On Australians buying US property...

With Australian property prices looking very toppy and the Aussie dollar going through the roof, the latest delusional investing fad in Australia appears to be snapping up foreclosed US properties. I've been hearing stories about this a while now, so I thought I'd look into it a bit. Firstly, in case you missed the story in The Age last week, here's a little extract to set the scene:

AUSTRALIAN property investors risk losing hundreds of millions of dollars after snapping up thousands of US housing bargains at forced-sale prices, experts have warned.
Emboldened by the soaring local dollar, Australians invested about $600 million on US residential property last year, according to the Washington-based National Association of Realtors, as overseas buying of US housing doubled.

But consumer advocate Neil Jenman predicts that thousands of Australians will lose their money after unwittingly buying undesirable property.
''It's going to be a calamity, for sure and certain,'' he says.

Another article from The Age tells the story of the following couple:

CLEANERS Ana and Miguel Canepa never imagined when they fled to Australia as refugees they would one day be landlords of four rental homes. But the residents of St Albans in Melbourne's outer north west are living the Australian dream, having last week signed contracts to buy their latest investment property. And it only cost them $A44,117.

That is because the three-bedroom house is in the US city of Phoenix in Arizona.
The couple, originally from El Salvador, have never been to Phoenix. But they already own two other homes purchased there this year for $A41,000 and $A52,100, as well as a fourth rental asset in Melbourne.

Real estate specialist Kevin Walters, who arranged the Canepa's purchases, will next month lead a shopping tour for 10 Australians and a tax firm that advises self- managed superannuation holders. They will visit Phoenix and Las Vegas, the foreclosure capital of the US.

''You can buy a house in the US for the cost of a deposit here,'' he says. ''Clients can purchase property in just two days, it's that easy. The only exception is that we don't have a lender for them at the moment, so they buy in cash.'' Mr Thomas says he gets rental returns of 16 per cent on his US assets, compared to about 3 per cent for his Australian properties. ''It doesn't seem a risk at all to me,'' he says.

What could possibly go wrong?

The Age quotes a Byron-Bay based buyers agent called 888 US Real Estate, which according to its website charges a "committment fee" of $380 and then a commission of $3,420 for each property purchase it handles for the Aussie battlers trying to realise their dreams. But 888 US Real Estate is just one of a handful of organizations that are sprouting up like weeds to flog US property to unsuspecting Australian buyers. Here are just a few of the ridiculous sales pitches made on some of these websites.

• "It's no secret: USA property investment gives you a 10-20% net return... Even after your expenses are paid you will still make money with My USA Property"
• "Once American banks start lending again, the USA market will recover. So you’d be wise to invest in an undervalued market now since every Australian dollar buys more"  (My USA Property)
• "When you say “Go!” you set the wheels in motion for an exhilarating ride as your property grows in value giving you the possibility to create enough cash to fund the rest of your life in a few short years. Call us now!" (888 USA Real Estate)

Now, before you leave to throw up, I'd like to note that the statements above would be illegal if these guys were stockbrokers. But apparently in property land it's OK to promise fantastical rates of return without pointing out any of the risks involved in the investment strategy. Speaking of the risks, we'll get to that later.

But for now, we should concede that some of the claims they make are accurate. It is indeed true that in many parts of the US today, you can buy a house for less than the price of a new car in Australia, or for less than the average deposit on a house in most Australian cities. Which raises another question. There are a lot of very smart American investors with a lot of money to burn. If properties in the US are such a bargain, why is it that many of these American investors still don't want to touch the property market with a ten foot pole?

Miami Vice
I'm not going to go into detail about what an absolute debacle the US property market is today, but let's just take a look at an interesting graphic in a recent report from the ratings agency Moodys. Moody's notes that there is still a massive surplus of housing inventory on the market, and that foreclosures and defaults are still skyrocketing in many parts of the country. You can see below that there are significant parts of California, Nevada, Arizona and Florida, where Moody's doesn't expect the housing market to fully recover until 2030. Yes, that's still two decades away.

