More and more Australians are viewing property as a means to getting rich quick. But are they setting themselves up for a fall?
by Mark Story
Australia's runaway residential property market is awash with investors who are fast crossing the line into speculative buying.
Lured in by record low rates, a faltering sharemarket and get-rich-quick do-it-yourself renovation shows, growing numbers of investors are making highly leveraged one-way bets on property.
Economists and wealth management experts are eyeballing new entrants into the market with some concern while even rusted on supporters of property as an asset class warn late-comers they will need more than just a good imagination.
The International Monetary Fund (IMF) is among those worried about unsustainable property price rises in Australia. A recent study showed Australia fifth on the level of prices relative to rent among 27 Organisation for Economic Co-operation and Development (OECD) countries examined.
Alarm bells are ringing loudest in Sydney where the median dwelling price soared 13.9 per cent to $690,000 in the 12 months to March 31, while national capital city prices jumped 7.4 per cent in the last year to $530,000.
The fear that speculators were driving the action was underscored by March figures on lending to property investors, which was up around 21 per cent from a year earlier, and twice the 10 per cent the banking regulator regards as a sustainable.
Residential property bubbles typically occur when participants who typically dwell at the margins are pulled into the market as prices spiral higher. They are often less experienced, have shorter time horizons and are more highly geared.
These three characteristics can typically create a buffer for the property owner, reducing the likelihood that they could be thrown out by the slightest shudder in the market, a shudder that is bound to materialise sooner or later.
The danger of throwing the fundamentals out the window and betting on price appreciation to generate return, says Shane Oliver head of investment strategy at AMP Capital, is that at some point the music has to stop.
Meantime however, despite a decade of mounting concerns over escalating property prices, Australians continue to pay more to each other to buy their homes.
With Australians now the most leveraged people on the planet, with a household debt-to-income ratio of 153.8 per cent, Oliver says the downside now outweighs the upside for investors' hell bent on flipping.
Admittedly, prices may take a dramatic tumble. But many experts can see a future where price growth is stagnant putting those models which rely on ever higher prices at risk.
One of the key measures Oliver talks about is price-to-income, which has doubled from a national average of three times income in 1990 to six times income today. In Sydney it's closer to eight or nine times.
"The best time to invest would have been in 2012 while the country was still fixated on cooking shows, and before home renovation shows made 'flipping a property for profit' look so easy," Oliver says. "The fact that property investing is being romanticised is a pretty good sign it's going over the top."
Clipping the ticket
With average wages only going up by around 2.5 per cent annually, Oliver says it's time for property investors to seriously question some of the 'rules of thumb' that best serve those who make a living clipping the ticket.
Oliver says that those who tell you that the value of a property doubles every seven years is one and the idea that property never falls is another.
"Investors must recognise that they're now buying a lot closer to the top of the cycle than the bottom," Oliver says.
While property price appreciation has been a key driver of wealth creation for generations of Australians, Oliver's concerned that soaring house prices are exhibiting the same characteristics as a Ponzi scheme, with the last ones into the market bearing most of the risk.
"Investors need to look beyond the next few years, when interest rates might be considerably higher and the construction boom has led to an oversupply of apartments."
Unlike 20 years ago when investors could have bought almost anything and done well, Matt Sherwood head of investment strategy at Perpetual Investments questions whether buying a property to manufacture instant equity through renovating, and quickly reselling for profit is still doable.
Underscoring the 'classic Australian renovation' is the expectation that by investing 10 per cent of the purchase price in renovation improvements, you'll unleash sufficient value to increase the resale price sufficiently to make a 10 per cent profit after costs.
But with the official interest rate at 2 per cent, Oliver suspects investors receiving high single-digit returns from rental income and capital growth should have little to complain about.
Renovation expert Cherie Barber is one of property's "true believers" but even she concedes that due to growing competition between owner-occupiers and property flippers in overheated markets like Sydney, opportunities to 'buy, renovate and sell' for any sort of profit are becoming much trickier to pull off.
Unsurprisingly, with the 'multiplier effect' from renovations alone being progressively squeezed, she says more property investors recognise that buying, renovating and renting is a safer and potentially more profitable strategy.
Not every 'reno' project is a goldmine, but Barber says property investors can typically make more money when the market is bad, and there's more stock, fewer buyers and greater competition amongst tradies.
