the impact of intensification on auckland housing valuations · nzier report – the impact of...

The impact of intensification on Auckland housing valuations

NZIER report to Auckland Council

August 2015

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© NZ Institute of Economic Research (Inc) 2012. Cover image © Auckland Council. NZIER’s standard terms of engagement for contract research can be found at www.nzier.org.nz.

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About NZIER

NZIER is a specialist consulting firm that uses applied economic research and analysis to provide a wide range of strategic advice to clients in the public and private sectors, throughout New Zealand and Australia, and further afield.

NZIER is also known for its long-established Quarterly Survey of Business Opinion and Quarterly Predictions.

Our aim is to be the premier centre of applied economic research in New Zealand. We pride ourselves on our reputation for independence and delivering quality analysis in the right form, and at the right time, for our clients. We ensure quality through teamwork on individual projects, critical review at internal seminars, and by peer review at various stages through a project by a senior staff member otherwise not involved in the project.

Each year NZIER devotes resources to undertake and make freely available economic research and thinking aimed at promoting a better understanding of New Zealand’s important economic challenges.

NZIER was established in 1958.

Authorship This paper was prepared at NZIER by Aaron Drew.

It was quality approved by Christina Leung.

We acknowledge the support of Chris Parker and Paul Owen (Auckland Council) and Adam Thompson (Urban Economics) in the preparation of this report.

mailto:[email protected]

NZIER report – The impact of intensification on Auckland housing valuations i

Contents 1. Introduction ...................................................................................................... 2

2. Methodology and assumptions ........................................................................ 4

3. Results and sensitivity testing ........................................................................... 7

3.1. No intensification effects .................................................................. 7

3.2. Allowance for intensification ............................................................ 9

3.3. Sensitivity testing ............................................................................ 11

4. Conclusions ..................................................................................................... 12

References ................................................................................................................... 13

Figures

Figure 1 Total returns to residential property under no intensification ....................... 8 Figure 2 Excess returns to cash for residential property ............................................... 8 Figure 3 Expected capital returns .................................................................................. 9

Tables

Table 1 Potential development capacity under the PAUP ............................................. 3 Table 2 Development costs and space created through intensification ....................... 5 Table 3 House prices in Devonport versus comparable coastal locations .................... 9 Table 4 Valuation of housing by intensity type ........................................................... 10 Table 5 Sensitivity of valuations to differing assumptions .......................................... 11 Table 6 Starting level of prices, rents and rates .......................................................... 14 Table 7 Construction cost estimates for terraced housing .......................................... 15 Table 8 Other assumptions .......................................................................................... 16

NZIER report – The impact of intensification on Auckland housing valuations 2

1. Introduction The Auckland housing market has become a key economic, social and political issue. At the heart of the matter is the widespread view that the market is over-valued based on historic metrics, and unaffordable for many residents, owing in large part –although not only – to a failure of housing supply to meet demand pressures.

In this paper we provide an alternative forward-looking valuation based lens to view the Auckland housing market. We treat residential housing as an asset class in which value is a function of expected rental earnings streams (explicit in the case of a landlord, implicit in the case of an owner-occupier) and their riskiness. We do not assume this expectation is only a function of rents on an existing dwelling. Rather, we build into our modelling the potential for a home owner to intensify a dwelling based on the proposed Auckland unitary plan (PAUP).

If the prices people are willing to pay for houses factor in the potential for intensification then the “high” current prices are not necessarily a sign of market failure – at least some fraction may reflect the rational discounting in of a higher potential rental earnings stream. Under this logic, if the PAUP has enabled a change to higher levels of intensification, or provides more certainty about which areas can be intensified, then we should expect to see prices rise in anticipation. Furthermore, this price rise may provide a strong signal to intensify. For example, a home owner who has a dwelling that can be aggregated up to a bigger parcel of land may find it advantageous to sell to a developer and shift to a location where the potential for intensification, and the price of a comparable dwelling, is significantly lower.

In our analysis we consider four cases of intensification for a “standard” stand-alone residential dwelling in the Auckland region (i.e. high, medium, low, and no intensification) for each of the seven previous Auckland territorial authorities. At least this level of dis-aggregation is required to reflect the different potential for intensification under the PAUP across the Auckland region, as shown in Table 1. Within Auckland City, for example, around 6% of the available land can be converted to high rise buildings while in other regions this option is either not permitted or only permitted on a much smaller scale.

