Tuesday, January 4, 2011

An investment property for the new year?

Some of you may remember that I was a bit harsh on our friends at Australian Property Investor in this recent post. I was planning to go easy on them for a while, but I just happened to come across their new issue online and it's so compelling that I can't resist. According to API, 2011 is the year of "RED HOT BUYING OPPORTUNITIES". Yes, you too can become a millionare.

Now, unfortunately you need the print version to get the full details, which apparently includes the story of a 24 year old role model for all young Australians who has racked up $1 million in property debt, but is "still in front"! Anyway, for those of us that don't have a subscription they have a nice little piece online titled 7 Reasons to Buy an Investment Property Now. It's a Pulitzer worthy example of the property spruiking genre, so I will quote all 7 reasons below, sprinkled with a bit of commentary in between: 
1. It's a buyers' market - most buyers don't buy in a buyers' market; investors buy in a buyers' market, so we should call it an investors' market. So what should investors do? Get out there and buy.
My first question here is, what the hell does this mean? I'm not really sure what they're talking about, but I think they're trying to tell us to just drop whatever the hell we're doing and go out there and buy some investment properties right now before they all disappear.
2. Prices for some materials are dropping so now is the best time to do some renovations or building.
What materials? Don't they say below that commodity prices are going up?
3. There's the emergence of a major commodity demand coming out of China and India. The Reserve Bank is forecasting a resources boom, so investors need to get ready for that.
The commodity boom is a double edged sword for Australia, as I argued here. If the boom continues, the RBA is probably going to keep raising interest rates, and the banks will follow by lifting mortgage rates. At the very least, this would reduce the returns on rental properties (which are already negative without capital gains). At the worst, higher rates will choke the rest of the economy and trigger a crash. On the other hand, if the bears are right about China and the boom busts, our economy is in big trouble.

So yes, API is right that "investors need to get ready for that". They need to get ready by not making dumb financial decisions that leave them overburdened with debt when things go bad. Dumb decisions like collectively buying $600 million of residential US property over the past year without a proper understanding of the risks involved, for example. (In case you're wondering, API has that covered too)
4. There's going to be an influx of workers, who will need somewhere to live and they'll most likely be renting properties.
5. A rental boom is just around the corner - as those workers come in there'll be increased demand for property and with a shortage of houses already rents are sure to increase.
Where is this influx of workers going to come from? Immigration is falling from its peak levels of earlier this decade and international student numbers are falling sharply. See the chart below.

Source: RP Data

6. Other markets - such as the sharemarket - are volatile but property is stable.
This is one of the biggest myths surrounding property investing. While it's true that property has historically been less volatile than shares, it's a different story if you're highly leveraged, which is the case for virtually everybody buying property. If you buy $50,000 of BHP Billiton shares with cash and the market falls 20%, you lose $10,000, or 20% of your investment. Bad news, but not a total disaster.

On the other hand, lets say you put this money in a $500,000 investment property. You put $50,000 down and borrow the rest at an LTV of 90%. In this case, if the market drops 20%, you have not only lost your entire investment, but you owe MORE money to the bank than the property is even worth. Negative equity. Another point to make is that unlike shares, property is highly illiquid. If you do need to offload that investment property in a hurry, it's quite possible there won't be any buyers.

Highly leveraged investments are great when markets are going up, which is what we've seen in Australia for most of the past two decades. They make a lot of ordinary people look very smart. But they also contain the potential for financial disaster when things go wrong, as we have seen recently in the USA, Iceland, Ireland and Spain. And just how leveraged is the average property investor in Australia? Very. According to Westpac around half of investor loans in Australia are interest only, meaning that they haven't even paid down any of the principal and are basically gambling on capital gains.
7. Growth in prices is coming - the cycle will soon turn. There'll be a rental boom and a shortage of housing will drive up prices. Investors should be getting ready for the next capital gain boom. Don't miss the boat.
So don't miss the boat. There's a massive capital boom coming because... well, you know, it's just "the vibe".

