~ Newsletters

In our newsletters we often talk about the issues that come from the complexities of real estate laws, interest rates and the vast variety of loan products that are out there these days. We need to understand all these things to safely buy and invest in property. Today though I want to talk about another complexity that is just as important to remember when dealing in property,  the human brain.

It's called the 'endowment effect', and it's a popular topic of research amongst Psychologists and Behavioural Economists. In short, just having something makes us think it is worth more than we would if we didn't already have it. This attachment to things we own means we think the items that make up our personal property are more valuable than they really might be. The researcher who first identified the phenomenon was Richard Thaler who in 1980 did an experiment in which he gave coffee mugs to one set of people and asked what they’d sell them for.  He asked another group of people what they’d pay for the mug.  Keep in mind these weren’t even people’s favourite mugs, just mugs they’d been given. Even so, those contemplating selling asked on average $7 for their mug while those saying what they’d pay for the same mug offered on average $3. The effect is stronger if we own the mug for longer.

In some ways this is a great little trick our brains play on us. We'll automatically be more happy with most things than we'd thought we'd be, just because we have them. It's a built in “no regrets” feature and it seems to have evolved to make sure we protect what we have. It's also exploited by companies offering money back guarantees. They know that just having the blender or espresso machine for a while will ensure satisfaction with them and as a result fewer returns.

So what does this have to do with real estate?

When analysing a valuer’s report with a disappointed client selling their home we invariably hear the statement "one sold next door and it was no where near as nice as ours".  One, perfectly reasonable explanation is that valuers tend to be on the conservative side – firstly because markets rise over time and they base their valuations on past sales, and also because they’re more at risk of being sued for negligence for an over than for an under-valuation. But the endowment effect could also be rattling around there as an explanation?  Try to keep this in mind for example when you're trying to sell and the crowds just don't seem to realise that your property is as wonderful as you think it is. While you may have reconciled yourself to its weaknesses and just love its attractions, buyers will be more dispassionate. They don't have the attachment you do and you may need to find a price based on similar properties rather than your feelings.

For the buyer the lesson is more immediate. The endowment effect can take root in your brain remarkably quickly and it’s something that real estate agents play on continually. Sometimes you don't even have to have bought something, just the idea of buying a certain thing can be enough. You may get attached to a house you've inspected and have your heart set on. This may lead you to offer a higher price, quite understandable. However if you are a little tight on deposit or equity remember the lender's valuation may not agree and that can have serious and expensive repercussions.  This is particularly crucial when bidding at auction as a mistake here can be dreadfully expensive.  Do your home work, we recommend if possible invest $250 and have a professional valuation completed.  It is fine to buy with your heart, just make sure your brain is connected with two feet firmly on the ground.  One thing that’s worth doing is bringing along a friend to your second inspection. Try to keep them away from the hype and even from your own enthusiasm for the property and then ask them what they think the downsides are, and what their valuation is.

But remember that you only live once. If you’re buying a property to live in, and you plan to do so for a long period of time, and – of course this is crucial – you can afford it – then the rational thing to do is to bid a little above the odds if it’s necessary to secure the property. You only live once.

It's time to revisit the old question; “To fix, or not to fix?”. Recent rate moves from the Reserve Bank,  show that the current low “emergency” rates are coming to an end and will start heading upwards again. It might be time to start considering your options, and whether or not you're ready for any rises that might come.  It depends on how fast they'll rise and how big a rise you think you can handle but if you don't have much room to move in your budget, you won't want a nasty shock later on.

We reckon the time to fix is not when you think the market has bottomed because that's not so easy to pick, the time to fix is when you feel comfortable with the rate being offered and safe in the knowledge that for the fixed period at least, you can afford your mortgage repayments.  Here is an example of what rising rates can mean, and how they compare to fixing at the rates offered now.

Say you're on a $380000 loan on a variable rate of 5.21 per cent over 30 years. You'll currently be paying $2089 a month in repayments. On a 6.99 per cent 3 year fixed rate you'll be paying $2528 – a whole $439 more a month. This seems no contest, who'd want to pay all that in an era of historically low rates.

