Credit crisis | How the housing life cycle is broken

Young couple with boxes on heads

In one of my recent posts I discussed how the Boomer population was the driving force behind the last boom and the massive increase we saw in house prices over the past 10 years in particular. The emerging issue I see is that Boomers are going to have to sell up property in a fairly big way pre-retirement. The big question is: Who will they sell to? To understand why they need to sell I’ve written up two stories that reflect a large number of clients we see. First we look at a Baby Boomer couple, Bob and Jane, and then look at a couple who are first home buyers, Brad and Jules.

Case Study 1: Bob and Jane (our Boomers)

Bob and Jane are 59 and earn around $110,000 between them. They have two grown kids who are just buying their first homes. Bob and Jane have $580,000 of equity in their two properties. Bob and Jane have a home worth $600,000 which still has $150,000 of debt on it. They have a rental they purchased for $300,000 back in 2005 and which is now worth $400,000. It has $270,000 of debt on it. They have to contribute $8,000 towards the rental each year to cover losses. At the moment they get $2,500 of that back as a tax refund. Bob and Jane want to retire at 65. It is going to take all of their surplus income to pay off their home prior to retirement. Mortgage repayments are $3,000 per month. New Zealand Superannuation is $30,000 per year for a couple. They cannot afford to have a negatively geared property in retirement – therefore the rental must be sold. The rental property is sold in 2012 for $375,000. They have to pay back $10,000 for deprecation and pay the real estate agent $15,000. They walk away with $80,000 (of which $50,000 is capital gain.)

Was it a good investment?

No. From an initial deposit of $30,000 and seven years of paying a net $5,500 in losses per year, they generate $80,000. From a financial perspective this is a 2.70% rate of return (at least 3.00% less than they would have received in the bank over the same period.) Where Bob and Jane have made money is in their home due to long-term property inflation.

Retirement

In 2016 Bob and Jane retire. They have spent the last five years clearing debt and have finally got their home cleared, but other than the $80,000 in the bank and $30,000 in KiwiSaver they have no access to other capital. On retirement their income drops to $30,000 per year. They decide to move out of Auckland to somewhere with a lower cost of living and better access to recreational activities. The house sells for $600,000 and they net $570,000. They buy a smaller house down in Papamoa for $450,000 and bank the $120,000. The $230,000 they now have invested in the bank creates an annuity of $1,500 per month over 20 years in addition to the $2,500 per month they get from superannuation. This gives then $4,000 per month and provides for comfortable living. Their worst case scenario? Property prices fall by 20% and they walk away from the investment property with nothing. In this situation Bob and Jane still sell the house to go down to Papamoa but now only net $450,000 on the sale of their home. The good news is that the house in Papamoa has reduced in price to $360,000 so they end up with $90k in the bank (and an annuity of $690 per month.)

Case Study 2: Brad and Jules (our first home buyers)

Brad and Jules are 31 and first home buyers.  They pissed around overseas for a few years, had a blast and have reluctantly come home to settle down.  They’ve been back 12 months and have $30,000 of savings and $15,000 gifted from Brad’s dad. They have combined incomes of $140,000. They intend to start a family in the next two years. They purchase a house for $450,000. It is tidy house in an average suburb in Auckland flagged as “up and coming.” For the next two years they work pretty hard at paying down the mortgage. It starts at $405,000 and after two years is down to $360,000.  Great start! At this stage however Jules spends the next five years juggling kids. On Brad’s income of $80k things are doable but tight. Ironically they earn too much for any government assistance, but it doesn’t feel like it! After the second child is two years old Jules decides to go back to work but only earning $45,000 per year. She chose a less career-orientated role to work around the kids. Problem is that childcare costs eat up $800 per month of her income, so it hardly feels worth it, and juggling a modern working family is chaos. Brad and Jules keep paying the mortgage off aggressively at $3,500 per month. That leaves them $4,200 to cover living expenses ($2,500), childcare ($800), holidays ($300), furniture and white goods ($200) and cars ($400.) They still need to be careful with their spending. Occasionally they go a bit overboard with the credit card (which they always regret and then argue about) and then spend the next 12 months paying it off! At this point everything is okay. When Brad and Jules reach 38 they really want to upgrade the house. In the preceding seven years they have managed to do some minor renovations and the property is now worth $480,000. The mortgage is down to $324,000.  Brad and Jules sell and walk away with a net $131,000 towards their next home. They purchase for $650,000 in Mt Albert to get an average house in a popular suburb. The new mortgage is a staggering $520,000. With both kids now at school they are back to a combined income of $140,000. The bigger mortgage chews up half their income and they need to put it back over a 25-year term. This time around they cannot pay it off quickly due to the size of the mortgage and having kids. Their home will be debt-free by age 63. They also have next to no spare income to renovate the property. In the absence of property inflation every dollar of debt needs to be repaid.

Key Points – Summary

Bob and Jane

  1. There are over 150,000 "mum and dad" investors like Bob and Jane who own negatively geared property. The big question is who will buy these negatively geared investment properties?  Other investors will not buy at these prices.  The emphasis now is on yield.  There aren't enough first home buyers to clear this level of stock.
  2. When Bob and Jane eventually decide to downsize, who will they be selling to?  Young people can stretch into the $400,000 to $500,000 range but $700,000 is a whole different story.

Brad and Jules

  1. Brad and Jules are in the top 10% of households and are struggling to buy into an upper-mid-range suburb at 38 with seven years of mortgage under their belt.
  2. The median house price for a four-bedroom home on the North Shore and Auckland City is approx $650,000.  If Brad and Jules are struggling then who will be buying these properties, or the 50% of properties in these suburbs that are over this price?
  3. Will Brad and Jules reduce their expectations and simply focus on getting debt-free with a less expensive property?  (People do not want to be a slave to their mortgage.)

The credit crisis has dramatically altered the outlook for couples compared to their Baby Boomer parents. You can no longer necessarily rely on property values increasing steadily and rapidly. The old housing life cycle has been upset by the global financial crisis and is putting pressure on almost every part of the housing market. Both these couples’ stories demonstrate the importance of making intelligent investing decisions. You don’t necessarily want to be pressured to keep up with the neighbours – whether it’s buying a rental or moving to a flash new house. Good advice, smart planning and an eye on the future are all vital if you want to be debt-free and comfortable in retirement.