Boom, Gloom or Doom?

What's Happening to the Property Market?

There's no certain way to know when, where, by how much or even if property prices will fall.

However enough compelling evidence now exists to give credibility to the belief that a correction, that is a fall back to the long-term average property price, is now more likely than less likely to occur and sooner rather than later.

My aim this month is to provide you with an outline of the economics of property market (which is global rather than Australia specific).

I'll be doing this within the context of two recent articles, which are summarised below from Infosource.com.au These articles are very interesting reading because they both give an insight into why property must eventually fall.

Article #1

UBS Warburg has warned that house prices will have to fall by an average 22 per cent across Australia if they are to return to their long-term average within three years. In Melbourne, where house values have almost doubled in the last five years, prices will have to drop by 36 per cent.

This isn't unusual, says UBS Warburg, and contrary to the myth that prices never fall, one only has to look at Sydney house prices over 1988-1990, when the median price fell by 25 per cent. The bank research house says it expects significant falls in both nominal and real prices over the next three to five years. It points to several signs of weakening demand in the property market, such as record highs in house prices in relation to rents, growing investor unwillingness to put money into property, lower auction clearance rates in Melbourne and Sydney, and the first home owners' grant - which has "pulled forward" demand.

Article #2

Australians are borrowing 10 times the amount of money for housing as they were 15 years ago, emphasising the pressure on the Reserve Bank to lift interest rates. In 1986-1987, Australians borrowed $15 billion for housing, while in the year to July 2002 the figure stood at $151 billion for buying, building and refinancing homes. Annual lending for housing was 5.6 per cent of GDP in 1986-1987, jumping to 21 per cent in 2001-2002.

During the 15-year period, house price in capital cities have trebled. Low interest rates over recent years have both encouraged the housing boom and protected home buyers from rising mortgage repayments. Household interest bills actually fell to $26.3 billion last year, from $28 billion.

Most analysts now believe that the Reserve Bank will raise interest rates over the next six months by a quarter of a percentage point, but BIS Shrapnel's Robert Mellor warned yesterday that rates could go up by as much as three percentage points by 2005.

The Property Market

Before analysing each article and outlining the specific factors that determine property prices, it's important to first review the nature of property market in general.

Property is a cyclical investment that has a positive long-term trend.

This means that there are periods of growth and decline in property prices, but overall the long-term trend is for property prices to rise.

chart

The cyclical nature of property is illustrated in the graph to the left. Note that there are two lines that regularly intersect each other. The straight or consistent line represents the long-term average growth in property prices. It has a steady slope that underpins the theory that if you hold property for long enough then it will eventually rise in price.

The curvy line represents the current median house price for an imaginary market. Unlike the long-term average, it has periods of peaks (above the long-term average) and troughs (below the long-term average) suggesting that the price in the current market may vary due to factors identified below.

Property Market Players

Every property market is made up of a combination of three players:

Home-buyers

Property provides shelter - which is one of the basic human necessities. In realty it provides a lot more because there is a dream and social status associated with owning your own home.

Home-buyers are not looking to play the market as such, instead looking for a nest equivalent to what their lifestyle can afford.

Capital gains are an after thought to emotional considerations such as proximity to schools, shops etc.
Investors

Unlike home-buyers, property investors are motivated by profit and are looking for a combination of capital gains and income returns.

There should be less emotion involved and more "science" involving a review of numbers, property condition, quality of tenants etc.

Unlike home-buyers who are looking for a nest, investors are speculators. This speculation introduces an element of uncertainty in the market and allows for property prices to rise and fall sharply if the speculation cannot be sustained.
Vendors (Sellers)

Sellers will actually be a mix of home-buyers (looking to trade in for a different home) and investors (looking to cash in on a profit).

It's the interplay between these three groups that determines the demand and supply of properties.

In a market where there are more buyers than sellers you can expect property prices to rise as investors and homebuyers compete for limited stock.