Our valuation framework enables us to address several questions of interest in the housing debate:

1. How much do current Auckland house prices, and prices within sub-regions, reflect the potential for intensification?

2. What types of intensification offer the best investment return?

3. Where and what type of intensification are we likely to see first given the differing investment returns?

4. Does the economics of intensification stack up given development costs?

5. What would the costs of development need to be to encourage more rapid intensification?


Table 1 Potential development capacity under the PAUP

Region Low density

(existing dwellings

and some scope

for infill)

Low rise

(4 storeys or less)

Medium rise

(5 to 9 storey

building)

High rise

(plus 9 storey

buildings)

Auckland City 36% 25% 34% 6%

Franklin District 75% 15% 11% 0%

Manukau City 40% 32% 27% 0%

North Shore City 37% 38% 25% 1%

Papakura District 49% 33% 17% 0%

Rodney District 94% 3% 3% 0%

Waitakere City 49% 21% 29% 1%

Auckland Region 45% 26% 26% 2%

Notes:

*Figures here are based on dwelling estimates and potential development estimates.

*The analysis does not include future urban zoned areas.

*The numbers above do not reflect Auckland Council's official view on growth.

Source: RIMU estimates, Auckland Council


2. Methodology and assumptions

We model the values of residential housing using a discounted cash flow (DCF) modelling approach. Key inputs and assumptions for the modelling includes:

The starting level of house prices and rents (for a “standard” family home)

Gross rental growth

The occupancy rate

Ongoing costs (rates, upkeep and insurance)

Development costs (in the cases of intensification)

Interest rates

Inflation

The residential property risk premium.

Annex 1 provides our assumptions for these variables, excepting development costs which are discussed below.

Housing valuation estimates are formed for the “average dwelling” (a three bedroom family home) across the eight regions, and for each region, across the cases of intensification shown in Table 1. We form an overall assessment of valuation for the Auckland region by weighting each model by its share of the land use, and the fraction of households in the Auckland region, i.e.:

Value Auckland = ∑ 𝑉𝑟 ∗ (𝑝𝑜𝑝𝑟

𝑝𝑜𝑝)

𝑛

𝑟=1, where 𝑉𝑟 = ∑ 𝑣(𝑖, 𝑟) ∗ 𝑝𝑟𝑜𝑏(𝑖, 𝑟)

4

𝑖=1

and 𝑣(𝑖, 𝑟)𝑖𝑠 𝑡ℎ𝑒 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 ℎ𝑜𝑢𝑠𝑖𝑛𝑔 𝑔𝑖𝑣𝑒𝑛 𝑖𝑛𝑡𝑒𝑠𝑖𝑡𝑦 𝑖 𝑖𝑛 𝑟𝑒𝑔𝑖𝑜𝑛 𝑟

In the models where intensification is assumed, we factor in the all-in cost of this intensification (i.e. land aggregation, demolition, new building costs, planning approvals, etc) and the higher rents that the intensified property could generate once the new dwelling structures are in place. This is a function of the number of dwellings created, and their rental streams.

In Table 2 our “base case” assumptions of the cost of undertaking a development (ex-land) and the units this creates is provided, along with the research sources that the assumptions are based upon. In the case of low rise developments, we assume this all takes the form of terraced housing where around 4 units can be created for an “average” 600m2 section. The size and cost of these units are assumed to differ across the Auckland region according to current market demand patterns. In central Auckland and the North Shore higher cost (and quality) developments are assumed, in Manukau and Papakura relatively low cost terraced housing is assumed, in other regions costs lie roughly in between.


In the case of a medium rise dwelling we assume a single site can generate 6 units of around 80m2 in size. Again we assume some difference in costs according to the quality demanded. In the case of high rise developments, which mainly are allowed for in Auckland City, a single representative cost is assumed. In all cases we assume an “industry standard” developer margin of 20% on the all-in construction cost.

We also need to assume when development takes place for the cases where this occurs, and how long it takes for the development to come to the market. All developments are assumed to take place in the 10th year of the modelling horizon, and the costs shown in Table 2 are adjusted for inflation between today and year 10. We also make the simplifying assumption that it takes one year for a development to be put in place, and in the year of development no rental income is earned by the investor. In the year following the development, it is further assumed that all units are rented out (subject to our occupancy rate assumption).

