Is it time to get nervous about the inner city apartment glut?

Boy are the inner city apartment markets of Sydney and Melbourne behaving differently.

And these differences are important for property investors to understand.

Looking back a few years, following their post global financial crisis (GFC) downturn, the inner city apartment markets of both Sydney and Melbourne boomed, in part due to investor demand and in part helped by low stock levels.

But over the ensuing years our two major CBD markets behaved very differently and now they are poles apart.

While limited new apartment stock was built in Sydney, Melbourne now has a significant inner city apartment market oversupply which is likely to cloud its market for a number of years yet.

You see, Melbourne town planners have approved the construction of over 20,000 apartments to be built in the central business district over the next four years. This is well above the previous annual construction level of around 1000 a year. In fact, construction has already started on some 7800 apartments

In addition, there are a heaps more planned or being built in the city fringe areas and in many Melbourne suburbs.

On the other hand in Sydney, only around 5500 apartments have obtained approval in the CBD; however, a greater number are being built in the suburbs, particularly around Alexandria and Parramatta.

According to Colliers International the number of CBD apartments approved or under construction in Brisbane is around 3000, while Adelaide is building 2300 and Perth 1700. While these numbers may not seem large, they are all huge increases on previous construction levels.

So what is going on?

After the GFC investors returned in their droves to the inner Melbourne market as the economic outlook improved over 2009-10, while demand in Sydney recovered at a more modest rate.

According to census data, in both Sydney and Melbourne the vast majority of inner city apartment occupants can be divided into three categories:

1. Students – largely from overseas;

2. Young professionals typically employed in white-collar occupations in and around the CBD; and

3. Older empty nesters who downsize when their children leave home.

The latter demographic are typically owner occupiers, while the first two make up most of the apartment market’s tenant pool.

Recognising their opportunity, Melbourne developers cranked up construction of new apartments in late 2010.

Over the next few years Victoria’s then planning minister, Matthew Guy, decided to “Manhattanise” Melbourne and encourage the development of large apartment complexes while the approval process for similar developments in Sydney was more arduous.

This happened at the same time as our Asian neighbours decided Australia was a great place to invest their money.

In fact, the vast bulk of Melbourne CBD developers (many funded by Chinese banks) and most of the buyers of Sydney and Melbourne CBD apartments are Asian.

Of course this has been helped by the recent fall in the Australian dollar as well as the lower international (and local) interest rates, both effectively lowering the purchase prices for Asian buyers of Australian property.

While the new Victorian government is likely to be more cautious in giving development approvals, it’s too late; the market is already flooded with too many one or two bedrooms apartments.

According to BIS Shrapnel’s forecast, by June 2016 there will be a surplus of 14,300 multi-residential dwellings in Victoria – see their chart below:

There is clearly a shift to apartment living and this trend is likely to grow with BIS Schrapnel predicting that multi-residential dwellings will one day make up more than half of national dwelling commencements.

However, in the short term we’re overdoing it and the huge oversupply is likely to cause a significant correction in property prices in the inner and near CBD apartment markets.

But here’s another problem…

Many of these new apartments have been built to a poor standard.

A critical report last year revealed that many of our tiny apartments would be banned in New York, while another report estimated that 55% of the city’s tallest apartment buildings are of “poor” quality, with common design flaws.

Too dense and too small

A scathing report from the Melbourne City Council shows some of the city’s newest developments are up to 10 times as dense as permitted by law in some of the world’s most urbanised centres.

Council experts have called for the development of new apartment design standards for the city that could include rules to ban very small apartments.

You see… Sydney, London and Adelaide all have rules that ban new one-bedroom apartments smaller than 50 square metres.

But in Melbourne, 40% of the city’s newest apartments are smaller than this.

Of course many of these sub size apartments are being bought by investors, many from overseas, and often they buy them off the plan not realising they are buying the slums of the future.

Why do I say this? 

Well…

Bad quality apartments overrun Melbourne’s newest high-rise towers.

A Melbourne City Council study has estimated 55% of the city’s tallest apartment buildings over 15 storeys are of “poor” quality, with common design flaws such as cramped layouts and a lack of natural light with windowless bedrooms in almost a quarter of new residential developments.

Melbourne City Council’s Future Living report, which analysed the design of 25 of the city’s new residential developments, found poorer quality apartments were more likely to be located in taller apartments.

All 11 of the high-rise apartment designs studied were considered either poor or average quality.

Common failings included kitchens in hallways, poor storage, lack of ventilation and excessive energy use.

But the report’s authors said as long as there was someone willing to rent the property, the investors who buy 85% of apartments in the municipality were not bothered.

Only buy investment grade properties

If you’ve been following my blogs you’d know I have always suggested you should steer clear from buying inner city off-the-plan apartments.

In general these have had poor capital and rental growth.

Instead to choose properties that will outperform the averages in the long term, I advocate using a 5 Stranded Strategic Approach to property selection:

1. I buy properties that appeal to owner occupiers, as (over the long term) owner occupiers make up the bulk of property purchasers and push up the value of certain types of property.
2. I buy a property below its intrinsic value – that’s why I avoid new and off the plan properties, which come at a premium price.
3. In an area that has a long history of strong capital growth and that will continue to outperform the averages because of the demographics in the area. This will be an area where more owner occupiers will want to live because of lifestyle choices and one where the locals will be prepared to, and can afford to, pay a premium price to live because they have higher disposable income.
4. I look for a property with a twist  – something unique, or special, or different or scarce about the property (you’re not likely to get that in a high rise tower), and finally
5. A property where we can manufacture capital growth through refurbishment, renovations or redevelopment.

By following this 5 Stranded Strategic Approach, I minimise the risks and maximise the upside.

Each strand represents a way of making money from property and combining all five is a powerful way of putting the odds in our favour.

If one strand lets us down, I have three or four others supporting our property’s performance.

Michael Yardney is a director of Metropole Property Strategists who create wealth for their clients through independent, unbiased property advice and advocacy.