But say rates increase by two percent, so that the variable rate is now 7.21 per cent. You're now being set back $2583 a month, $594 more a month than today's variable rate. If you reckon you might struggle and think a 2 per cent rise might seem a little extreme, remember that 12 months ago a good competitive discounted variable rate was 8.74 per cent!  If we returned to those levels, you'd be put back a whopping $2987 a month, almost a thousand more a month than today's rates!  

Keep in mind that fixed rates normally come with a lot of restrictions* and in the event, unlikely as it might currently seem today that fixed rates come down, you could be up for very high exit costs to get out early. 

No-one, not even Governor Stevens, knows how fast rates will go up or by how much, but if you think you'd have troubles paying the fixed rates being offered now, you should consider whether your budget could handle the hit from an even higher variable rate in the future. If not, perhaps the security of a fixed rate is worth considering.

* Most lenders restrict principal repayments and redraw on fixed rate loans.  The Rock Building Society offers fixed rates with 100% offset accounts and or fixed rate lines of credit.

 The property market can look a little daunting to many home buyers and investors today. They know they want to “get a foothold”, but the prices are so high. So they and their friends, who are in the same boat, grumble and moan until...eureka! Each one of them alone can't get a foothold, but if they join forces....

It is becoming more common for groups of friends and investors to jointly purchase properties, and lenders are putting out a large range of products to cater for them. These products may allow you to buy property when you couldn't before. But there are important issues to consider, such as the effect on your borrowing power and possible legal entanglements..

Let's imagine two friends, Andrea and Peter. Each of them is renting, but they wish they were buying instead. Both of them have savings, but not enough for a deposit, and their incomes aren't quite big enough to cover a mortgage near the places they want to live and work. Andrea and Peter decide to pool their resources with a co-ownership product. Together they have enough for a deposit on a two bedroom apartment, and their combined income is enough to cover the loan repayments. They now own their piece of property.

Andrea and Peter are close friends, but they're not that close. They want to keep their finances separate. So they made sure they found a product that allows them to pay their loan automatically out of different bank accounts. They're in each other's house, but they don't need to be in each other's accounts. They also have different opinions on financial matters. Peter is pessimistic about where interest rates are going and wants a fixed interest rate. Andrea isn't concerned however, fortunately their loan can also cater for their different choices in matters like this. Peter can fix his part of the loan, and Andrea can leave her rate variable.

Co-ownership products provide a way for people to buy property who were previously locked out of the market, and they increasingly allow the partners to keep much of their independence and make choice according to their individual preferences. There are some very important issues to keep in mind however, and some important downsides.

The first, minor, issue, is that whilst both of them are buying their first home, they have to share a single First Home Owner's Grant. There's only one grant to a property purchase, and they'll never get it again. Much more importantly, Andrea and Peter may be getting a piece of property pie, but each of them is liable for the whole debt on the property. This can be a blow to their borrowing power in the future. Lenders will see the whole debt liability, but only part of an asset and a terrible income debt ratio.  Even if the property becomes an investment the entire loan is considered a liability while only half of the rental income is accepted.  As a result lenders will be much more wary of lending them money than they usually would be.

Now say that Peter finds the love of life and wants to get a house all of his own.  He can only use the equity he has in the half share  if he stays with the same lender and even then only with Andrea's permission and probably with her as a guarantor.   If he wants to go to another lender  he would have to convince Andrea to agree to a refinance or simply forget the equity he has.  Even so he may struggle to secure a new loan because of the existing debt against his name, so he wants to sell out his part of the property. But who is he going to sell it to? Andrea may not be willing or able to buy him out. They could try to find a replacement for him, but there's not much of a market for halves of apartments, and Andrea may not be comfortable in a financial relationship with someone else.

What if Andrea falls behind on her payments? Is their agreement prepared for this? Can Peter carry the debt, after all the bank still expects to be paid.   If these agreements go wrong - and over the life of a mortgage many unexpected things can happen - it is a recipe for litigation nightmares.

The products becoming available have agreements designed to cover many of the issues that can arise, such as defaulting or a partner wanting to sell out, but they can't account for every problem. It also needs to be well sorted out in advance. This requires rigorous legal advice and consultation with your broker. It may seem a hassle, and perhaps a strain on a relationship, but lawsuits are even worse - and a lot more expensive!

Co-ownership products may be a good option for you if you want to buy a home or invest, but consider all these issues before you get in. They provide a lot of opportunities that wouldn't otherwise be there, but a lot of potential problems as well.