And guess where the property spruikers are trying to talk Australians into buying investment properties? You're right. Places like California, Nevada, Arizona and Florida. Here's are a couple of listings in Florida from My USA Property:

Now, on the surface, property prices in Florida look like a real bargain, since they've already fallen around 45% in Miami and more than 40% in Tampa, as you can see below.

Source: www.data360.org

Unsuspecting Suckers
But there's no guarantee that prices are ever going to return to these peaks again, at least for a very long time in some of these areas. In fact, one recent study (which I might examine in more detail when I get the chance) argues that the housing bust may have created new types of "declining cities" across the USA -- certain cities which grew rapidly in the boom, attracting huge population inflows and investment -- but which are now facing the prospect of decades of stagnation thanks to a vicious circle of falling house prices, declining populations, rising vacancies, and increasing crime rates.

Some Australian investors are already finding this out the hard way. From the above story in The Age:

Sydney woman Kathy Graffiti bought three properties in upstate New York in 2005 and estimates she has lost between $300,000 and $400,000 on her investment. She bought two properties in Rochester and one in Buffalo for a total of $250,000, expecting rental yields of between 22-23 per cent.
The rental income stopped in 2007 and Ms Graffiti was forced to sell two of the properties at a significant loss. She has been offered $10,000 for the third property. 

According to Neil Jenman, the consumer advocate quoted in The Age above, Buffalo, NY is one of the many areas where American "flippers" are buying up properties at fire-sale prices and then selling them on to "unsuspecting Australian suckers" at much higher prices.

Typically, the American promoters work in tandem with Australian property spruikers who Jenman says are the "same rogues" who used highly questionable tactics when selling residential property on the Gold Coast and in the outer Melbourne suburbs.

Jenman says some Australians paid $50,000 for US houses with expectations of extraordinary rental yields and now can't sell the properties for $25,000. And he knows of an Australian who paid $80,000 for a house and now is unable to sell it for $40,000 – the best offer has been $10,000.

Dumb Things
Without a doubt, there are going to be some good investment opportunities in some parts of the US. But how the hell are you going to identify them from Australia, and can you really trust the clowns at places like 888 US Real Estate to pick the winners for you?

And that's not to mention the myriad of other problems involved with buying property in the US, which the property spruikers gloss over, but include:

• Significant foreign exchange risk
• Major tax complications including the necessity to pay income tax in the US on any rental income
• Stronger legal protections for tenants in the USA and a greater likelihood of lawsuits which can significantly raise costs for landlords compared to in Australia (see here for example)

Finally, you may have wondered how Australian investors have been financing these purchases. The answer is that American banks generally refuse to grant loans to overseas property investors (they're having enough trouble dealing with all the dumb subprime loans they made to Americans), so the majority of purchases are being made in cash. And where is this cash coming from? Usually, one of two things. Either a line of credit based on the equity in their Australian property holdings, or cash from their self managed super funds. Does this sound like a smart idea to you?

It's time to wrap this up. Let's end with an appropriate Aussie classic from Paul Kelly.

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?

The cult of property

When a cult is under siege, its members tend to cling to their fanatical beliefs even more strongly than ever.  This phenomenon is in full force at the end of the year as the property spruikers that dominate Australia's media come out en masse to tell us the recent softening of the market is a huge "buying opportunity" (as I noted in my last post). Now, I don't want to waste too much more time examining these claims, but sometimes an article comes along that is just too good to pass on.

The Australian Property Investor's Michael Yardney is feeling very smug and self satisfied this Christmas season, because The Economist, Steve Keen, Jeremy Grantham, and other so called experts like the IMF told us that Australian property prices were overvalued, but "awkwardly" for these know-alls, we don't have a bubble and there hasn't been a crash! "Oops!" he celebrates in the magazine's blog.

Mr Yardney concedes that prices could fall a teeny bit in some areas, but then recites the standard mantra of population growth and housing shortages -- the same one that was popular in California in the years up to the 30% crash there -- before revealing the secret weapon in his logical arsenal.

