Gambling with property

Closeup of board game, start

When buying property near the top of the property cycle it's important to understand the risk return trade-off and not blindly buy into a simple rationalisation on property prices. There are clearly widely differing views on the property market, some informed, and plenty driven by anecdote. Those driven by anecdote tend to pick up on a few key headlines that reinforce their personal beliefs or what they want to believe. They don’t tend to think much beyond that. For what its worth, my view is that the Auckland property market is over-valued by about 25% but I don’t see a short-term reprieve for buyers.

The lack of supply will prop up house prices for the foreseeable future. However, at some point there will be some sort of market correction as they tend to come around every 7-10 years and it has been 7 years since the GFC. Right now interest rates are low, we have strong immigration, and everyone is wet with excitement that prices might keep increasing. Psychology and confidence are major drivers of price, so it becomes self-fulfilling.

Prices will continue to rise this year. How long they’ll increase for is anyone’s guess. Six months, maybe a year. Throw in an anecdote of hot Chinese money flooding Auckland and maybe it could go another two years. But prices are heading well above fundamentals and increasingly it’s a speculative play. We all know the party will come to an end but nobody knows when. Who predicted the Swiss would drop their peg to the Euro or that oil prices would tank and send Russia into a severe recession? The point is there are a number of possible global events that could start the next major correction. None of them are predictable. The more risky or naïve will keep speculating right up until the next market correction. Some will get it right and many won't.

Most discussions on property tend to be a simple discussion on whether or not prices will increase. It is rare to have a proper discussion of risk versus return. That brings me to an example:

I had a new client come in recently who wanted to buy a new owner-occupied property and keep his existing house as a rental. This would be his sixth property and take him to $2.4m of debt. His servicing was so tight that only one lender would approve finance.  It would also take him up to an 80% overall loan to value ratio. My feedback was by all means to trade-up, but to sell his existing property. Although average prices will likely go up this year, his was already a high price for West Auckland and wouldn’t appreciate nearly as much. I was concerned with both the high LVR but also the weak servicing. In the unlikely event he found himself in financial trouble, they’d have very limited financial options. I questioned whether he was prepared to put all of his equity ($600,000) at risk for an extra $40,000 of speculative capital gain. If he was right he’d get $40,000 and if he wasn't he was at risk of losing everything. He decided to keep his old house and play those odds.

I find property investors underestimate how illiquid property can become. The mistake is often assuming that equity is like cash. It isn't. In a market correction lenders are likely to force all proceeds from the sale of property into debt reduction so good luck on getting any cash out. Similarly, Revolving Credits are a one-year renewing facility. Although it hasn’t happened here in my working life, it is dangerous to assume banks wouldn’t cancel them if we had a major economic crisis and things got ugly. Luckily we haven’t had it ugly for a long time and hopefully it stays that way. Leverage works extremely well when there is liquidity and when prices are trending up. For the most part property has and will continue to deliver on this. However, it's those small periods where the rules don't apply that hides the risk. For the most part the risk of market failure is swept under the table due to lack of hard evidence in the past twenty years. Nonetheless it exists and for all of us, including me, I hope we never see it.