The Only Way Isn’t Up


A Special Report into the Pending Correction of Australian Residential Property Prices

By Steve McKnight

If you’d prefer to view this article as a PDF then you can download it here.

Do you remember the 1980’s pop group YAZZ? They had a hit with ‘The Only Way Is Up’.

Well, if you were born after 1985 then you could be forgiven for thinking YAZZ were singing about Aussie property prices, because from the time you started noticing real estate values, they’ve pretty much gone up, and up, and up!

Property prices don’t always go up.

Yet property prices don’t always go up. Those a little longer in the tooth can testify that real estate values have a tendency to go sideways for long periods of time when prices stagnate, and can even fall from time to time as happened in regional cities such as Gladstone and Moranbah, and even in metropolitan Perth.

Skill is not particularly needed during periods when real estate values are rising rapidly because all ships float on a rising tide, which means that during a property boom just about all property – regardless of location and condition – will tend to increase in value because sentiment and speculation, rather than sense, drive value.

Markets that have overshot on the upside tend to overshoot on the downside.

However, all booms must eventually end (usually when sense overrides sentiment), and when they do, markets that have overshot on the upside tend to overshoot on the downside; the bigger the boom, the bigger the bust.

Of course, if you’re trying to time your entry and exit to perfection, the ideal time to buy is at the bottom when prices are cheapest, and the ideal time to sell is at the top when prices peak. Being able to do this though is pure speculation and requires extraordinary luck, as you never know the highs and lows of market cycles until after they’ve occurred. This is why practically (as opposed to theoretically) the best time to sell is just after the peak, and the best time to buy is just after the bottom.

Sophisticated investors strategise rather than speculate.

Sophisticated investors strategise rather than speculate. They look to the data, not their emotions, to set their strategy and match it to the prevailing economic conditions of the day, being greedy when people are fearful, and fearful when people are greedy – a saying attributed to Warren Buffett.

So what does the data say about current market conditions? While a detailed analysis of the conditions in each State will be provided at my upcoming 1-day seminars, two interesting graphs based on research from investment house JP Morgan are particularly thought provoking.

Affordability Conundrum

Figure 1: Price to household income by city

Source: J.P. Morgan, ABS, CoreLogic

Figure 1 measures property prices as a ratio to household income over a 35-year period in Melbourne, Perth, Sydney and Brisbane. It reveals:

  1. As far as risk of over-valuation is concerned, the present order of high to low risk (at least by the portion of income needed to afford a home) is as follows: Sydney, then Melbourne, then Brisbane, and lastly Perth.

You want to be ‘invested’ during the growth times, and ‘divested’ soon after the peak until the next growth period begins.

  1. If you are looking for affordability with respect to median house price as it pertains to income, then you should be targetting (in this order): Perth, then Brisbane, then Melbourne, then Sydney. This is relevant because the more affordable a house is, the less susceptible it is to price shock. Hence, if you wanted to own real estate in a capital city that offered ‘value for money’, and was also less likely to fall in a pending correction, then presently Perth looks good.
  2. After market ‘peaks’, there tends to be a multi-year ‘catch up’ when property prices stagnate while incomes rise, before another ‘growth’ cycle begins. The lesson here is that you want to be ‘invested’ during the growth times, and ‘divested’ soon after the peak until the next growth period begins again. This is because during the flat and down times the risks of owning property exceed the returns.

Investing Sense and Sensibility

Figure 2: Price to market rents by city


Source: J.P. Morgan, ABS, CoreLogic

Figure 2 speaks to the ‘sense’ of values as they pertain to income returns, and reveals a level of speculative lunacy, particularly in Sydney and Melbourne, which is worrying.

Back in the early 1980s, investors bought real estate primarily for positive cashflow rental returns first, with any capital growth a bonus. This was a valid strategy because the debt underpinning the property was self-liquidating; meaning the loan could be serviced and repaid from the net rent.

Fast forward today and net rental returns are negligible or negative. Now property is purchased for growth with the underpinning debt usually not repaid at all. Instead interest-only loans are the debt instrument of choice, and loans are ‘traded up’ when the property is sold or refinanced into the next more expensive deal. Today, debt is something you get in to and never out of.

Sometime in the early to mid 1990s, investors swapped owning real estate for income to owning real estate for growth, and debt changed from self-liquidating to speculative.

Did you notice the switch? Sometime in the early to mid 1990s, investors swapped owning real estate for income to owning real estate for growth, and debt changed from self-liquidating to speculative.

Purchasing an asset with the strategy of making a certain (income) loss today in the hope of an (uncertain) growth profit tomorrow is inherently high- risk. That said, such a strategy has worked, by and by, in Australia since around 2000. The question remains: how long can property prices rise in a market where income returns are negligible or negative? The answer is: only as long as investors can afford it.