Sure, some Australians currently have issues with housing affordability and are putting off their home buying decisions. But people still need a roof over their heads. People are still getting married and people are still getting divorced, some are having babies and others have to move house for their jobs.

So there you have it. Australian house prices must continue to grow exponentially because some people are getting married, some are getting divorced, and some are having babies. Because people don't get married, divorced, or have babies in other countries like the USA, Spain, Ireland or Japan. I'm glad he's cleared that up.

In any case, he tellingly concludes the article as follows:

Our property markets have changed – don’t expect the type of capital growth in 2011 that many of us enjoyed in the past year or two. The Reserve Bank has deliberately put speed bumps on the road. They have increased interest rates to slow our booming property markets, and to an extent the general economy, on purpose. What this means is that buying any property and hoping it will make a good investment just won’t work in this new era in property. Now is the time to buy well in areas that will outperform the averages and buy properties to which you can add value.

This is the "new paradigm" talk that Delusional Economics wrote about this week, and which we are starting to see quite frequently. When faced with evidence that prices are starting to fall in certain areas, the property spruikers are trying to reassure us that "as long as you buy in the right areas, you'll be protected from any falls, and you have nothing to worry about." Go right ahead and take out that big mortgage.

Needless to say, I think this is pretty bad advice for the average punter. How do you identify areas "that will outperform the averages"? Australian Property Investor tells us in another article that it's as simple as "concentrating on suburbs with limited supply and choosing properties that will stand up in soft and hot markets".

But if you do believe that prices are going to fall, this is not likely to give you much shelter. Evidence from other housing markets around the world suggests that in areas with "limited supply", prices tend to appreciate much faster during bubbles, and crash much more violently when housing bubbles burst (this follows from basic economic theory; see here for example). Still, Australian Property Investor is apparently preaching to the converted.

For pure entertainment value, I recommend you check out the comments from some of the property bulls on API's blog posts, in particular, this one about the attractiveness of property versus shares. API tells us that it's better to buy property than shares, because you can leverage property more aggressively, and, as we all know, it only goes up. One reader who is well and truly drinking the API kool aid even claims that property prices have doubled every 7-10 years "in the past several hundred years just about everywhere in the western world."

Because I am a masochist, I just did the calculation, and worked out that a doubling every 7 years for 300 years would mean that house prices increase by a factor of 2.6 trillion times. That sounds like an excellent long-term investment, especially if you add leverage! Speak to your accountant, because you could probably negatively gear it too.

But back on a more serious note. Luckily for us, the IMF has a fascinating chart (from this article) based on the longest study ever done of housing prices. It's a house price index for the Herengracht neighborhood of Amsterdam, and it goes all the way back to 1628. Interestingly, it shows that despite huge booms and huge busts, in the 200 year period from 1628-1828, house prices basically went nowhere. And in the 380 years since the beginning of this survey, house prices in Herengracht have only risen by a factor of 3.5. This is a much smaller number than 2.6 trillion.

Source: IMF

But this is just a small suburb of Amsterdam. Surely it's different elsewhere, isn't it? Well, funnily enough, Robert Shiller (the author of "Irrational Exuberance") has compiled a house price index for the United States that shows a similar result when looking at price trends from 1890 to today. See below.

You can see that real house prices -- or house prices after taking inflation into account -- have risen only around 30% in the US since 1890, roughly in line with building costs, which have risen not much faster than inflation. This gives you an annual real return of about 0.23% over the 120 year period. Again, you can see huge booms and busts over the years, but in the long term,  the evidence suggests that house prices generally don't rise much faster than inflation.

It's important to keep this kind of long-term evidence in mind, because it puts things in perspective. If your only experience of property investing is the past two decades in Australia, you could be forgiven for believing, that, yes, prices double every 7 years. But the past two decades was an extraordinary period that we may never see again in our lifetimes. Note that in both the series above, there are also long periods of several decades where prices are stagnant or even falling, despite strong population growth.

I'm tempted to post this on the Australian Property Magazine blog, but I'd probably be excommunicated for life. Such is the nature of cults.
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UPDATE: Who Crashed the Economy has some great long-term charts for Australia too.