Investing in the current environment - b 2010

The Reserve Bank's decision to increase interest rates after a 17-month hiatus is the right move at the right time.

Many property investors have been nervous in the wake of November's 0.25% increase in interest rates. But the move was an appropriate correction, as world economies appear to be recovering. Providing the Reserve Bank shows its usual good judgement and moderation, there should be no cause for alarm. There will be no devastating "bubble bursting" as forecast by some. The adjustment will be more like someone blowing the froth off a beer! Prices may continue to fall a little after this as well.

We've been oversold the idea of a property 'bubble'. The media exhibits 'speculative bubbles' of its own and they've been blowing this one up for a year or so now.

House prices are not that far away from their 'fundamental value'. This is because at the bottom of the last housing cycle, which lasted from the early to the mid-1990s, house prices were hugely undervalued. Inflation had fallen from around 5-7% to 2-3% in the wake of the 'recession we had to have'. That allowed housing interest rates to fall from around 13% to 6-7%. A halving of interest rates means a doubling of the amount of borrowings any given wage or other income stream (like rent) can service. So the doubling of house prices in the last few years has broadly restored old relationships.

Imprudence was rewarded during the boom. People did silly things - borrowed too much and invested too much. But they got away with it! That kind of success leads to a 'one way bet' mentality and more and more people pile into the market.

Investment property used to account for around 30% of residential lending. Today it accounts for closer to half - around 44%! So it's likely that those parts of the market that are heavily exposed to investment lending are vulnerable.

Now the trick for the Reserve Bank will be to manage interest rates through this difficult period. Given that at least part of what 'bubble' there was began correcting itself before rates rose, there is a case for caution on further rate rises to avoid exacerbating a downturn. For this reason I think the RBA should and will wait until the dust settles from this rate rise before repeating the dose perhaps more than once next year. 

Impact on Investors

House prices will be only moderately affected by interest rate rises. Indeed, I would not be surprised if they fall a little, say by 5% or less, quickly reflecting the changed psychology of auctions. However, for high rise units - and especially those in places like Melbourne's Docklands where investors were already losing on resales before the rate rises - I would expect a 10% fall with another fall of similar magnitude as rates climb over a period of time. For the record, I bought several investment properties through the boom and we sold the last of them off a month ago. Without their capital gains, Peach would probably not exist!

At the very least, investors considering purchasing a new investment property can now take their time on investment property.

An important exception could be regional properties with high yields. In the last year there has been a noticeable rush from overpriced markets in Sydney and Melbourne to markets that are underpriced in the regions. There are still 'bargains' to be purchased in regional Australia with rental yields of 8% plus. That fact alone gives them some scope for capital gain - if not through rent growth then through the 're-rating' that has occurred in big city markets recently as people scavenge for investment property value.

What to do?

Get the market to work harder

Borrowers should make the market work for them. Before the rate rise, many borrowers were paying over 6%. They'll be paying more than 6.25% now. Generally where investors pay higher rates it's because they've been sold fancy 'extras' like offset accounts and lines of credit or they're 'low docs' borrowers who cannot substantiate their income.

The market is always getting more competitive, so you can now get all these loans at 6% or under (6.25% after the rate rise). By shopping around, you can even commence such loans with a honeymoon. 

Consider fixing

I have some happy clients who fixed when I recommended it three months ago when rates were 5.99% for five years. Today they've risen by about a percent making 'insurance' that much more expensive. Fixed rates are not usually as good value as variable loans, and we are being rushed by people keen on fixing - and I hate following the herd. But fixing is still a reasonable strategy if the prospect of rates rising by more than another half a percent alarms you. 

I think the premium for five years is a bit steep, so fixing for three years at 6.7% gives borrowers good cover to outrun this cycle. One argument against fixing is inflexibility. But the market is sorting that out too. Those in the know can secure competitive fixed rates with all the flexibility to make additional repayments and access a redraw that one would expect of a variable rate loan.

Asset allocation

For those exposed to investment property now is a good time to diversify into other investments. I'd steer clear of any 'fancy' property investment - like 'mezzanine finance' - and reserve my adventurism for equities. Share prices have been sluggish for years, so that spells a great 'contrarian' investment opportunity. 

The big risk is that the American economy will take off and push rates here up by another percent or more. If that happens, commodity prices and our exchange rate will rise, hurting non commodity exporters - like manufacturers. Aside from that risk, there should be plenty of value in Australian shares. 

I've also been holding off from any exposure to overseas share-markets because of their high valuations and our low dollar. The former has been substantially corrected - though only partially in the US - and now our dollar can purchase overseas assets at fair values. So I'll be buying some foreign equities. If the dollar rises I'll buy some more - and wait till it falls again, as fall it will! 

And on that happy note, I'll sign off and wish you well until my next newsletter.



AKA Dr Nicholas Gruen
Feb 2010
Disclaimer: Nicholas Gruen is not an investment adviser and the comments offered here represent his opinion only and made without any indemnity whatsoever to anyone who is not a client of Peach. For Peach clients they are offered subject to our normal limitation of liability. The comments are general in nature. Before making any investment decisions, clients are advised to seek independent advice relating to their individual circumstances from those professionally qualified to offer such advice. Unfortunately many people who are entitled by law to offer such advice are poorly qualified and/or have a conflict of interest in the provision of their advice as they receive commissions on the products they recommend. Dr Gruen recommends that clients find someone who has sound understanding of investment markets, a capacity to provide well explained advice relating to their individual situation and is not in receipt of any commission from those selling investment products.