The Canary in the Property Coal Mine

In the absence of rising wages (you’ve probably heard how wages in Australia have been stagnant for a long time), investors have been able to afford higher priced property because:

  1. Interest rates have fallen, so for the same loan repayment they can afford a bigger loan sum; and
  2. They shifted from principal and interest (P&I) repayments to interest-only repayments, thereby allowing them to borrow more for the ‘same’ loan repayment amount (that is, the previous principal portion now gets applied to additional interest).

The canary in the property coal mine is mortgage stress, defined as when a household’s income doesn’t cover its outgoings, including mortgage repayments.

The canary in the property coal mine is mortgage stress.

According to Digital Finance Analytics in October 2017, 29% of Australian households are presently under mortgage stress at a time when home loan interest rates are at, or near, all-time lows. This finding is supported by the following particularly alarming research done for the ABC in August 2017 by Inga Ting, Ri Liu and Nathanael Scott:

Increase in interest ratesExpected impact
+50bpIf interest rates increased by 50 basis points then approximated a third (i.e. 1 in 3) of all households* will be under mortgage stress. 170 new postcodes become ‘mortgage stressed’.
+100bpIf interest rates increased by 100 basis points (i.e. back to interest rates as they were in August 2013) then mortgage stress increases to 40% of all households*. Furthermore, mortgage stress in some postcodes such as Keilor in Victoria, North Fremantle in WA, Church Point in NSW and Buranda in Qld is expected to reach as many as 8 in 10 households*.
+200bpIf interest rates increased by 200 basis points (i.e. back to interest rates as they were in June 2012) then it is estimated that 1 in 2 households will be mortgage stressed. In Sydney, virtually every household in Silverwater and Kurnell is forecast to be stressed, as is Fawkner in Melbourne’s north. Imagine that, people in every home with a mortgage are struggling to pay their bills!
+300bpIf interest rates increased by 300 basis points (i.e. back to interest rates as they were in November 2011 then 9 in 10 metropolitan households* will be struggling to pay their bills.
+400bpIf interest rates increased by 400 basis points (i.e. back to interest rates as they were in October 2008) they’d have returned to roughly their average over the past 20 years. Now nearly 2,000,000 households* are in mortgage stress. It’s a mainstream problem with 80% of the highest population postcodes affected.
+500bpIf interest rates increased by 500 basis points (back to interest rates as they were in March 2008) there are forecast to be only 20 metro postcodes in the entire country not in mortgage stress. At the other extreme, 170 metro postcodes have at least 90% of households* in mortgage stress.

* households with a mortgage

Conclusion

It’s becoming harder and harder to mount a sensible argument for how price growth can be sustained.

Pushed along by the extraordinary tailwinds of low interest rates, tax incentives, foreign demand and speculation, Australian residential home prices have enjoyed a near 20-year boom. It’s been quite a property party.

Yet it’s becoming harder and harder to mount a sensible argument for how price growth can be sustained, especially as economic conditions shift towards real estate headwinds: the prospect of higher interest rates – especially for investors – new restrictions and dis- incentives for foreign buyers, more restrictive lending practices, changes to depreciation, and negative gearing being targetted for change.

Australia is ‘due’ for a property price correction. The trigger will be rising interest rates.

If it’s true that markets that overshoot on the upside tend to overshoot on the downside, then surely Australia is ‘due’ for a property price correction. What will be the trigger? You now know the answer: rising interest rates. It doesn’t need to be a dramatic increase. As mentioned, just a 50-basis points increase will add an extra 170 postcodes to the list of those areas where households with mortgages are struggling to meet their repayments.

You’ve been forewarned. If you want to be forearmed so you can protect your prosperity during times when property prices are flat or declining, then be sure to attend one of my upcoming one-day seminars. It’s a non-profit community service event and all tickets are sold at cost. The alternative is to remain ignorant, take your chances, and expose your financial future to untold and avoidable risk. Choose wisely.

Regards,

Steve McKnight

 

Comments

  2. Profile photo of Schnake

    Very succinct article. Thanks Steve.

    I hear what you and others are saying about rising interest rates, its inevitable. (On a $1M loan 1% = $192 per week! Ouch!)
    Though I recently received an email from CBA advising a change in their repayment / redraw conditions.(https://www.commbank.com.au/banking/changes-to-loan-repayments-and-redraws.html#redraw) This has me thinking if this is a way for the bank to de-risking their portfolios. Sure it provides flexibility for the customer, but its also a safety net for those who should be caught standing with their pants down when the tide goes out. (Yes, that’s a Buffet quote).

