The undersupply down under

Years of muted residential development and a rapidly growing population have placed Australia’s capital cities into a housing crisis. A severe undersupply has left renters on the eastern seaboard facing a 24% increase in rent since 2017. The vacancy rate for rental apartments is also under 2%. Melbourne is expected to face the most strain in the coming years as it grapples with becoming Australia’s largest city within the next two decades.

Melbourne's rental apartment vacancy rate has now fallen to below 2%

According to Australia’s Centre for Population, net overseas migration in Melbourne will return to pre-pandemic levels by 2024-2025. Along with a significant fall in the net number of leavers post-covid, the city will again be the fastest-growing capital. It could pass Sydney as the largest city as early as 2032, and is expected to house between 6.5 and 9.9 million people by 2071.

Are new policies a panacea or just a band-aid?

Part of the solution for increasing housing supply is to make it attractive for developers and mid- to large-scale residential investors. The federal and local government in Melbourne is providing supportive policies for the development of more build-to-rent (BTR) homes.

The federal government confirmed that it‘s reducing the withholding tax rate for eligible fund payments from Managed Investment Trusts (MITs) from 30% to 15%. This is expected to come into effect during 2024. The government also confirmed that it’s increasing the depreciation rate for capital works from 2.4 to 4% per year for eligible properties. The reduced withholding tax rate provides a significant concession to MITs that are looking to invest in the residential BTR sector. Projects are now more likely to be commercially feasible for foreign investors who usually invest into BTR developments via MITs. Additionally, the increase in the depreciation rate for capital works translates into a higher depreciation expense that leads to a lower tax bill for BTR developments.

At a local level, the benefits include time saving, which also positively impacts costs. The Melbournian government has an accelerated planning programme for residential developments that provides at least 10% of affordable housing, with a minimum development cost of AU$50 million. But there may be some developments where it’s not feasible to include affordable units, because of the market position of the intended operator. The good news is that the accelerated planning programme is also available via a levy system. In this case, 3% of the total development cost can be paid to a programme run by the State Government called Homes Victoria, which is then channeled into social housing.

Is this the panacea Australia has been looking for? Not quite, and we think there’s more room for policies to evolve. But right now, with these measures, the numbers have started to work for institutional investors.

A different Melbourne in five years

Melbourne is in an interesting spot right now. While demand is strong for ‘living’ assets, the office sector is struggling. According to CBRE, Melbourne’s average office occupancy in the third quarter of 2023 hovered around 56%. A recovery is more marked in other capital cities, where the average occupancy rate for offices was over 75%. This mismatch could offer opportunities, but conversions can be tricky. The feasibility of an office-to-residential conversion is usually determined by the current office size and the distance from the windows to the core of the building. The Building Code of Australia states that 'habitable rooms' require permanent access to fresh air and natural light. Offices that have too big a floorplate, or windows positioned too far from the core, present challenges in terms of access to natural light and ventilation when divided into apartment units. This could violate the building code.

Older and poorer-quality offices at the edge of Melbourne’s central business district (CBD) may be smaller and easier to convert. For example, the offices on St Kilda Road nearer the Kings Way and Toorak Road junction tend to fit a conversion strategy. Connectivity to that area is soon to be boosted by the completion of Anzac train station. With amenities such as Albert Park, the Royal Botanic Gardens, and medical facilities nearby, this area should be attractive to young renters who are looking for a place close to the city, and to older renters who are looking to downsize. In five years’ time, we may see clusters of poorer-quality offices being transformed into attractive neighborhoods in which to live. This would give a very different look and feel to the outer edges of Melbourne’s CBD.

Is this enough to sustainably house the incoming population into Melbourne? And is it investible? We think there’s still room for more supply. If we look at the expected construction rate for the next three years, around 4100 homes should be completed each year. But the projected demand for BTR over the next 10 years indicates that just over 12,000 homes will be needed each year. This persistent undersupply is likely to push up rents, and the increased institutional interest in Melbourne BTR will likely push yields modestly lower. Therefore, we think it’s investible for now, but it's probably going to become more expensive over time.