"If rates fall by a further 2.0% and prices by 3%, household debt service ratios would fall to their 25 year average which should stimulate activity within low end markets.
"Thirdly, the buy versus rent decision has become more compelling due to affordability improvements and rising rents.
"Using a total return model and a 10 year holding period, a typical first homeowner should receive a ~12% annual equity return purchasing a home."
But the negatives are stronger, according to Merrills:
"After a decade of strong credit, income and asset price growth, imbalances now exist in household balance sheets. Household gearing increased from 12.1% to 18.5% between 1990 and 2007 and house prices currently exceed 6.5x pre-tax incomes.
"These in combination make the market particularly sensitive to employment and income growth, which will likely worsen in the coming years.
"Our economists are forecasting unemployment will rise from 4.2% to 5.75% by mid 2009 and income growth will slow from 6% to 4.5% pa. In this environment, households are likely to de-lever and the residential market is likely to worsen."
As a result Merrills said "We forecast total price declines of 10% (including the ~3% declines to date) over the next two years followed by 3-5 years of relatively flat growth (~CPI) while unemployment stabilises. We forecast volume declines of 10% in 2009.
"In conclusion, we believe the effects of highly geared households combined with rising unemployment and slowing income growth will offset the positive effects of excess housing demand, improving affordability and a more compelling buy versus rent equation.
"We believe home prices and sales volumes will continue to fall into 2009 resulting in margin contraction and falling EBIT for residential developers.
"House prices have risen 140% in nominal terms and 90% in real terms over the past 10 years, boosted in part by the availability of credit and build-up in debt.
"After 12 successive rate hikes, this trend started to reverse with national prices falling 1.3% in the June quarter. With slower income growth and rising unemployment we expect house prices to continue to fall despite further interest rate cuts.
"We forecast total price declines of 10% (including the ~2% declines to date) over the next two years while unemployment rises followed by 3-5 years of relatively flat growth (~CPI) while unemployment stabilises."
Merrill Lynch said that with the group of residential property orientated stocks it covered, it had Stockland (SGP) on a neutral rating, Lend Lease (LLC) and Mirvac (MGR) on an underperform rating.
"Whilst there is value to be found in all three, downside risk to FY09-10 earnings will continue to overhang these stocks.
"We forecast residential EBIT declines of 18-21% in FY09 and expect a ~25% erosion in inventory value over the next two years driven by ~10% price declines plus two years holding costs. We have downgraded our EPS forecasts 2-3% for each, and lowered our PO's to $1.40 for MGR, $4.80 for SGP and $7.00 for LLC"
It looked at Mirvac (MGR) in some depth yesterday:
"Whilst MGR has only ~$100m of drawn debt expiring pre-2010, it has a $1,112m undrawn syndicated loan facility maturing in June 2009. Given MGR's net capital requirements over the next 12 months (we estimate $330m) and the further credit rationing by lenders over the past 2 months, MGR is facing a material refinancing risk which may lead to an equity raising, in our opinion.
"In our report titled "Residential unwind" (the summary is above) we have updated our outlook for the Australian residential sector and reviewed MGR's residential business.
"Whilst (1) there remains a supply shortage, (2) affordability is improving with rate cuts, and (3) the buy-versus-rent equation is becoming more compelling, we believe these will be more than offset by lower income growth, rising unemployment and the de-leveraging of the household sector.
"We forecast total price declines of 10% (including the ~3% declines to date) over the next two years and volume declines of 10% in 2009.
"MGR's '09 guidance assumes development EBIT grows 13-21%, an aggressive forecast in the current market. We forecast a 15% decline in total development EBIT and an 18% decline in resi EBIT.
"In addition we expect a 25% erosion in MGR's inventory value (driven by 10% price decline and 2 years of holding costs) over the next two years which could result in further inventory write-downs.
"We believe MGR will continue to trade at a significant discount to while debt refinancing/equity raising and earnings guidance risks remain."
Investors took the Mirvac comments and downgrade to heart yesterday, slicing more than 11% off the company's shares by the close at $1.25, after hitting an all time low of $1.235 during trading.