    • Profile photo of Steve McKnight

      Thanks for the link Schnake.

      I have to admit I needed to read the text 3 or so times before figuring out what it meant, but I think it means that the bank won’t allow you a loan facility for the term of the loan equal to the amount you initially borrowed, but rather, an amortised facility up to the amount of pre-paid principal you’ve made.

      The get-around here is to refinance the loan periodically and ‘reset’ the start date and hence get a higher amortisation base. Of course, that only works if property prices are the same, or higher, and if lenders preserve the same LVR% as was made initially.

      Regards,

      – Steve

      • Roy Violi

        One of the changes APRA, ASIC and some other governing bodies are proposing to make to loan refinancing is that in doing so, the term of the loan cannot be changed only the interest rate or type of loan structure

    • Profile photo of Steve McKnight

      You’re very welcome Ricky.

      I’m not saying “stop looking” for real estate deals, but rather, take note that conditions are changing, and that better buying opportunities are on the horizon should interest rates rise.

      Sincerely,

      – Steve

  5. Jorja

    As ever Steve, you have taken our complex economic climate and given a clear, concise, and immensely helpful analysis. Thank you :)
    I’m so bummed I won’t be able to attend your 1-day event (I’ll be OS at the time) but to anyone wondering if this event will be worth their time attending – I say a loud YES YES YES

  6. Jo Lindo

    Thanks Steve,

    Well written and reinforced my recent decision to sell an investment that was starting to cost money, thank you for that. Money is my hands is better than a languishing market with rising interest rates helping the bank’s cash flow not mine : put in my stop loss.

    Jo
    WA

  8. Profile photo of andyfev

    Hi Steve,

    Your report and email today regarding the Dow and US interest rates is very informing and perfect timing for Emma and I. We’re forearmed now so if we don’t act it’s only ourselves to blame… I’ve been sharing your article with those important in our lives… everyone thus far agrees but none are willing to a make change… what’s the saying? “Success comes from doing things differently”… kudos Steve

    • Profile photo of Steve McKnight

      That’s the saying Andyfev!

      Those in the greatest danger as I see it now are those who have leveraged to the max, and because of their lack of skill or inability to control emotion, have paid more than they should have for a property.

      Note this is not necessarily applicable to a home purchase, provided there is a medium to long term horizon, and that the debt is affordable, even at +500bp.

      Regards,

      – Steve

  9. Profile photo of Simonp

    You say that “you want to be ‘invested’ during the growth times, and ‘divested’ soon after the peak”
    The definition of “divest” is to “rid oneself of an investment”
    Given the costs of buying and selling property, are you seriously advising that well positioned, income-earning property should be sold, or just no more property bought?
    To quote your words back at you: “Of course, if you’re trying to time your entry and exit to perfection, the ideal time to buy is at the bottom when prices are cheapest, and the ideal time to sell is at the top when prices peak. Being able to do this though is pure speculation”

    It sounds like you’re advising us to be speculators, not investors

    • RichardC

      Steve is saying that if you WANT to sell then the best time is just after the peak. He is also trying to get us to examine if we NEED to sell in view of what might be around the corner as there is no point or perhaps profit in trying to sell when everyone is rushing for the exit.

    • Profile photo of Steve McKnight

      Hi Simonp,

      RichardC has the gist of it. I’m still actively looking to buy property now – and have my eyes on one investment property in particular (and hope to share the details at my upcoming 1-day seminar as a show-and-tell case study). That’s me though – currently with low debt and increasing cash reserves.

      If you’re highly leveraged with speculative growth properties, then I would be asking whether that position is appropriate given a rising interest rate climate, where the cost of holding rises, and there is downwards pressure on prices. At all costs, you don’t want to be a forced seller in a down market.

      Regards,

      – Steve

      P.S. Glad I could help you make some money! Now let’s make sure you keep it!

  11. Profile photo of qweqweqwe

    Hey Steve, I have been thinking about the Melbourne workshop for a while, at the end I have pulled the trigger, $100 spent today (well, it is actually wife`s San Valentine present) are $50k if not more saved in future. I am sure you will give us some precious insights as you always do.

    Good article, I think each market brings different opportunities. I find old house on big blocks to be chopped in half a good strategy in current market. Don`t need to chop ASAP but you are aware that you have some money sitting there.

    Luca

  12. Lintong

    Thanks Steve.
    The critical question would be: will the property market just stagnant or tank? Is the latter likely, and if it is then by much?
    By the way, it seems there are 5 lines in the charts which make the listed 4 cities a bit confusing.