Table 2 Development costs and space created through intensification

Low rise

terraced housing

Medium rise

apartments

High rise

apartments)

Base case developments costs

m2 $3,600-$5,070a $4800-$8,000

a $8000

b

Average unit size 100-150m2 80m2 55m2

Base case cost per unit

$362,000-

$760,000

$350,000-

640,000 $440,000

Number of units 4 6 74

Total cost of development (ex-

land) $1.5-$3.1million $2.1-$3.8m $32million

Number of 600m2 sections

required 1 1 5

Average number of bedrooms

per unit 2.5 2 1.5

Notes:

(a) This cost is based on analysis by Urban Economics.

(b) This cost is based on Grimes and Mitchell (2015).

See Appendix A for further details.

Source: NZIER

Given our valuation estimate, we form a forward-looking view of returns, and compare this to both the risk free rate of return (which we take to be 90 day bank bill rates) and return we think an investor should require given residential housing’s risk characteristics. The key assumption we make in forming this return expectation is


that housing can be treated as an asset class in which prices ultimately reflect their earnings stream and its riskiness. We think this is increasingly justified in the case of New Zealand housing given widespread investor ownership.

The next most critical assumption is the pace at which prices ultimately revert to some notion of fair value. Our approach is to assume this is relatively slow – we build in a 7 year horizon period of adjustment. This is broadly in line with the period of mean reversion we see in international listed equities, but is slower than what typically occurs in the New Zealand dollar (2-3 years) and by extension potentially other New Zealand asset classes. The implication of this assumption is that the adjustment of Auckland house prices to fair value is smoothed out over a long time period. The risk is that a “catalyst” could cause a much more abrupt adjustment.


3. Results and sensitivity testing

3.1. No intensification effects The charts below show estimated average returns over the next 7 years given our starting-point valuation gaps and assumed period of adjustment under the assumption that prices do not reflect any potential for intensification.

The Auckland housing market as a whole is assessed to be expensive with prices around 33% above estimated value. As a consequence, the total return is around 2% per annum – around the pace of CPI inflation – implying real total returns are expected to be flat for the next 7 years. The total return, however, includes the net rental yield from housing (around 2% currently). This implies the capital gain expected is mildly negative (around -0.5% per annum) over the next 7 years. If these forecasts hold true, Auckland prices will be around 3% lower than where they are currently in 7 years.

The charts, however, also show a high degree of variation within the Auckland region. The North Shore and Auckland City are assessed to be very expensive, Waitakere, Rodney and Manukau are moderately expensive, Papakura is close to fair value, and Franklin is slightly cheap.

Location and amenity values clearly matter for explaining differences in house price levels – we should always expect an Auckland City property to trade at a significant premium to, say, a comparable property in Franklin given its much closer distance to the CBD. Given that location and amenity should also factor into the rents that a tenant is willing to pay it is not obvious, however, that they explain differences in the estimated values across the Auckland region.

This pattern of significant valuation differences across the Auckland region is in line with large estimated differences across New Zealand. For example, within Otago, Dunedin City is assessed to be cheap whilst Queenstown is assessed to be expensive. In part, the relatively poor value estimated for Queenstown, the North Shore and Auckland City may reflect off-model non-financial “lifestyle” factors, or the impact of absolute international house price convergence. As part of the globalisation of Auckland and recognition of its quality of life we should expect to see housing levels for premium parts of Auckland get more in line with premium destinations in comparable cities. Table 3 suggests this process has much room for movement yet. Across Auckland as a whole, however, this impact is likely to be relatively small.

The differences in valuations also hint at the impact of land supply constraints. The potential for significant green field expansion of the residential housing stock is the highest in Franklin, Papakura and Rodney, and lowest in Auckland City and the North Shore. Hence, land and house prices in Franklin, Rodney and Papakura are less likely to be bid-up well above the cost of developing and bringing to market a new single dwelling family home. The threat of more supply is real. In contrast, given greenfield supply is much more limited in Auckland City and the North Shore, this factor is likely to be less important. Instead, as next discussed, pricing in these areas may be more influenced by the potential for intensification.


