What If the Worst Happens?

The Australian Financial Review has reported that Morgan Stanley, an investment bank, is expecting residential property prices to be negatively affected by changing expectations and credit availability, resulting in a percentage value decline in the “high single digits”.

It raises the question of ‘what might happen if a severe correction or crash was to occur in the property sector?’

Here are six probable outcomes:

1. Decline in value ‘feedback loop’

The saying ‘the bulls climb the stairs and the bears jump out the window’ is an apt way of describing how prices tend to rise gradually, but then fall suddenly.

It is true that bad news travels fast, and what causes rapid property value declines is a sudden spike in forced sales, at a time when there are fewer buyers looking to purchase. The result is sellers then outcompete each other in a race for financial survival.

More and more forced sales feed a whirlpool of declining property values, and as prices fall further and further, more and more property owners are drawn in via negative equity and loan margin calls.

2. Retirement Shock

Australian’s hold a large amount of their wealth in the value of their homes. If there is a value collapse then that will decimate retirement nest eggs, meaning those who are expecting to downsize to a comfortable retirement may need to reassess their plans.

The fall in values will reverberate through the SMSF sector too, where owning real estate has been increasingly popular.

3. Banking Shock

There will be an increase in mortgage defaults, which will require lenders to increase doubtful debts and ‘book’ losses. The value of their shares would be expected to fall. This will add to the erosion of further wealth for retirees and SMSFs.

4. Insurance Shock

The ability of mortgage insurers to payout large numbers of claims will be an interesting scenario. If they default, then lenders will be at risk of failing too, and Australia could have its own version of a domino-style financial collapse of brand name institutions. It is likely the Australian Government would have to step in to prevent a larger scale banking collapse.

5. Buyer Lock Out

Many people have mentioned to me that they’re waiting for a price crash, at which point they’re going to buy up ‘big’. This sounds like a nice plan in theory, but unless they’ve hoarded cash, it’s unlikely to work in practice. Why? Three reasons: the value of their homes and assets will be falling too, so their wealth will be declining; lenders will almost certainly stop lending to all but the most gilt-edged borrowers and properties; and the ‘blood on the streets’ psychology will make it hard to stomach risks.

6. Economic & Social Shock

Large scale job losses are likely as people stop spending and more staff are retrenched. Local tourism evaporates. Mental illnesses rise sharply, as do crime levels. Tragically, incidents of domestic violence and suicides rise too.

How To Avoid The Carnage

To ensure you don’t get caught up or wiped out in a severe property downturn, you really only need to avoid being a forced seller, and that means:

1. Have no or low debt

Leverage is your friend when prices are rising, and your enemy when prices are falling.

Having low, or ideally no, debt means you’ll have ‘margin’ to soak up falling property values without having to sell.

2. Maintain appropriate insurances

If losing your job means you couldn’t afford to make your loan repayments, then you ought to see an expert about the merits of getting income protection insurance as soon as possible.

3. Avoid buying in investor-rich areas

Avoid areas where there are a high percentage of owners who are investors, as these locations tend to fall faster in value and it can take a lot longer to sell. For more on this topic see this article.

4. Keep cash reserves

Cash reserves will provide breathing room in a crisis. The more cash you have, the greater your margin to ride the rough economic waves.

The Financial Storm Won’t Last Forever

While a severe property correction or price crash will be a horrible and bleak time, it too will pass – eventually. Prices will rebound and sentiment will recover, which is why the ones who stand to lose the most are the poor folks who will be forced to sell at distressed prices.

Application

Have you stress-tested your property portfolio recently to ascertain how well you’d survive if property prices fell a little or a lot? For instance, how would your wealth scenario look if you lost your job and/or property prices were to fall 10%?  What if they fell 25%, or even 50%?

Let’s hope a severe property correction or property crash doesn’t happen, but it would be wise to have a financial survival plan in place, just in case it does.

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.