That's enough about the property spruikers for now, because there are more interesting things that I'd rather write about. But there's a serious point behind making fun of these guys, which is that Australians are getting a lot of very bad advice on property investing -- the risks involved are rarely properly explained. On a related note I would like to draw your attention to an interesting post by Delusional Economics earlier this week. Citing a particularly egregious example of property spruiking in the Herald Sun, they ask the excellent question of whether or not advice on property investment is subject to regulation by the Australian Securities and Investments Commission (ASIC).

Well, apparently not, according to this comment posted by Delusional Economics reader PETER_W.
The Real Estate industry is exempt from the Financial Services Reforms (Financial Advice) Act... The real estate industry lobbied very hard to ensure the dumbest of the very dumb... i.e. their own members the real estate agents were exempt from being licenced under the AFSL... Australian Financial Services Licencing Act. So long as their advice is only constrained to real estate they can tell the public that house prices will grow at 20% compound for the next 40 years with no legal constraints. 
Since a house is by far the most important investment most people make, shouldn't there be some sort of regulation here?

18 comments:

  1. People do not realise that it is all about indebtedness, leverage and liquidity when the shit hits the fan.

    What impact will the fallacy of composition play in the minds of the Australian property investor who can survive the double edge sword of leverage?

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  2. at a friend's place saw today tonight or some such show - featuring perth investor buying ex housing comm houses spending $50k renovating and walking away with $40k profit (after taxes).

    four years ago these homes could be purchased for $80-90K, this guy now buys them at $380K!!!!, invests $50K ($430K) and confident of selling at $470-$480K+. a myriad of 'professional' advisors appeared on the show all urging investors to get in quick, good money to be made. these homes are tiny and in awful areas. something is terribly wrong...and like lemmings...

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  3. congrats - saw one of your posts over at The Automatic Earth - you deserve a wide readership.

    and just for fun:

    http://www.youtube.com/watch?v=K7Pahd2X-eE&feature=player_embedded#!

    cheers.

    ReplyDelete
  4. Just read through the Australian Property Investor website and am now trying not to vomit.

    "Nine devastating mistakes homebuyers must avoid"...er...shouldn't #1 be DON'T PAY RIDICULOUS OVER-VALUATIONS?

    "Ten ways to increase your borrowing capacity" (because you need to to fund ridiculously over-valuations)...don't take a 30-year mortgage, take a 40-year mortgage instead! Be a slave to the mortgage for another decade and make thousands more in total repayments!

    The world has gone mad.

    Love reading your blog, keep up the great work.

    ReplyDelete
  5. The point about exemption from the AFSL is a good one: most retail investors (who are the ones the FSR was designed to protect) will pour more money into real estate than they could ever hope to put into shares or any other market.

    Another point worth making about the supposed lack of volatility of share prices is that the volatility is really just hidden because property is not traded on a highly visible exchange. If there was a way to have Alan Kohler include the day's change in value of your property on the finance segment of the news, people might have a different view about volatility!

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  6. Thanks all for the comments.

    Stubborn Mule -- Good point there. The supposed lack of volatility is mostly just a result of property not being traded on exchanges like shares.

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  7. Singapore joining Hong Kong in efforts to prevent more bubble action. Our own government clearly has it's head buried in the sand.

    http://www.bloomberg.com/news/2011-01-13/singapore-imposes-more-housing-curbs-as-residential-prices-rise-to-record.html

    ReplyDelete
  8. Investments have different meanings in finance and economics. The financial investment is to put money into something with the expectation of profit that a thorough analysis has a high degree of security for the principal, and an assurance of return in due time.

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  10. The investment growth is a two pronged blade for Sydney, as I suggested here. If the growth continues, the RBA is probably going to keep increasing prices, and the banks will follow by raising home loan prices. At the very least, this would reduce the profits on rental properties.

    Cash Flow Savvy

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  14. Obstinate Mule --Good focus there. The gathered absence of volatility is basically only a consequence of property not being exchanged on trades like allotments.

    ReplyDelete
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