property more affordable than renting property in many cases.

At the same time, we are aware of many families who have had to combine their households or to downscale because of the loss of income owing to the lockdown. While our first months out of lockdown Alert Levels 5 and 4 have reflected some of our best sales figures, we also predict that this level of activity is partly owing to pent up demand and it will not last forever” he says.

The future performance of the rental and housing markets all depend on how quickly our economy can recover. The demand for housing will always exist. It will be interesting to see what new trends emerge out of these challenging circumstances.”

Many strategists place 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 ration, this at some stage should ultimately lead to the rental option winning greater appeal relative to home buying as home ownership affordability deteriorates relative to rentals. This would contribute to a ‘cooling off’ in the property 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. This decline is insignificant” says Loos.

However, given that many households utilize 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.”

The second index is not only driven by house price and rental trends but by interest rate moves. With significant interest rate reductions, it has plummeted by a massive -26.1% since a decade high recorded in May 2016. This points to an important improvement in the appeal of home buying, relative to rentals and most of this relative change due in 2020 is because of SARB’s sharp rate cuts.

The unknown in the equations is sentiment. Does the current recession dent confidence levels to such an extent that many risk-averse households prefer to rent temporarily until the uncertainty has passed, despite low interest rates? This is possible and this is the wildcard.

In recent years, we have assumed the likelihood that economic and home buying market ‘stagnation’ would see the home rental market outperform the home owner market, rental inflation thus outpacing house price inflation, and ultimately rising income yields on residential property” says Loos.

A mild outperformance of the rental market over the homeowner market has been witnessed since 2016 / 2017. At the time, the continuation of this scenario appears in doubt in the near term with average rental inflation slowing from 5.7% year-on-year in 2017 to 1.8% in the most recent Consumer Price Index survey. This 1.8%, now a similar rate of increase to FNB’s House Price Index’s 1.2% and, the rental inflation, may soon underperform house price growth.

We say this because, while a weak economy causing a slowing in rates of new household formation can equally impact on both home owner and rental markets alike, sharp cuts in interest rates play relatively speaking into the hands of the credit-dependent home owner market” says Loos.

And so, while we see severe weakness in rental tenant payment performance, pointing to a rental market under pressure, the anecdotal evidence seems to be that the home buying/ownership market has come back reasonably well after hard lockdowns have been relaxed.”

Whether this ‘mini-recovery’ in home buying after lockdown holds, remains to be seen in a tough economic environment, but it is possible that the move towards significantly higher, and more attractive, yields on residential property may be “on hold” in the near term” he concludes.