Where there are more sellers than buyers then property prices will fall since sellers will compete for the attention of limited buyers.

The number of buyers and sellers in a market determines if the current market property price is above or below the long-term average. This means that there are always upswings and downswings in prices depending on the prevailing market conditions.

Property Prices Trend Upwards

The stockmarket is much more volatile than property in that it can rise or fall 5% or more in a day or even hour.

Movements in property generally take a lot longer because the forces that entice buyers and sellers to enter the market occur over a much longer time period than the release of information (such as a profit warning) that can drag a stock instantly lower.

Looking back at the graph you can see that the long-term blue trend line that it is consistently positive, although during the time it took to get to point 6, current market property prices were intermittently above and below the long-term average line.

The positive trend in property prices is a result of two factors:

Inflation

A dollar in 1970 would buy more than a dollar today because prices have risen in the meantime.

Property is seen to be a hedge for inflation because property prices reflect changes in the buying power of money. That is, the cost of building a new property increases as the components (nails, plaster, wood, bricks etc.) rise in price over time.

So too older properties increase in price because although the components they are built with were purchased in dollars at the time of their construction - it would cost a lot more to rebuild the house again in today's dollars.
Population

The generally increasing nature of population means that there is more people than land which has the effect of increasing land values over time, especially in areas where the land is limited, for example beachfront property.

Accordingly, so long as a population continues increase then you can expect the average house in the average city to increase in value because demand will continue to exceed supply.

Population decreases, such as that experienced in many rural towns, will see property prices fall as there is more land than people; it is not scarce.

Understanding population trends is critical to identifying areas that are likely to appreciate in capital gains.

A great example is Ballarat. When I purchased my first property in 1999 I saw that the rural areas were contracting and that people were moving to regional hubs looking for work. This meant that demand for houses in this area would increase as land was becoming scare compared to the swelling population.

Then David identified a similar trend in the La Trobe Valley, where you have three satellite towns of 15,000 people close together. Moe and Morwell lacked the infrastructure and employment opportunities, but Traralgon was booming as people from Moe and Morwell sought to move there.

The same could be said for Fort McMurray in Canada where I understand that booming infrastructure (particularly oil) has had a similar impact on prices.

Be careful though that you avoid temporary increases in population that mean prices spike and then fall. A good example is with the Sydney Olympics where property prices leading up to the event generally rose and then fell back to more realistic values when the event concluded.

A Few Property Facts

Let's review some of the statistics relating to property over the past ten or so years.

Standard variable home loan interest rates peaked at 17.00% in 1989 (per RBA data) and a recession soon followed that lasted between 1991 and 1992.

Between March 1989 and April 1993 Sydney median house prices fell from $210,000 to $180,000 (down 14.29%) and in Melbourne prices were flat - moving marginally from $137,500 to $145,000 (per REIA data).

Put another way - growth in the two markets was either negative or flat for more than four years.

Housing interest rates fell below 10% in April 1993, but rose again briefly until May 1996, when they fell below 10% where they have remained to this date.

Since April 1993, Sydney median house prices have increased 107% and Melbourne 114% - a boom that has lasted over nine years.

Median property prices from 1980 to 1989 had generally risen consistently 3.2% a quarter in Sydney and 3.3% a quarter for Melbourne.

What Drives the Market?

The competition between home-buyers, investors and sellers is moulded by four prevailing factors.

Let's examine these four factors to see if we can better understand what influences buyers (that is demand) and sellers (that is supply) of property.

Interest rates

Home loan interest rates have a lot to do with the state of the property market because they impact on the affodability of housing.

Homebuyers and investors do not have an unlimited budget, so when the cost of owning a home or investing in property climbs then more and more buyers seek alternatives - either renting or investing elsewhere.

The current standard variable home loan interest rate is 6.55%. Sure, cheaper rates exist, but this is seen as the benchmark.

It did fall to 6.05% in late 2001 / early 2002 which was the lowest rate since March 1970.

