Frank Newman: Interest rates and lending restrictions

Last week the Reserve Bank left the Overnight Cash Rate (OCR) unchanged at 2.25%. The Monetary Policy statement that accompanied the announcement has some interesting commentary about what is ahead for property investors and homeowners.

When discussing the state of the property market and the future it said, "Low mortgage rates, high net immigration, and the shortage of housing in Auckland have contributed to high house price inflation.

"The changes to restrictions on loan-to-value ratios for investors, and government tax measures implemented late last year saw Auckland house price inflation slow through late 2015. However, the impact of these policy changes on house price inflation is expected to be temporary, and Auckland house prices have rebounded in recent months. Outside Auckland, house price inflation has continued to increase, and nationwide annual house price inflation reached 13 percent in April."

"We project house price inflation will remain high over the next 18 months, underpinned by low interest rates, strong population growth, and a shortage of housing in Auckland (figure 5.7). House price inflation then moderates as increasing residential construction begins to address housing shortages, net immigration moderates, and affordability constraints begin to bind."

In other words, in the short-term property prices are going to charge ahead but that will come to an abrupt end in 2018. This should send a very strong signal to long-term property investors. Smart investors in for the long haul would be cautious about gearing up now, and instead wait for prices to decline, when rental yields will be better and the media headlines will be leading with the plight of heavily indebted property owners.

The biggest risk in my view is a slow-down in immigration. Migrant flows can turnaround very quickly, and will do so as the overseas economies recover (Australia in particular).

The Reserve Bank had this to say about interest rates. "Recent OCR cuts have not been fully matched by falls in mortgage rates because of rising bank funding costs. Longer-term wholesale funding costs increased in early 2016 as financial market volatility increased and investors grew concerned about the profitability of banks globally. Banks have increasingly turned to term deposits as a substitute, and competition for deposits has pushed up the cost of this funding as well...Another reason that mortgage rates have fallen less than wholesale rates has been a partial recovery in bank margins. Banks typically set mortgage rates in accordance with the cost of funding those mortgages plus a margin...The extent to which any future OCR movements are matched by mortgage rates will continue to be influenced by these two factors."

The margin, known as the Net Interest Margin (NIM), measures the difference between the interest income generated by banks and the amount of interest paid out to their lenders (for example, deposits and funds sourced from overseas). This is in effect the gross margin that a retailer would add to the cost of their product to cover overheads and a profit margin.

Currently that margin is about 150 basis points. In other words, if the average cost of their money is say 3% the banks are lending that on at 4.5%. That is quite low by recent standards where 200 basis points is more the norm.

Still on matters to do with interest rates, Westpac and ANZ have announced they will no longer be lending to non-resident borrowers. This is probably because they believe there is now more risk in the property market, and they are limiting their exposure to a high risk group - those who are most likely to walk away if a loan goes bad.

While this may have some affect on property demand, it is not likely to be noticeable given that the number of overseas-based buyers is relatively small. Nor would it stop those who are lending from another source, or do not rely on borrowed funds.

A greater influence is likely to be further lending restrictions imposed by the Reserve Bank. Graeme Wheeler said, "We've been doing a lot of analysis on loan to value ratios, and whether they should be modified in some way and perhaps connected to investor properties."

That would likely be achieved by increasing the minimum deposit requirements that apply already, but targeted to investors rather than home buyers. The Bank is also working on possible debt-to-income restrictions, but any new rules would be some time away.