6 Risks Property Investors Face in 2016
Property investors face risks at all times, and in all seasons, so 2016 is no different than any other year in that respect. The difference today is that the risks for investors entering the market now are not necessarily what they were three, five or 10 years ago.
Unless you’ve been living under a rock, you know that since 2013, we’ve experienced spectacular growth rates in our largest capital cities. In fact, the latest research from Core Logic suggests that home values have continued to trend upward across each of the capital cities over the first four months of this year.
With median home values in Melbourne and Sydney now 10 to 12 times greater than median incomes, the Australian Dream seems farther out of reach for first home buyers than ever before. Logic suggests we could be nearing the peak of a property cycle, and opinions differ greatly on what this means for the future of real estate prices.
Regardless of your opinion, wisdom demands that we consider the greatest risks of buying and holding property in 2016. Here are six risks every investor should consider:
1. Changes to Tax Concessions
For mum and pop investors entering the market in 2016, yields are at record lows. Investors who borrow big to speculate on price growth now find that capital city rental properties produce very little income relative to their values, and therefore their interest payments.
Unless an investor gets creative, negative cash flow is virtually inevitable. Without a corresponding tax benefit, buying negatively geared real estate would be hard to justify.
The negative gearing tax offset and the capital gains tax discount, as we know them, are both on the chopping block. Labor has already laid out its plan to rework them, and at present the political race is virtually a coin toss. You can read more here about what investors can expect if Labour wins the upcoming election and negative gearing gets scrapped.
2. Tighter Restrictions on Foreign Investment
Foreign Investment Review Board rules stipulate that non-residents can purchase only new properties, making overseas investors prime targets for developers seeking sales of off-the-plan houses and units. As such, foreign purchases make up anywhere from 40 to 60 percent of all new apartment sales in Victoria, Queensland and New South Wales.
All four major banks have recently announced they would either stop writing mortgages to non-residents, or at least reduce loan-to-value ratios and tighten lending criteria. It’s becoming increasingly more difficult for foreign investors to fund local purchases.
Restrictions are also tightening from government. Victoria just announced an increase in the foreign investor surcharge from three percent to seven percent. If other states follow, developers, and the property market as a whole could take a hit.
According to NAB, nationwide foreign investment in new and established properties dropped last quarter to its lowest point since mid-2014. Overseas buyers made up 11.8 percent of demand for new homes, down from 14.4 percent in the previous quarter. In the existing home market, demand dropped from 8.6 percent to 7.2 percent. If this trend continues down, property values could fall.
3. Falling Valuations for Off-the-Plan Apartments
Due in part to demand from overseas investors, developers have been building new units at a record pace. The number of new dwellings currently being built exceeds the pace of new household formation. These increased levels of supply present some significant settlement risks.
According to basic economics, when supply increases faster than demand, prices fall. If prices fall, then bank valuations that determine how much an investor can borrow may not be high enough to meet the contract price of these units.
If these buyers cannot access more cash for deposits, or if tighter lending restrictions mean they are unable to borrow, these buyers will be unable to settle. In this case, we could see developer fire sales which could lead to contagion throughout the market.
4. Rising Interest Rates
One of our members living in New York recently commented that he had just locked in a 30-year fixed rate mortgage for his personal residence at a 3.5 percent interest rate. Yes, that’s a fixed amount for 30 years. No matter what the federal funds rate is between now and then, his minimum mortgage payment will never change.
Unfortunately, investors and homebuyers in Australia are not afforded the same peace of mind as Americans are. We face an interest rate risk that U.S. investors do not.
Interest rates in Australia are not likely to increase anytime soon. In fact, the RBA’s cash rate will probably go even lower, but eventually, interest rates will rise. As such, Australian investors who buy expensive homes today at low interest rates will face higher mortgage costs, if they choose to hold these assets into the future.
If and when interest rates rise, cash-strapped investors may begin to sell. Once supply exceeds demand, prices should fall.
5. Stagnant Property Prices
Some of the most optimistic forecasts include relatively flat property prices over the next few years. Due to the high cost of holding and selling real estate, even stagnant property values can result in a loss for homebuyers if they must sell.
For example, if you purchase a home in Victoria for $750,000, you will pay a stamp duty of about $40,000. If you can charge $550 per week rent for this property, your negative cash flow for the year after your tax benefit will be somewhere in the order of $5,000.
If you’re forced to sell in five years, and the market at that time will pay you $750,000, you’ll have sales costs of about $25,000. This means that between your purchase and selling costs, combined with the inevitable legal expenses, you’ll lose about $95,000.
6. Doing Nothing
Some property investors will be paralysed with fear in light of the previous five points, so they will most likely do nothing in 2016. These investors also face a risk by sitting on the sidelines by holding cash in a bank account. If property prices do increase and the Australian dollar loses buying power, which would not be a surprise in our current low-interest rate environement, cash will be the wrong asset to hold.
The RBA and at least half of our politicians are highly motivated to keep propping up asset values. Banks’ profitability is dependent on ever increasing levels of debt, which hinges on moderately increasing property values.
When debt is cheap, calling the top of the property market is an extremely difficult thing to do. Many people thought real estate was overpriced in Sydney and Melbourne in 2013, but look at home prices now.
Conclusion
If you’re not sure what to do, you may want to read an article I wrote earlier this year called, “How to Invest in Uncertain Times.”
When feeling uncertain, the best defence is to increase your knowledge, skills and competency. That way, you’ll be able to recognise opportunities that already exist, avoid opportunities that are foolish, and take advantage of opportunities that arise when the market shifts in your favour.
The worst thing you can do is sit idle and inactive while waiting for your fears to subside. In Steve McKnight’s Property Apprenticeship course, we train investors to develop a clear vision, a thorough plan and implement a comprehensive due diligence system that will empower them to invest with confidence. You can learn more about our training programs here.
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