Beware False Assumptions

There are two big assumptions every investor seeking capital appreciation makes:

1. When it comes time to sell there will be a purchaser who wants to buy the property; and

2. That purchaser will be willing to pay more than you did when you bought.

While these assumptions appear common sense, they’re often overlooked or readily dismissed because of the misconception that property prices only ever increase.

Time and time again this is proven not to be the case. Most recently, mining towns from Karratha and Port Hedland in WA through to Miles and Mackay in Queensland have all experienced quite spectacular price corrections from their peaks. Falls in value of up to 50%, or more, have wiped out profits and in some cases resulted in investors owing more than the property is worth.

While those who can hold through the downturn might be able to ride the market to a future recovery, those forced to sell can suffer devastating financial consequences, even bankruptcy.

Can such dramatic price corrections occur in city markets? The answer is – yes.

Investors only need to look at what happened in the US between 2007 – 2012 to appreciate that no property or postcode is immune from falling prices.

The pre-cursor to a crash is the emergence of substantially more sellers than buyers. If this occurs gradually then the change could take several months to unfold. If it occurs suddenly, perhaps because of en masse unemployment (mine closing) or an interest rate shock, then the shift can be quite sudden.

Clearly you never want to be on the wrong end of a property correction, and one of the ways you can protect yourself is to learn to identify and read the signs of a changing market, keeping a careful watch for instances of irrational behaviour.

Investors acting irrationally evidence a departure from the proven and necessary economic fundamentals that underpin sustainable markets. It stands to reason that the greater the incidence of irrational behaviour, the more erratic the price reaction – up or down.

It was with one eyebrow raised then that I noticed a news article about a property in the Melbourne suburb of Mount Waverley: 2 – 5 Charles Street, to be exact.

By way of background, the 5 bedroom 4 bathroom home previously changed hands on 4 December 2014 for an impressive $2.05m (median price for the suburb is $1.215m). Apparently it was bought by an investor who was going to redevelop the site and build two new high end townhouses.

They must have changed their minds though, as eight months later the property was sold in the same condition via auction to a home owner for $2.89m! That’s an $800,000 gain in 8 months, even after deducting entry and exit costs.

While we should be happy for our fellow investors, we should also be a little worried as such a big gain is surely an indication of irrational market behaviour (such as rapid and unjustified price growth), and a strong warning of unsustainable price behaviour.

Of course, this could just be an out of the box result, with the buyer willing to pay any price for the property regardless of concepts of reasonable market value.

You’ll need to make up your own mind. Just remember that when you assume you risk making an ass out of you and me (ass-u-me).

What assumptions have you made about your ability to exit your market position at a time and price you hope? How would you cope if those assumptions were wrong?

Make good choices.

By Steve McKnight

Steve McKnight, the founder of PropertyInvesting.com, is a respected property investing authority as well as Australia's #1 best-selling business author.