The most common mistakes pundits make with investment decisions are firstly to extrapolate historic returns (recency bias) but secondly not adequately consider the risks. Much has been said about whether or not Australia currently has a “bubble” in residential property and this conversation has been going on for a long time. There are those that say it is all good “nothing to see here” to others who believe it is a classic Ponzi scheme that will end in more tears than a screening of Beaches at a girl’s night out.
This matter is further complicated by the fact that we need somewhere to live and the Aussie dream is fundamentally connected with owning your own house.
In regards to helping clients assess this situation and to help them address what they should be doing, it is actually quite an easy process. We simply don’t rely on incorrect “facts” that you cannot lose money on property but rather we try and figure out how they could lose money on buying property and assess the alternatives.
This scenario really plays out in two main ways. Given that investors purchase property with debt the first is the impact of rising interest rates. By historical standards, even after the rapid increases over the last few years, they are still at low levels. The easiest way to assess the problem is simply to forget about the actual interest rate and assess how much interest, measured in dollars, you would need to pay on a loan at the current rate. Therefore, we need to consider we interest are we paying now but how much would a 20-50% increase in the amount of dollars you require out of your budget to pay the mortgage? This is your actual ability to service that debt in that scenario. We will not enter the discussion on whether such an increase in rates is likely or how it will happen we will just look at the impact if it does and we treat it as the first major risk of the exercise.
When we see the impact of changing interest rates on the household budget we can then quickly determine the level of financial risk we are taking in regards to the proposed transaction. If we cannot afford to hang onto the property for a long period of time than Murphy’s Law states we will be forced to sell at the worst possible time. With the increases in interest rates over the last few years and the continued reliance on the property market in terms of pricing, affordability looks stretched for most Australians.
The second thing we then consider is the payback period for the investment. Quite simply this means that when we put money into an investment we then need to assess how quickly we will get our money back. Much has been said about the impact of our taxation system in regards to negative gearing and the concessional tax on capital gains but ultimately regardless of whether or not they exist it is still a mathematical exercise, it’s just that the numbers change. If you are purchasing a house to live in then you need to consider what the difference is between the costs of being a homeowner and a renter and what is done with any difference.
Initially, we have stamp duty and other costs. Subsequently, we then have the annual “cost of carry”. The “cost of carry” is the cost of expenses which includes things like interest, rates and agents fees minus the rent received. Commonly in Australia, properties are in the position of being negatively geared if the property was purchased as an investment. This is where there is a tax benefit to the investor as they have incurred an expense in the course of trying to produce assessable income. Any tax benefit needs to be added back to the cost to correctly calculate the cost of the investment exercise. In saying this there can be a timing difference to when the tax benefit is derived so the actual weekly or monthly cash flow of the exercise will be different to the pure accounting numbers.
Given the property purchase generates a negative cash flow for quite a number of years then this amount of money along with set-up costs is then considered the “cost” of the investment.
So where does the return for the investment come from?
In short in the first decade or so the only return comes from the appreciating value of the property. If the property is worth more than what you paid for it then this paper gain is a chance of being greater than the actual cost you incurred to hold the property.
Subsequently, there is the second major risk that the property does not appreciate at a rate that is expected by the investor. There is a whole raft of reasons why property appreciates (or doesn’t appreciate) but we are just interested in quantifying what we need to happen. It becomes evident very quickly that if there is no capital appreciation then this investment exercise could result in a “payback period” that is incredibly long. If this period is longer than what the investor is willing to hold the investment then we have a major mismatch and the investor may be forced to sell at a loss.
With the return of inflation, it is also important that you measure your return in “real” terms. This means that you need to make more than what the rate of inflation has been. It is possible to make a “nominal” profit however not keep up with inflation (a real loss). For example, you spend $100 and make $105 over the term. If inflation ran at 10% over the term then you would need $110 to be able to buy what you could at the start of the investment with the $100. As we only $105 we have made a “nominal” profit but a “real” loss as the breakeven with inflation was $110.
This appreciation effect on the profitability of the investment is magnified because of the high level of borrowing that investors use when purchasing property. This is because regardless of whether the property goes up or down the amount of your loan stays the same. It is this use of financial leverage in a climate of falling interest rates that has made property investing a very popular and lucrative investment strategy since the early 1990s. Along with financialisation this has provided the perfect conditions for the strategy.
So, what happens if there is a perfect storm?
Given the large increase in residential property values over the last couple of decades it becomes unlikely that such rates of return will continue as these returns normalise, as they always do. We have had the low interest rates of Covid and now the massive immigration influx continues to keep demand higher than supply and prices growing.
From a risk perspective, this becomes particularly important for investors that have a short time frame or investment window. When we are talking about the use of gearing we regard periods of up to 10 years to be classified as a relatively short time frame. For example, if you are in your 50s looking to enter a gearing strategy so as to accumulate assets for retirement the risks are quite large. Instead of saving for your retirement, you may be pouring tens of thousands of dollars or even hundreds of thousands of dollars down a well that you will never be able to tap as you will not be able to hold onto the property long enough to reap the appreciation in value required.
Seek advice from a qualified financial adviser and consider the potential risks as well as the potential returns.
Article by: Robert Coyte, CEO, Shartru Wealth