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Economics

The Property Volcano

Date: 08/08/2018

With the exception of Hobart, where property prices continue on their bull run, elsewhere around Australia, and in Melbourne and Sydney in particular, real estate has an unpleasant stink about it at the moment.

Depending on how pessimistic you are, and from where you get your news, we are either in the early stages of a mild property hiccup, and feeling the effects of an inevitable correction, or at the dawn of a cataclysmic crash.

My own opinion, for what it’s worth, is that the property market is like a volcano. For much of the time, it can be happily climbed and the view from the top is spectacular. However, infrequently there can be an eruption, and when that happens, you don’t want to be anywhere near it.

Keeping the analogy going, after a long period of calm and peace, the Aussie property volcano has recently ‘come alive’ and can now be seen venting a plume of ash, steam, and a fair bit of rotten egg gas – hence the stink.

It’s presently no cause for panic, but it might be if things get worse.

A Dose Of Reality

Unless you paid a silly price for something recently, I wouldn’t call what we’re experiencing in the property market right now as anything other than mild and normal turbulence.

Take Sydney for example, where median house prices in March 2018 (latest data available from the REIA) have retreated a little over 4% from their peak in June 2017.

Sure, that’s unpleasant, but when you take into account that between September 2016 and March 2017 (nine months) Sydney house values rose by 11.2%, it follows that giving back just over a third of the recent gain isn’t cause for alarm.

And even if there were a property crash and values across the board declined by a substantial 25%, which is enough to mean that any 80% LVR loan taken out recently would be against a property that is now in negative equity, the table below reveals how many years of growth we would be ‘giving up’ by indicating the approximate date that property values were last at that price:

CityReduced
Price
Last At
That Price
Approx Years Of Growth Given Up
Sydney$863kSeptember 20144
Melbourne$641kDecember 20135
Brisbane$386kSeptember 200711
Adelaide$353kDecember 200711
Perth$383kJune 200612
Canberra$481kDecember 20099
Hobart$369kJune 20126
Darwin$379kDecember 200612

Source: REIA, PropertyInvesting.com

For Melbourne, Sydney and Hobart, the price retreat would just be handing back the recent round of appreciation. It would be more severe in other cities that did not experience a price boom in the past three or so years.

Even a 50% decrease would see us return to values as they were more or less a decade ago, and hardly affordable in the sense of property prices pre-2000 (when the median house in Sydney was around $300,000 – which was considered expensive in its day!).

Rumbles

Can anyone predict what the property volcano will do next with complete certainty? No. Like volcanoes, in real estate, there is a fair amount of theory about what should happen, but no one knows for sure because mother nature (or the herd mentality) cannot be tamed.

That said, I’m seeing some signs that have me feeling like there is more downside risk of further price falls, as opposed to upside optimism that prices will quickly recover, including:

Falling Rents

I saw a report in the Financial Review last weekend indicating that rents are now falling in Sydney. If rents fall, prices will eventually follow because real estate will become less affordable and the amount purchasers can borrow will decrease.

Since so much of the nation’s media is based in Sydney, journalists tend to report what is happening there as if it is happening everywhere, and so the Sydney prices sniffles can mean other areas catch a property cold.

Less Liquidity

It’s getting a lot harder to borrow as much money as even a few months ago, with valuations being squeezed to the low side, and at the same time lenders now want to know whether or not you had sauce on your pie at lunch, and if you did, how did you pay for it?

Okay, perhaps that’s a bit dramatic, but it is not far off the level of inquisition some borrowers are enduring today, where previously there was none. Don’t expect things to get better anytime soon. As the Royal Commission winds up, I predict it will take even longer to get a loan, and harder to borrow as much money as before.

Fewer borrowers with less cash at their disposal will put downward pressure on property prices.

Increasing Interest Rates

Even though the RBA is sitting pat on their benchmark cash rate, and despite some lenders actually reducing their headline interest rates to attract customers, the general trend is now set for interest rates to increase because the cost of borrowing on world markets has risen. Faced with a choice of lower profits or higher interest rates, it’s no surprise that more and more lenders (starting with the smaller ones) are choosing the latter option.

