Doom, Gloom Or Boom?

The Sydney property market has been breaking records with a recent auction clearance rate of 88.3 percent. Melbourne wasn’t far behind, with 78.7 percent of auctions clearing. In fact, Melbourne’s outer east suburbs have been particularly strong, with clearance rates well above 90 percent.

It’s no wonder then that one investor described the market as “Moving like a freight train.”

The question investors ask in times like these is, “Can we maintain this level of activity?” Of course, history tells us it can’t, so a more precise question would be, “How long can we maintain this level of activity?” For investors, the answer to that question isn’t really what we want.

What we really need to know is the answer to the ultimate question, “How will the market respond once this unsustainable growth comes to an end.” Will it level off and consolidate to form a new base, or will it snap back to a more “realistic” value?”

If you attended any of Steve McKnight’s recent Market Update events around the country, you may have heard his take on the state of the current property market. Steve didn’t just share his opinion. He shared many current economic statistics, and then he sought to teach investors how to read the signs of where the market might be heading.

In case you missed it, here is a summary of the information he presented:

How Will The Market Respond When This Period Of Growth Ends?

On the question of how will the market respond when this period of growth is over, I will quote an important market dynamic that Steve shared:

“Markets tend to overshoot on the upside because of greed, and then overshoot on the downside because of fear.”

In other words, the market tends to overshoot due to the psychology of buyers and sellers. It’s investor greed that creates market bubbles and investor fear that causes them to pop. Not unlike a rubber band that gets stretched to capacity, financial markets can snap back rather quickly when the prevailing psychology shifts. In light of this, buyers today should be very careful.

What Is A Bubble?

According to Nasdaq, an economic bubble is described as:

“A market phenomenon characterized by surges in asset prices to levels significantly above the fundamental value of that asset. Bubbles are often hard to detect in real time because there is disagreement over the fundamental value of the asset.”

This is a great definition because it brings up the question of the “fundamental,” or intrinsic value of an asset. This value may or may not be the same as the current market value.

As investors, what we should learn to ask ourselves is, “What does the fundamental analysis lead me to believe about the intrinsic value of real estate in my area?”

The fundamentals of the property market are based not on buyer psychology, but rather on other factors, such as scarcity, employment levels, lending practices and new dwelling construction. Bubbles, in contrast, are the result of extremes in buyer psychology.

In his recent talks, Steve shared the following four distinguishing marks of a financial bubble:

1. There’s Lots Of Talk About The “New World” In Which We Live

The problem with bubbles is that many people fail to see them. Buyers assume that the world has changed, and that the current market is the new normal.

Bubbles are even more challenging to see by those who have never been through difficult economic times. Over the last two decades, western nations have experienced unprecedented growth in asset values.

The typical investor today was in primary school in 1989 and 1990 when interest rates were 17 percent. In contrast, older investors who owned assets during that time may be a little less inclined to be complacent in today’s market. In this case, history is an effective teacher.

2. There’s Plenty Of Justification For Acting Irrationally

Because people tend to see today’s high asset prices as the new normal, they create stories to justify the market’s irrational buying activity, such as:

• “If I don’t buy now, I could get locked out of the market.”

• “You can’t lose if you buy real estate, especially near the CBD.”

• “Look at immigration and the undersupply of housing. There’s no room to move but up.”

Whenever you hear someone in the media justifying high asset prices, be sure to consider how the person who is speaking is incentivised by market growth. For example, here’s an article that quotes China’s state-run newspaper on how the 80-percent growth in the Chinese stock market over the past six months is a sign that the bull market “has just begun.”

3. Things Just Don’t Make Sense

As mentioned above, understanding the fundamental or intrinsic value of an asset is crucial to determine whether a market is experiencing a bubble or not. In other words, when the fundamentals don’t line up with market activity, warning bells should ring loudly.

If employment is rising in an area, that would serve as a fundamentally bullish signal for property. If the employment rate is falling, that would be a fundamentally bearish signal.

One of the trends that Steve recently reported on at the Market Update events is that, in all of the capital cities of Australia, unemployment is rising, while at the same time property is getting more expensive. That is an example of data that just doesn’t make sense because the fundamentals aren’t aligning with the hype.

4. It Takes Time To Inflate, But The Bubble Can Pop In An Instant

This is the rubber band effect. Although it often takes many years for asset prices to stretch beyond rational values, they can snap back in a matter of months, or even days, when bad news causes the buyer psychology to shift.

This is why it’s crucial for investors to be able to read the warning signs, and then time their entrances and exits into the market better.

Investors have made a lot of money while riding the wave of inflated asset prices, but they can also lose unrealised gains in an instant.

What’s even worse is that unsuspecting novice investors can lose a lot of money if they buy big right before the bubble bursts.

What Is Driving Growth In Aussie Real Estate Values?

At the recent Market Update events, Steve shared the following helpful insights into the factors currently driving growth in Australian real estate:

Ideally, we would want to see the largest segment of the market being owner-occupiers using savings to purchase new homes. Together with strong employment, this would be a sign of a fundamentally strong property market having the prospect of sustainable growth.

The reality, however, is quite different. The Australian economy is generally in decline, with unemployment trending up in every state except Tasmania. That alone should be a reason for caution.

Furthermore, the primary drivers of growth are cheap finance, and both foreign and local investment.

Current property owners are taking advantage of historically-low interest rates to refinance their mortgages and use equity as deposits to buy investment properties.

According to NAB’s most recent Quarterly Australian Residential Property Survey, foreign investment accounted for 21 percent of the total real estate market demand in Victoria and New South Wales.

Nationally, the local investor market makes up approximately 24 percent of real estate purchases. In other words, almost half of all property purchases in Australia were for investment purposes.

According to Steve’s stats, between 60 and 80 percent of the new inner urban Melbourne apartment market is investor-owned. In Docklands, more than a quarter of the units are unoccupied. Interestingly, according to NAB’s report, the demand is still high for inner city apartments, even though there is oversupply in the market. Can anyone say “irrational behaviour?”

Investors should ask themselves these questions:

• Is this trajectory sustainable?

• What will happen to the Australian property market once the refinancing stops and the foreign investment dries up?

• What would property values be worth if half of the current buyers were no longer in the market?

Investor Beware

In closing, Steve encouraged investors to beware of four shifts that could significantly impact real estate values in Australia:

1. A rise in interest rates.

2. The drying up of foreign money.

3. A change to negative gearing.

4. An increase in unemployment.

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.