That's why she says investors' may find better opportunities within declining markets like Perth, Hobart or Darwin than Sydney or Melbourne. "There's a fine art to flipping for profit, and while Australia is full of unrenovated houses, the big question is whether the numbers stack up."
Despite the national love affair with bricks and mortar, Perpetual's Sherwood, author of book Intelligent Investing, reminds investors that when it comes to assessing residential property as an asset class, it repeatedly underperforms everything but cash and gold.
Given this, it's hard to fathom the attachment to property on raw numbers however one theory is that many property investors have trouble removing the impact of gearing from the end result.
While property is typically geared anywhere between five and 20 times and thus creating some genuinely outsized profits few sharemarket investors would consider gearing anymore than 50 per cent.
Perpetual's Sherwood however says that investors need to remember the power of income from shares which are either unencumbered or with the additional benefit of franking credits while rental income from property is usually spent on upkeep.
"The share market outperformance simply reflects the power of reinvesting income," Sherwood says. "Since 1974 there have been seven periods where sharemarket prices have fallen by 20 per cent-plus, yet it still managed to deliver a four-fold rate of return over property."
While they never want to invest in assets that lose money, one reality check investors must also understand, adds Sherwood is that $2 in every $3 of income from residential property on average will be lost in associated costs.
With property being expensive to maintain and insure, on top of strata levies, real estate fees, renovation work, and repairs all eating into income, he says property has to get a strong rate of return just to break even, let alone to repay you for sunk costs like stamp duty.
Before investing in residential property, Sherwood says investors really need to understand how it behaves as an asset class. Properties are unique and the prices paid for them can depend on any number of seemingly inconsequential factors.
It's equally important, adds Sherwood for property investors not to fall into the trap of believing the rental yield represents the income they will receive or the mirage of thinking they're wealthier than they really are.
"Income is a cash flow and yield is a ratio, they are completely different concepts; one does not present the other, and they need to consider income after expenses," Sherwood advises. "Investors should be making decisions based on total rates of return after all costs, which is where professional advice helps."
Sadly, Ron Malhotra of Maple Tree Wealth Management says Australians tend to plunge into residential property, only to work out the details after the event. To avoid speculating when they should be investing, he says the entire process needs to be reversed. He says there needs to be sufficient time spent assessing the fundamentals to minimise the risks associated with purchasing any asset.
Then there's the tendency Australians have of buying an investment property up to the maximum amount they can borrow against the equity in their home, regardless of the pros and cons of doing so.
Malhotra says people who have never sought financial advice are more likely to invest in residential property as a single strategy solution; and the shorter the time frame, the riskier a single strategy approach becomes.
The better approach, says Deutsche Bank's head of private wealth management Chris Selby is to incorporate property investing within a diversified plan that takes into consideration an investor's work situation, current investment experience, lifestyle and family considerations; including assets, liabilities and expenses.
"Before buying anything, it's important to understand a client's needs and skills," Selby says. "There are investors with a history of buying and selling properties, but to inherit a lump sum and put it all into a property without any experience could be disastrous."
Due in part to the tax advantages, he says property belongs within every investor's portfolio, but due to poor liquidity suggests its limited to between 10 to 20 per cent. "Unlike shares, which are marked-to-market daily, the value of property is only marked at purchase price, and the transactions costs are difficult to measure," Selby says.
It never ceases to amaze Selby the number of Australians who invest in property without seeking independent professional advice. He reminds investors that unlike the professional advice community – including financial planners and accountants – self-promoters charging big money to attend courses or unlicensed property spruikers offering free seminars, typically aren't accountable for their underlying advice.
"The danger with property specialists is they're only wedded to one asset class," Selby says. "Similarly, with property agents, it's not about a client's personal circumstances, and only ever about the transaction."
It's self-managed super funds (SMSFs) that have also succumbed to the hard sell from unlicensed property spruikers, and this has squarely put them on the radar of ASIC for further scrutiny. Real estate, particularly apartments can be mortgaged inside a SMSF where existing super is used for a deposit on the property.
However, Nataliya Denisov financial adviser with Rise Standards says the purchase of any asset within a SMSF should be treated as a long-term strategy, rather than a quick profit making transaction. If having satisfied the 'sole purpose' test a SMSF wants to purchase a property to improve its long run value, she says members should be aware of the issues around such strategy.
"For example, if an investment property was purchased by a SMSF using borrowed funds and the borrowing remains outstanding, you're restricted from using the borrowed funds to renovate," Denisov says. "In this situation, you can only use the borrowed funds to make repairs to the property."