As I’ve written not long ago, interest rates won’t have to rise too much for there to be a profound impact on Australian households. We’re so hocked up to the eyeballs in debt, just a half-to-one percent increase is going to tip a considerable number of mortgage holders into mortgage stress. As more people have to sell, there will be even more downward pressure on property prices.

Contagion

When (not if) interest rates increase by that half-to-one per cent, households will have less discretionary money to spend on everyday goods – from coffee to holidays, and the economy will increasingly groan under the weight of our debt burden.

Dare I say it? At that time we will enter the recession that will be the inevitable consequence of so much debt-fuelled consumption. It will be the late 1980’s all over again, except that interest rates at circa 7 to 8% today will have the same impact as interest rates at 17 to 18% did back then (because we have so much more debt today).

What Am I Doing?

Well, exactly what I’ve been telling you to do for quite a while now.

  • I’ve sold some property I don’t think is helpful to own in less optimistic times.

  • I’m critically analysing my property portfolio to ensure it is being managed well

  • I’m making offers on good deals if I see them come up (there aren’t many, but they are starting to be more prevalent), and otherwise, I’m being patient and boosting my cash reserves.

  • I’m actually not holding any ‘net debt’ right now because the name of the game is to maintain my borrowing ability so that I can jump on the next great deal.

Takeaways

Wrapping up, here is a summary in the form of five takeaways:

  1. The possibility of financial loss is increasing, and that means investment risk is increasing too. The correct response is to be more prudent, cautious and diligent. Now is not the time for wild, or super speculative, property investing.

  2. Debt is getting harder to get. In my case, even though it is a little more expensive than the headline interest rates being advertised, I’m happy to hang on to an existing debt facility that was written under more favourable conditions than what might be offered today.

  3. It doesn’t quite carry the same punch as the Game Of Thrones catchcry, but Spring is coming, and with it, the peak time to sell. If supply increases without demand picking up, expect prices to fall.

  4. A little price slippage isn’t panic stations. Property prices would have to fall by more than 10 to 15% off their peaks to get me nervous, and we are a long way away from that just yet. Still, if a price fall of that magnitude would cause financial heartburn for you, then maybe you should consider cutting your losses so you can live to fight another day. Don’t assume you will get today’s price tomorrow, in a soft or down market.

  5. Better and better deals are coming on the market, but vendors are still hoping for more or less top dollar. Presently it is development and renovation opportunities that have become more prolific, but often these are still being marketed at inflated prices by vendors who have just realised they won’t make their expected profit, or can’t get the finance to proceed with construction. Be patient. Give it time.

That’s it from me. See you in September.

Until then, remember that success comes from doing things differently.

– Steve

P.S. If you’re interested in watching one of the development projects in my USA Property Fund get built then check out the webcam feed at the bottom of the left-hand menu at www.PassiveIncomeFund.com

Have a comment, thought or question about this article? Post it below.

Profile photo of Steve McKnight

By Steve McKnight

Steve McKnight, the founder of PropertyInvesting.com, is a respected property investing authority as well as Australia's #1 best-selling business author.

Comments

  1. vic

    It’s not about property or loans it’s about servicibilty. No matter the property price or the loan, if a borrower has not spare income to service the loan there will be no loan no matter the property price.

    All the analysing and postulating is speculation and hot air. Watch household disposable incomes. At present they’re rubber band taught.

  2. Profile photo of cs_rlewis

    I dont think we will get a ‘crash’. Australia still pay its workers a good wage and I dont think we give out loans as easily as the USA did in 2008. If we do get a crash can you imagine all the middle class cashing in on the low prices, they will just go up again just as quickly.

  3. Jessica

    It doesn’t quite carry the same punch as the Game Of Thrones catchcry, but Spring is coming, and with it, the peak time to sell. If supply increases without demand picking up, expect prices to fall.

    I think you might mean the peak time to ‘buy’?

    • Profile photo of Steve McKnight

      I guess the corollary of peak time to sell is, by definition, also the peak time to buy Jessica.