    • Profile photo of Steve McKnight

      That’s right Lintong. As I see it, the three options are:

      1. Interest rates remain low and the party continues

      2. Interest rates rise, and so do wages. Property prices are flat.

      3. Interest rates rise, and wages do not. Property prices correct in the short-term, and worse if there is a sudden spike in interest rates.

      – Steve

  13. Profile photo of Benny

    Hi Steve,
    Another commentator today put their point of view – that Rates won’t/can’t climb until wages have started their climb. And that remains unlikely in their opinion because wages growth is almost underground. They included a chart showing wage growth over the last 10 years – started at a 4% figure, collapsing to 2% last year.

    With wages growth right at the bottom of the RBA’s favourite “band for inflation”, any Interest Rate growth is looking pretty unlikely any time soon.

    Now Steve, I don’t have much knowledge of this area, so I’m parroting these quotes somewhat. But what are your thoughts in that regard? Do you reach any kind of agreement with this commentator based on the little data I have given you? If so, that could certainly put some kind of slowing action on any IR rises (which is a good thing imho). We don’t want any huge increases in a short period – that would destabilise everything wouldn’t it?

    Great article too – I like that you are “looking ahead” and mapping out the “gotcha’s” before we get to them,

    Benny

    • Profile photo of Steve McKnight

      Hi Benny,

      There is interest rate increases by choice, and interest rate increases by necessity.

      I think by choice, the Aus wages argument in isolation means that the RBA won’t be in a hurry to raise interest rates.

      That said, if the US Treasury rate increases, then in order to preserve the value of the AUD, it will need to offer a higher rate to continue to attract capital. Now, some decline in the AUD will be welcome as it will make our exports more competitive and imports more expensive. But too much of an AUD decline will result in input-led inflation.

      Then there is the narrative that the banks will continue to do the RBA’s work for them under the argument that their cost of funds will increase when US rates increase, and so they are just passing on the increase – principally I believe, to investors who are less of a voting block than owner occupiers.

      But, when it’s all said and done, I don’t know when interest rates will rise. I do know it won’t be pretty when they do.

      – Steve

  14. Marguerite

    As always, a clear and to the point post about the property market today. I must say it has sent chills down my spine. I’m on the phone right now to speak “sell” to our realestate agent of choice as we’re overexposed in our portfolio anyway. Thank you again for your insights!

  15. Mark

    Great article but it furthers my frustration. Madly learning at the moment including “0 to 130” but cant come to your seminar as I will be overseas. I wish I could get more specific personal advice today as I think rates will rise and doom me to hold my assets.

    • Profile photo of Benny

      Hi Mark,
      “I think rates will rise and doom me to hold my assets.”

      That is an interesting comment, Mark. Can you add more to it, as I find it intriguing.

      First off, I don’t believe Interest Rates are likely to bounce any time soon (certainly not today, next week, etc) – but, as Steve mentioned in reply to me, we are beholden to “International Forces” (USA) so they might start to tick upward some time this year. Keep in mind that, even though the US exchange rate got down to 0%, we bottomed out at 1.5% – thus, when the US rate starts to lift, we don’t immediately need to follow them.

      Can you mention WHY you think you might be doomed to hold assets? If that seems like a problem, why not sell now? I gather you want to sell at some stage, otherwise the use of “doom” is a bit unusual…..

      Anyway, share what you can – someone will drop by to pop a few ideas in for you once we know a bit more of your concerns. In the case of “personal advice”, perhaps just a mention of what type of advice you need – we have finance people on board, as well as lawyers, investors, etc. Maybe we have someone who can be of assistance to you……??

      Benny

  16. Mannix

    Interesting articale Steve.I did note this week, ( December 2020) an advert by one of the Big 4 advertising a 4-year fixed rate at 1.99%. Seems like low rates are here for quite some time yet.

    • Profile photo of Steve McKnight

      Sorry Abby. I don’t really do live in-person events anymore. Aside from COVID, I am just over travelling around. I do regular online webinars though, and when I do, I email out notification a week or so in advance.

      – Steve

  19. Profile photo of Roda@propertyinvesting

    Hi Steve,
    I’ve just recently bought your book 0 to 130 properties due to a very good friend’s recommendation, and I can say it has brought so much excitement in me. I couldn’t stop reading till I realised its nearly 0300am 😊. I am a nurse midwife by profession but I am reinventing myself to venture into property investing/development. I am so blessed to be connected with this community. And most of all so excited to know that you are a believer of Jesus (read that on your acknowledgement in your book). I’m sure that I will get to meet you in person one day to thank you personally for your kind, generous support that you offer to people like myself even if you don’t know them personally. God bless you more in everything that you do. 🙏

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