Are interest rates at their peak in New Zealand?
The Reserve Bank of New Zealand reaffirms that interest rates have peaked, so what does this mean for borrowers?
Following the Reserve Bank of New Zealand’s (RBNZ) 12 July review, the Official Cash Rate (OCR) was unchanged for the second review in a row. This has reaffirmed the RBNZ sentiment that the OCR has peaked, after increasing by 525 bps from its low of 0.25% since October 2021 to 5.50%. However, there remains some divergence from market commentators on the matter, with some expecting another 25 bps of hikes to manage the high inflation environment we are experiencing.
Based on the more popular view that interest rates have peaked, the focus will shift to when the RBNZ should start easing interest rates. The consensus is that it will not happen until mid-2024.
Figure 1: RBNZ OCR forecast and 90-day chart
Source: JLL, RBNZ, RBNZ MPS May-23
For many borrowers, interest rates have risen due to the increasing base rate (90-day) and credit margins. With a higher interest rate environment for the foreseeable future and softening property yields, owners may need to adjust approaches, especially with major banks and non-banking funders focusing on funding covenants.
While the Loan-to-Value Ratio (LVR) is an important metric to understand the impact on equity, an increased focus from the funders has been on the Interest Coverage Ratio (ICR). The ICR is a measure of a borrower’s ability to service funding interest payments from an asset(s)’s income stream.
Pre-pandemic, the ICR was commonly set at 2.00x of net income, which was easily met by many borrowers due to extremely low-interest rates. There are many cases in which the ICR has been reduced to 1.25x and 1.50x levels for existing clients. The example below shows an increase in rent having minimal impact on the ICR due to the interest rate being 3.6 times higher than its lows in 2020.
Figure 2: ICR calculation table
Fundamentally, banks are working with their existing borrowers, especially if interest payments are being met and/or there is a strategy in place such as future rental growth, further leasing or asset sales. However, if the funding is due for renewal, the bank may ask the borrower to reduce some of the funding to help bring the ICR back to acceptable levels. Banks tend to be more flexible with existing clients on ICR levels but more stringent on new funding proposals.
Figure 3: NZ mortgage interest rate maturity profile
As of 30 April 2023, 22.8% (NZD$79.3 billion) of residential mortgages are floating or fixed for less than three months, with a further 37.9% (NZD$131.8 billion) maturing within the next 3-12 months. That’s NZD$211.1 billion floating or maturing within 12 months. This has seen commentary suggesting as mortgages re-price onto higher interest rates over the next 12 months, we would see average household debt servicing around 10% of disposable incomes - levels last seen in 2011.
The funding and higher interest rate environment is expected to keep a lid on property prices, and in some cases, there will be further softening.