Figure 1 Total returns to residential property under no intensification

Source: QVNZ, REINZ, NZIER forecasts

Figure 2 Excess returns to cash for residential property


-5.0

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

Expected excess returns to cash for residential property


Perc

ent

- - - Long run residential property risk premium


Figure 3 Expected capital returns


Table 3 House prices in Devonport versus comparable coastal locations

Location Average house price

(NZD)

Devonport, Auckland $1.4m

Sausalito, San Francisco $1.7m

New Brighton, Melbourne $1.9m

Manly, Sydney $2.1m

La Playa, San Diego $2.5m

West Bay, Vancouver $2.8m

Source: Various

3.2. Allowance for intensification A summary of the impact of intensification on our valuation modelling is provided in Table 4. In the North Shore and Auckland City properties that are able to achieve the highest intensities are estimated to be more highly valued than properties where no, medium or low intensities are permitted. This reflects the economies of scale with higher intensity developments. As a consequence, the overall valuation uplift is highest in Auckland and the North Shore and lowest in Rodney, Franklin and

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

Expected capital gains for residential property


Perc

ent


Papakura. We also see that, in general, low intensity terraced housing provides a larger valuation uplift than medium-sized high rises – the latter do not have the scale advantage of high rises, yet still have higher costs than terraced housing (e.g. because of the need for deeper foundations and lifts).

Table 4 Valuation of housing by intensity type

No

intensity

Low Med High Overall

Value

%

change

from no

intensity

% mis-

priced

Rodney 596,488 596,488 732,897 0 600,603 0.69% 20.20%

North Shore 631,360 846,182 788,991 1.028m 772,580 22.37% 26.03%

Auckland City 625,567 836,518 780,306 960,100 845,523 35.16% 17.35%

Waitakere 550,196 550,196 601,576 550,196 576,039 4.70% 14.03%

Manukau 592,234 592,234 701,050 0 620,028 4.69% 11.15%

Papakura 494,546 603,859 678,687 0 560,716 13.38% -9.72%

Franklin 568,426 568,426 616,999 0 573,650 0.92% -10.67%

Auckland

Region 598,494 701,325 17% 15%

Notes:

1. Calculated by multiplying the values in the row by the probabilities in Table 1.

2. Calculated as the population weighted average of the column above.

Source: NZIER calculations

While intensification raises estimated value there are a few cases where it doesn’t (the shaded brown cells). In these cases the costs of intensification is higher than the discounted stream of the rents and hence intensification is uneconomic, for example, our estimates suggest it would be uneconomic to build high rise developments in West Auckland given the relatively high construction costs and relatively low rent levels. In these cases, we set the value of housing to be the no intensity case on the basis that the development would not go ahead.

The overall impact of factoring in the potential for intensification is to (i) reduce the differences in the extent to which sub-regions are mis-priced and (ii) to move the Auckland market as a whole closer to fair value. That said, while the impact is significant – value for Auckland overall is 17% higher – the market is still assessed to be expensive at around 15% above fair value.


3.3. Sensitivity testing The table below reports the impact of the Auckland valuation estimated to a range of sensitivity tests around the base case assumptions.

We see that building costs are an important sensitivity for the valuations. If building costs were reduced 10% across the board we estimate the Auckland housing market would be closer to “fair value” as it would make the economic case for intensification stronger. Note that in this case we should not confuse the higher valuations with reduced housing affordability; instead the price signal would encourage a greater level of development and improve overall affordability.

In contrast, if the risk premium on development were higher (because, for example, of increased uncertainty over permitting processes) the value of the housing stock would be lower, and the supply that would come on stream would likely be lower.

Table 5 Sensitivity of valuations to differing assumptions

Factor Over-valuation in

Auckland (%)

Base case intensity 15%

Building costs are 10% higher 24%

Building costs are 10% lower 7%

Probability of intensification is halved 20%

High rise intensification is doubled in areas allowed under the PAUP 12%

Higher risk premium on property development (+50bps) 25%

No intensity 33%

Source: NZIER

Another key risk to the assessment of value is the extent to which the development activity actually takes place. We have made the bold assumption in our base case valuations that full intensification occurs in year 10. The reality is the process will be smoothed out and it is unlikely that all sections that can be intensified will be, even over a much longer horizon. Halving the probability of intensification increases the overall valuation by around 4 percentage points. This is not particularly large and reflects the fact that the biggest “bang for the buck” occurs in the higher intensity developments, which are already a small fraction of permitted developments. The flipside is that increased high rise intensification has a large marginal impact on housing valuations, particularly in Auckland and the North Shore.


4. Conclusions In this paper we show that intensification under the PAUP may be a factor supporting the high level of prices in Auckland. Our modelling suggests that this impact roughly halves the over-valuation estimated for Auckland, with the largest impacts in the North Shore and Auckland City where the potential for intensification is highest. This result depends on the assumption, however, that intensification occurs within a 10-year period. The impact is smaller if lower levels of intensification are assumed (and hence the degree of over-valuation is higher).

