by Roger Montgomery
The property market has been a happy hunting ground for Australian investors and home owners for most of this decade and beyond. But for over two years we have seen the party as coming to an end and have publicly said the short-term prospects for Australian property are negative. Sadly, the impact will not only be felt by borrowers but also shareholders in companies with direct and indirect exposures to property.
Passive investors in residential property have been caught up in the boom and appear to have forgotten, or ignored, the basic principles of investing in the hope of a quick capital gain.
The basic principle is this, the higher the price you pay, the lower your return.
The real worth or value of an asset such as property, is all the potential income that can be generated over its useful life, discounted back to today. The price however, is not the “value”; the price is what someone is willing to pay.
So your job as an investor is to buy at a discount to the underlying value.
Australians love residential property but it is telling that the stock market contains no listed property trusts that own residential property. Why? Because no professional investor is able to extract a positive income yield from residential real estate at current prices. After maintenance costs, professional property management fees and interest on debt is included, residential property cannot produce a positive cash return.
What does that mean? It means anyone buying a residential property as an investment isn’t actually investing at all. They are speculating that the price will go up. And because the income isn’t positive, the only way the speculation can be successful is if someone else comes along willing to pay more. That’s gambling, not investing.
Another way to think about this is that if property prices over the last several decades have increased by an average annual rate of six or seven per cent, and more recently prices have risen by 15 per cent or 20 per cent, then the strong recent period is “borrowing” returns from a future period. Consequently, booming prices must be followed by an offsetting weaker period to come back to the long run average. It should not be a surprise to see a period of negative returns for property.
For some years we have published our view that a high-rise construction boom would increase supply and raise risks for lenders to a sufficient extent that bank lending would be curtailed either through self-policing or by a regulator.
That’s starting to happen. Regulators have tightened investment loan requirements. The banks are cutting back the volume and value of investment loans by a remarkable two thirds and interest only loans are being converted to principal and interest. That means higher repayments for investors.
The banks are cutting lending to apartments and the market is set to decline. But prices are still being held up because vendors won’t accept the new reality.
But only a few very fortunate vendors will be able to now sell their property for the price their neighbour achieved six or 12 months ago.
Meanwhile short-term global funding rates are going up, including Australia’s bank bill swap rate and eventually this must feed into higher mortgage rates so the banks can maintain their profit margins.
The changes are tantamount to a credit crunch with the rug effectively pulled out from under buyers’ feet, while pushing more and more of the most recent leveraged owners over the edge.
One question is, how far could house prices fall?
There are two important things to keep in mind. The first is that the great mass of property owners does not determine prices. Prices for everyone are determined by what sellers and buyers do this weekend. We call this weekend’s seller the “marginal” seller.
Australians love residential property but it is telling that the stock market contains no listed property trusts that own residential property. ’
Second, it is important to keep in mind that property price declines are global. While Australian prices are now sliding, so are prices in London, New York, Hong Kong, Canada and New Zealand. If the theme is global then typically, so is its cause. That means stemming the tide will be beyond the control of local influences and factors such as strong immigration and the cancellation of excess apartment settlements in Brisbane and Melbourne.
For the stock market, less buying and renovating means less demand for building products. That’s not good for the profit and share prices of businesses like Bunnings (owned by Wesfarmers), Reece, Beacon Lighting and Metcash who own Home Timber and Hardware as well as Mitre 10.
As building activity falls, there could be less work available to tradies too. Note for example builder Mirvac told the market when it reported its full year results that 2019 would see it sell an estimated 2500 residential lots, a fair bit less than the 3477 in 2018.
If tradies are earning less money, pressure on their finances could adversely impact discretionary retailers. Nick Scali and Harvey Norman have already indicated that times are tough.
Recently, investment bank UBS asked borrowers who took out an interest only mortgage why they did so. And 18 per cent of more than 1000 respondents answered they “can’t afford to pay principal and interest”, while 11 per cent said they expected house prices to rise and to sell the property before the interest-only period expired. A further 44 per cent answered that an interest only loan gave them more financial flexibility, probably a euphemism for not being able to afford other terms.
That means there are a substantial number of borrowers who have taken out an interest only loan for the wrong reasons.
More frightening is the admission many of these borrowers don’t understand their loans or the fact that the interest-only period won’t run more than five years. When they start to repay principal their budgets as well as property prices and the profits of building related companies will all suffer.
If cash is paying 2.5 per cent and there is zero risk of capital loss, isn’t that a better deal than earning a negative yield and inheriting the risk of substantial capital loss? On that basis cash currently offers a better risk adjusted return than residential property. As I simply point out, earning 2.5 per cent is not very attractive but it’s better than losing 20 per cent. And cash is not such a bad place to be if you agree that there’ll be some bargains in the next few years.
Roger Montgomery is founder and
Chief Investment Officer with Montgomery Investment Management.