If an investment property was purchased by a SMSF using borrowed funds but an investor will be using SMSF funds for the renovations, then she says you can renovate a property to improve it as long as you don't change its character.
"The only time you have full flexibility is when a SMSF owns the property outright and is using its own funds for the renovations," she says. "However, this creates an issue of liquidity, so it would be important to hold other types of assets within the fund that can assist with funding all necessary outgoings of the SMSF."
Due to the complexity and limitations, she usually suggests clients consider alternative tax structures, especially if the aim is to make a quick profit. "They need to be aware of capital gains tax, and how it may affect their personal tax liability," Denisov advises. "It comes down to careful planning that assesses all possible options based on the real objective behind the idea."
The perfect flip
After attending a renovation course over a year ago, a Melbourne couple decided to buy a three bedroom, one bathroom house 30 kilometres south-east of the central business district for $450,000. Not wanting to be taxed on their capital gains, they decided to make the property their principle place of residence for the minimum 12 months, and proceeded to cosmetically renovate four months before selling.
Based on course provider recommendations, they spent $34,375 over 13 days on a new kitchen, painting throughout, new shower screen, new fence and blinds, and removed a non-load bearing wall to modernise the house with an open-plan feel.
With the local market running pretty hot and the time, the house was quickly auctioned, and following some competitive bidding sold for $565,000. After factoring in the $40,000 in resale costs, including stamp duty, legal fees, holding and professional costs, the couple made a pre-tax profit of $40,000.
Based on their success, they now plan to buy another property in the area and repeat the exercise.
The flip gone wrong
Six months after attending a renovation course in 2012, middle aged professionals embarked on their first property flip 20 kilometres north-west of Sydney's CBD. Contrary to the advice they were given about starting small, they paid $680,000 for a 'four by one' house with pool and garden which needed a lot of renovating inside and out.
They earmarked 36 per cent of the purchase price ($250,000) for renovation costs and gutted the house before redesigning two living areas by removing non-load bearing walls, adding walls to accommodate a new study, plus extra bathroom, separate third toilet; and landscaping around garden and pool.
However, by the time they'd found a suitable replacement for the original builder who went AWOL, they'd spent eight months paying dead money on mortgage repayments. Then there was a $40,000 blowout in originally budgeted renovation costs.
Wanting to resell immediately and clear bank debt, they opted for an auction. While there were two interested parties, bidding dropped away quickly. Within the next half an hour, following some panic decision making, they accepted the best offer of $1.02 million, which after costs left them with a $30,000 loss.
Based on what they have learned, they now are looking for a less challenging 'buy, renovate and rent' project.
Modest long-term assumptions
Based on ABS figures, around 70 per cent of investors sell residential property within five years. But the smarter way to generate wealth from residential property investment, says Malhotra is to buy, and hold over two property cycles, typically around 15 years. "To stress-test your projections, factor in modest annual capital growth, and interest rates well above where they are now," Malhotra advises.
For arguments sake, he says if you were buying a residential house today for $450,000 then factor the following conservative assumptions into an investment calculator over 15 years:
Purchase price: $450,000
Stamp duty and costs: $22,000
Vacancy rate: Two weeks
Rental yield: 3-4 per cent
Interest rates: 7 per cent
Annual capital growth: 5 per cent
Projected price within 15 years: $935,000
Pre-flip check list
- Check how much cash flow you'll need to allocate weekly/monthly on a before-tax basis to hold the property.
- Assess how much income protection you'll need to avoid selling the property in the event of illness/accident, especially if negatively geared.
- Run a line-by-line spreadsheet on all costings, factor in the purchase price, the expected sell price, plus all the associated costs; including a record of proposed removals and new installations, stamp duty, agent's fees, plus CGT.
- Become an expert on the small cluster of suburbs you're thinking of buying in, and understand council plans, future infrastructure developments and long-term growth drivers.
- Find out how much recently renovated properties sold for in the area.
- Ask up to 10 agents what people want in the area.
- Pressure-test up to five agents before engaging one.
- Acquire the right renovation knowledge, and tap into experts who've done it before.
- Decide what material changes will deliver the best uplift in value.
- Scrutinise tradies, and check they're licensed and insured.
- Assess potential changes to personal circumstance exposing you to excessive debt.
- Establish a plan for monitoring quality control.
- Conservatively project future rental yields and interest rates.