At this low rate many buyers who would otherwise rent have been able to enter the home-owner market (especially with the government incentive outlined below) as the margin between renting and owning has fallen with lower interest repayments.

Similarly investors are earning great yields - even positive cashflow yields - on property that at other times in the interest rate cycle would earn a cashflow loss.

But the current low rates are potentially misleading and might lull buyers and investors into a false sense of security.

A sobering figure is the long-term average interest rate, calculated by taking the average monthly standard variable home loan interest rate between January 1970 and August 2002 (source: Reserve Bank of Australia). That figure is 10.31%.

The impact of the difference between the long-term average and current interest rate is significant.

For example, buying a property priced at the median house value in March 2002 would have cost $316,500. Assuming you borrowed 80% of the purchase price on a 25-year principal and interest loan at 6.55% then your periodic repayment would be $395.53 per week.

The same loan at 10.31% interest would be $542.33. The difference is $146.80.

If you were funding your home loan out of salary and you were on the top marginal income tax rate, then in pre-tax dollars you'd need to earn an extra $14,822.52 just to cover the additional interest at the higher rate of 10.31%. [Calculated by: (($146.80*52)/(1-0.485))]

The bottom line is that if housing interest rates move back to towards the long-term average, then unless investors and home-owners can reduce debt then owning property will become a lot more expensive.

Cheaper interest rates have seen more money borrowed and invested into housing. Article #2 observes:

"Australians are borrowing 10 times the amount of money for housing as they were 15 years ago... Australians borrowed $15 billion for housing, while in the year to July 2002 the figure stood at $151 billion for buying, building and refinancing homes..."

The standard variable home loan interest rate fifteen years ago (April 1987) was 15.5%. In April 2002 the same rate was 6.55%.

If we assumed that every loan was borrowed at the low interest rate of 6.55%, then the annual interest paid on housing debt would be $9.89 billion.

Should interest rates increase to the 30 year average of 10.31% and debt levels remain what they are today then the interest figure would blow out to $15.57 billion - an increase of 57.41%!

Furthermore, the extra interest payments could not be expected to be funded from increases in salary (salary growth has not kept pace with housing price growth) or from increased rents as tenants will only pay so much before looking to share or go cheaper.

If you haven't already come to the same conclusion yourself - these are scary statistics.

So how likely are interest rates to rise?

Well, Article #2 says:

"...warned yesterday that rates could go up by as much as three percentage points by 2005."

The Governor of the Reserve Bank, the organisation that sets interest rates, suggesting that the low interest rate environment could not last.

I don't think I'm be too cautious by agreeing that interest rates could be two or three percent higher in the next few years following on from a number of small increases - say a mix of between 0.25% and 0.5% increases every other month or so.

Just as low interest rates have fueled a massive increase in property prices, it's reasonable to expect that high interest rates will provide the necessary financial pressure to force people who have borrowed too much to sell.

This means that supply of properties for sale (and distressed sales too) will increase and real estate prices will naturally fall.

In our earlier graph, the market movement from point 2 to point 3 will have run its course and the line will now retreat south back towards the long-term average.

Interestingly, Article #1 suggests:

"...In Melbourne, where house values have almost doubled in the last five years, prices will have to drop by 36 per cent."

If this was to occur then the median house price will have to drop by $113,940 to $202,560.

Note that while the value will fall - the debt will not and for people who have borrowed against equity (which has now evaporated) the urgency to sell may be great.

On the demand side, as interest rates rise investors will look to other vehicles to make money since property no longer delivers. Home-buyers will decide to rent as they can no longer afford to own.

I don't write this to be deliberately alarmist, just to give you the likely situation when interest rates rise.

Managing Risk

You must develop a plan to manage the associated risk today.

Investors or homebuyers who have used equity rather than cash as deposits should be sure to invest in assets where the current cashflow is high enough to absorb an increase in interest rates of between 2 and 3 percent in the next five years.