      Typically Spring is known as ‘selling season’, more so than ‘buying season’.

      – Steve

  4. Bernie

    Hi there
    We have 6 properties.4 in victoria and 2 in Nevada,and no debt!
    The level of debt in Australia is unbelievable.
    Apparently we have twice the debt as the USA in 2007 when the property market went down.
    Sadly we need the recession because Australians getting deeper and deeper into debt.
    It will be a very tragic time.
    What went up, must come down

  5. David

    The RBA won’t raise rates for some time and if they did, everyone spends less, slows the economy, affects the retail market, slows inflation and halts the chance of further rate rises but opens the consideration for further rate cuts.

    ANZ was the first bank to come out last week announcing new customer variable rates of 3.65% with other banks surely following suit. I don’t see there being some form of financial Armageddon in Australia but I guess anything’s possible. People have been saying property will crash for decades and these same people are probably still renting and waiting for their prophecy to come true. Sounds similar to the story of a Jewish carpenter who’s supposed to return haha.

  6. Stevef

    We have 250k+ people added to our population every year who have to live somewhere. So demand is greater than supply which means a crash is a long way off guys.

    • Profile photo of Steve McKnight

      I’d be inclined to agree except…

      In SE Queensland it was expected property prices would boom with the forecast baby boomer retirement migration to come, as well as just about everyone else in Australia wanting to live in the sun and surf. It is yet to happen.

      In 2005, prior to the last great property price crash in Florida, the story was that Latinos generally, as well as US citizens from colder States up North, would flock to Florida in record numbers and push up property prices massively. Five years later property prices were 50 to 75% lower.

      Everyone has to live somewhere, but not everyone has to own somewhere.

      – Steve

      • Profile photo of MICHELLE

        Awareness of what could go wrong is perhaps more powerful than expectations about what could go right. If we have a sustained recession (not probably but definitely a possibility), do you think the migration level will stay the same? If I am not wrong, net migration includes students on temporary visa (I could be wrong), and I guess Chinese students would account for a large number of that. If China decides to curtail student visa, would that have an impact.

        No one knows the future. But its always a danger sign when everyone has the same opinion (i.e. property only goes up, Sydney will be fine because of population demand).

  7. Stevef

    A tale of 2 cities Steven. Price increases in Phoenix USA has been dramatic since the GFC because of the refugees from California. However house prices have not increases as much in Detroit because not as many people have moved there. Prices in Australia may drop but I doubt they will crash because new settlers will either buy a house or will rent so increasing demand relative to supply.

  8. Sam

    I don’t think interest rates will go up any time some either, like others have said the household debt levels are still very high and although the economy grew at a decent rate of 3.1% last I heard the statistics the debt levels surely have to be the number 1 consideration, I did see that the minimum wage rise was 3.5% and even though thats minimum wage it was well above the second quarter inflation of 2018 of 1.7%. I personally feel that the interest rates will be on hold to end of year as a bare minimum and then we’ll have to see what 2019 holds. If individual tax cuts end up passing parliament this could
    aid in decreasing household debt and increasing societies potential dispabale income, let’s see what happens with the proposed corporate tax cuts and how rapidly future expansion may be and what RBA do, I’m really looking forward to this springs property market and sales results to compare to last years clearance rates and number of properties up for sale.

    P.S love the volcano analogy/metaphor :-)

  9. Jon

    Hi Steve, just a small point – corrections are more significant than you’ve made out. Gaining 11.2% and then losing just over 4% of the gain isn’t giving back just over a third. It’s more like giving back a half.

    For example if a $1m property was to increase by 100%, it would be worth $2m. If it then lost 50%, you’d be back to $1m and would’ve given away all the gain, not half of it.

    Thanks for all your advice over the years.

  10. Keith Lai

    Great article, Steve. Thanks for sharing your thoughts and the actions you’re currently taking. My take away from the article is that prudent investors need to anticipate their own level of risk and prepare themselves to mitigate this. Ultimately, it’s a decision that each investor will need to make according to their specific circumstances.

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