Is Auckland good value?

Housing Market Written by Peter Norris, May 1 2018

We ran a seminar recently where clients were lucky enough to hear from Ludo Campbell-Reid, the design champion for Auckland. I came away from the evening inspired about the future of this city. We’ll throw up a video of his presentation on our Squirrel blog soon. Definitely check it out.

It got me thinking though: “If Auckland was a company, would I buy it?” and what sort of P/E multiple would I pay for a company like that? My thinking was that property prices could be a proxy for a share in Auckland’s future.

The same logic could be applied to New Zealand, but for the most part I wanted to understand how Auckland house prices could become so disconnected from the rest of the country. Auckland is not unique however, with a similar phenomenon occurring in other popular globalised cities around the world.

So let’s start with a pricing model. There are three factors in a P/E model. There is the cash flow (E) which we’ll take as rent, there’s a growth rate (G) for which we’ll use the change in GDP (income) and a discount rate (K). So, price = E / (K-G).

For the discount rate I’ve assumed 70 percent debt and a required return on equity of 20 percent.

This is where it starts to get interesting.

There is an absolute relationship between interest rates and asset prices. The value of future cash flows is discounted by an interest rate to come up with a present value for that asset. The lower the interest rate, the higher the value of an asset.

Between say 2007 and 2017 we’ve had a big change in what is considered a neutral interest rate. That’s partly the result of low inflation and partly the result of a lower risk economy that is becoming more diversified.

I’ve assumed that the neutral interest rate has fallen from 7.50% to 5.50%.

1/ 0.07 = 14

1/ 0.05 = 20

This change in underlying interest rates would increase the price by 40 percent.

The next thing we need to consider is the growth rate. In the past, three percent would have been an acceptable growth rate applied to New Zealand. Although, Auckland could have always been argued to be slightly higher – so let’s say four percent.

According to MBIE, Auckland is currently growing its GDP at seven percent. That doesn’t surprise me with our population growing at close to two percent. There’s also the growth of the knowledge economy. A recent MBIE study showed the ICT sector is growing at nine percent per year and has the highest wages of any sector at close to $100,000. It’s also a sector where the costs are largely human capital.

If Auckland is part of a global movement towards a fourth generation knowledge economy, with productivity driven by technology and innovation, what would that mean? Of course, it’s not about Auckland it’s about the attraction of New Zealand. Auckland is simply the place within our country that has the scale to do business and attract talent.

If we use our same model and now subtract a growth rate from the discount rate, the price goes up by 350 percent.

1 / ( 0.11 - 0.04) = 14

1 / ( 0.09 - 0.07) = 50

Growth expectations can have a massive impact on value. If you think about a high growth share it will trade at a multiple well above its current price. Another way of thinking about that is that property is also trading at very low yields, or conversely high multiples.

The thing that we tend to miss with Auckland is just how strong the underlying growth rate is. It’s not about Auckland, it’s about the knowledge economy and picking those places around the world that are going to benefit the most from it – recognising that human talent is mobile and a critical success factor. From my perspective, I’d put Auckland on that list of global cities and I’d buy that share.

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