You can immediately do two things - repay debt and consider locking in interest rates.

Investors planning to retire on capital drawdowns rather than independent positive cashflow income are in trouble, as are home-owners who have extended their financial ability to repay and bought on the basis of extended low housing interest rates.

Historically interest rates have risen and fallen depending on the prevailing general status of the economy. Believing that rates will stay high or low forever is not representative of the 30-year average that came to 10.31%.
Incentives

Article #1 revealed that:

"...the first home owners' grant - which has "pulled forward" demand."

That the First Home Owner's Grant has influenced buyers by enticing them a certain segment of the market to purchase perhaps earlier than they might otherwise had intended to make sure they do not miss out.

I can remember in the months between the grant being announced and becoming available, demand in the La Trobe Valley dropped and we were able to buy property at artificially low prices since there were still a number of vendors that needed to sell.

You could say that demand during this period was "pulled-back" as first homebuyers delayed buying to ensure they received the grant.

So it makes sense that when the grant is either further reduced or eliminated then there will be a demand gap caused by the home-buying segment of the market being 'pulled-forward' to ensure they receive the grant; the opposite of what happened when the grant was introduced.

The First Home Owner's Grant has certainly stimulated buyer demand - especially in the new house construction where the introduction of GST threatened to cause a building collapse.

Yet in reality the initial $14,000 and now the $7,000 is of little compensation when you consider that new homes now attract the 10% GST and older homes have risen far beyond $7,000 anyway and the equivalent extra stamp duty wipes out part of the gain.

The entire Grant is something of a false economy - an incentive with little benefit when you consider its impact.

Thus by itself it is of limited value, but combined with low interest rates and the emotions of fear and greed, it has nevertheless enticed buyers to get into the market when but for these factors they would have remained renting. That is, there has been a 'pull-forward' of demand.

Phasing out of the Grant will have minimal impact unless the timing is in conjunction with rising interest rates, in which case the impact may be more dramatic since it will help to quickly shift market sentiment.
Easy Money

I can remember my Mum taking me into the National Bank as a child and setting up a passbook account in my name. She, correctly for her generation, believed that borrowing money was a lot easier if you had an existing relationship and a savings history with a bank.

Who was to know post-deregulation accessibility to money would be so easy and that relationships would count for so little?

But that is the reality of today where the radio and print media are full of ads enticing people to borrow money. More recently it has been to borrow against equity and fund lifestyle expenses - a dangerous practice given the comments above.

There have been two components to the 'easy' money situation that have been favourable to home-buyers.

The first is the shift away from dealing direct with a bank and instead dealing with a broker who assists people to find the right lender for their situation.

So whereas people were refused loans before, the growth in the number of lenders has meant that niche markets have been created for financially challenged persons such as self-employees and low income earners.

Dealing with someone who only gets paid when you're successful too has meant that mortgage brokers have been able to unlock the finance riddle for customers who would otherwise have been knocked-back.

The second component is the range of loan product features that are now available, especially redraw and offset accounts that make it more affordable to borrow money.

Not too long ago the only loan product available a twenty-five year principal and interest home loan that customers paid over twenty-five years.

But today we have lines of credit, redraw facilities, split loans, facilities with credit cards etc. that all work to reduce the amount of interest that you pay and enable you to own your own home sooner.

What we see today is that it's easier to access finance than it ever has been before in an environment that has seen the lowest interest rates in more than 30 years. The result of which was identified in Article 2 as:

"Low interest rates over recent years have both encouraged the housing boom and protected home buyers from rising mortgage repayments."

How long can the good times last? Not forever.

When interest rates rise, or if the job market softens, or when housing prices cease to boom, then home loan defaults will begin to rise and lenders will react by being a lot more selective of the quality of new loans being written.

The figures that I have calculated reveals the interest rate figure that will see defaults rise is approximately 8.5%.