Our modelling also shows that high rise intensification and low rise terrace housing offers the best returns, whereas medium-sized apartments are marginal. As such, all else equal, we should expect to see these developments lead medium intensity developments as Auckland intensifies over time. The policy implication is also clear – zoning more land for high as opposed to medium rise developments than what is currently available under the PAUP may enable faster intensification.


References

Roberti, J (2014) Trends in new residential construction in Auckland, a case study based on the Auckland Atlas of Construction, Study report SR307, BRANZ.

Grimes, A and I Mitchell (2015) Impacts of planning rules, regulations, uncertainty and delay on residential property development, MOTU Working Paper 15-02.


Input data and Appendix Aassumptions

Table 6 Starting level of prices, rents and rates

City/Region Average house

price

Average rent Gross yield Average council

rates

Auckland 809,210 490 3.1% 2,764

Rodney 721,948 478 3.4% 2,549

North Shore 973,684 529 2.8% 3,170

Auckland City 992,227 501 2.6% 3,216

Waitakere 656,880 442 3.5% 2,388

Manukau 689,147 464 3.5% 2,468

Papakura 506,213 433 4.4% 2,016

Franklin 512,419 422 4.3% 2,032

Source: QVNZ, Auckland Council


Table 7 Construction cost estimates for terraced housing

Low costs Medium costs High costs

Build costs Construction cost

m2 1,800 2,400 2,900

Cost for terraced

house 180,000 (100m2) 360,000 (150m2) 435,000 (150m2)

Civil construction costs

Demolition Costs 7,500 7,500 7,500

Landscaping 2,500 2,500 2,500

Civil Work 2,250 2,250 2,250

Driveway 2,250 2,250 2,250

Utilities construction fees Telephone 300 300 300

Power 5,000 5,000 5,000

Water 12,700 12,700 12,700

Professional fees Project Manager 3,600 7,200 8,700

Town Planner 500 900 1,100

Engineer 1,800 3,600 4,400

Architect 5,400 10,800 13,100

Surveyor 900 1,800 2,200

Geotechnical 900 1,800 2,200

Legal 900 1,800 2,200

Real Estate Agent 13,500 23,600 27,000

Development contributions

Consents 3,000 3,000 3,000

Development levy 18,000 18,000 18,000

Insurance 1,500 1,500 1,500

Total

Development Cost 262,500 466,500 550,900

Finance 13,100 23,300 27,500

Contingency 26,300 46,700 55,100

Total Final

Development and

Finance Costs

301,900 536,500 633,500

Developer Margin 60,380 107,300 126,700

Total Cost 362,280 643,800 760,200

Source: Urban Economics


Table 8 Other assumptions

Variable Short run (0-7 years) Long run (+7 years)

CPI inflation 1.8% 2.0%

90-day interest rate 4.1% 4.8%

Real (inflation adjusted) rental growth rate 3% 2.5%

Occupancy rate 94% 94%

Upkeep cost as percentage of building value (increases at the rate of CPI inflation)

1.5% 1.5%

Property risk premium 3.5% 3.5%

Notes

We assume that interest rates will rise from current levels (starting in June 2017) to

an OCR peak of 4.5% in 2022. If rates stay lower for longer the value we estimate

would be higher, all else equal, but we note the RBNZ has not been able to

engineer a tightening cycle yet where it hasn’t had to significantly over-shoot

“neutral” policy levels.

We assume that local body rates growth is in line with recent Auckland Council

announcements (they increase from around $2,700 currently to $3,500 over the 7

year period). A higher rate of growth in rates would reduce housing valuations

unless we build in cost recovery via higher rents.

We assume investors require a risk premium of 3.5% over cash for holding

residential property. Around 200bps of this is compensation for systematic risk (i.e.

the contribution that housing makes to risk in a broadly diversified portfolio), the

remainder is compensation for illiquidity and concentration risks.

We abstract from tax and leverage impacts in the estimates presented. On balance,

at the present time we estimate, these serve to magnify the impact of the

overvaluation, which could be a key catalyst of more abrupt adjustment than the 7

year path assumed (i.e. if investors started worrying about their equity being

wiped-out we would see strong selling pressure).

Source: NZIER assumptions

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