Bearing in mind that the 30-year long-term average is 10.31% and economists in Article 2 are expecting a rise as much as three percentage points (bringing the rate to 9.55%) by 2005, it's reasonable to expect both the number of defaults and the difficulty of borrowing money will both be on the rise soon.

It's important to position yourself to ensure that you can continue to secure finance, which is why it's critical that you don't max-out now either personally or from an investment sense.

Cash is king and will be a powerful negotiating tool when securing deals and the more of it that you have when applying for finance then the less problems you'll encounter.
Fear And Greed

To differing extents both home-buyers and investors are motivated by fear and greed.

Fear arises from missing out and greed relates to making money... lots of money and without much effort.

Home-owners are fearful that unless they get in now then property prices may continue to boom and they will be forever restricted to renting. Also, we have ourselves or know of friends who purchased something a few years earlier and now benefited from their property rising a massive 40% in value! It's easy money that requires no more effort or expertise than to buy something and wait.

Investors have similar emotions in that any fool should have made money from real estate in the past three years - and many fools have. This gives an illusion of success (the 'I just can't lose' mentality) in a rising market that results in complacency suggesting that the good times will continue indefinitely.

A property market driven by fear and greed is already at an advanced stage of its peak / trough cycle, since prices are not necessarily underpinned by value but by pure speculation.

You know the end is near when reasons why this boom is different to all the others - similar to the coining of "new economy" stocks on Wall Street just before the tech bubble burst. This hasn't happened yet... but keep watching for comments that real estate agents will make to keep the market buoyant.

Summary

In the four years between 1989 and 1993 the property market was depressed experiencing flat or negative growth.

Between 1993 and 2002 the property market corrected to catch-up to the long-term average and then to rise well above it as property prices run rampant.

Now we are faced with three possibilities...

Property prices can continue to rise, defying logic and affodability concerns that say that sooner or later home-buyers and investors will be priced out of the market as it will be cheaper to rent and the negative-cashflow will make investors wary.
Property prices will flatten out and then hold steady for a number of years while the long-term average and income levels catch up (represented by points 5 to 6 on the graph) This is a likely situation if interest rates rise slightly but do not stay above the 8.5% level for an extended period. There would also need to be low home loan defaults and the continuance of easy money so that the market psychology does not change forcing more people to sell and prices to drop.
Property prices will fall in response to a significant change in market conditions. Sustained interest rate rises will quickly take the heat out of the market and will force investors and home-buyers who have borrowed too much money to sell-up. This will begin a snowballing effect that will see property prices drop back to or below the long-term average line - perhaps to the extent outlined in Article 1 of 22% around Australia.

Regardless of what happens though... there are some key points to remember:

Great deals exist in every rising and falling market. Just last week David agreed to buy $750,000 worth of property (more about this next month...) Don't become spooked by the hype and complete a due diligence every time you buy.
Making money in property is about creating leverage or using other people's money. Lenders make profits by providing finance which means that as long as you present as a good risk then you'll be able to beat the extra scrutiny when the easy-money dries up. You'll need to have cash to put into deals to avoid mortgage insurance if the number of defaults increase.
Don't rely on capital gains to fuel retirement income or equity to continue investing when it's more likely than less likely this won't occur in the next five-year period. Make sure that the rent from your properties at least covers your interest payment and if it doesn't then ensure you have other income to fund the shortfall.
No one ever went broke making a profit. If you have multiple properties on a capital gains strategy then make sure you are managing your portfolio prudently. Watch out for greed and fear that may see you defer making a decision that will cost you in the long run.

My strategy during this turbulent period is:

To continue building a cash reserve equal to at least three months of repayments on all our property to build a buffer against the immediate impact of rises in interest rates.
Keeping our loan terms as principal and interest rather than interest only and as such ensuring that when interest rates rise the impact will be mitigated since we owe less money.
Being careful about what deals we sign for and which ones we leave on the table. The due diligence process that reviews the numbers in a deal is even more critical now given that we have moved beyond the lowest of the low in the interest rate cycle.