Category Archives: General Finance

Mining Towns and Bad Advice

The following is an extract of an email I recently sent to a client who had been convinced by someone that an investment in Karratha was a sound idea…

As for developers and real estate agents they  have a clear interest in talking up the market.  But many so-called “property investment mentors” also have direct financial interest.  This is from an article in the Property Observer July last year titled “Port Hedland and Karratha “the best places to buy”? Don’t get roped into that one”  read the full article here
Another more recent article on what is happening in other mining ‘boom’ areas  where he points out “The decline in these markets is not just about hard times in the iron ore and coal sectors. It’s also about over-building by developers and a failure to appreciate the full impact of the growing use of FIFO ( fly in fly out) workforces accommodated in temporary workers villages.”
We have many successful clients with strong property property portfolios and some of them did well out of the mining boom, buying ahead of the market.  We also have some clients who didn’t – this is a recent example I came across:
I foolishly I bought in Blackwater and Mackay when rents were crazy and out look was bright. Now rents in Blackwater have gone from $950pw, purchase price $495k to now $350pw and an agent told me today if I sold now I would expect $200k as there is zero interest in a property like mine. Mackay is a similar story, rent $700pw, PP $485k to $300pw and a $380k expected sale price. I am currently on a fixed rate for the next few years of 4.89%.
This person has little choice other than to sell their  family home in Sydney losing all of their  equity.
So my negative attitude to your Karratha strategy comes from my experience over the last 15 years.  Keep in mind that lenders also know about booms and bubbles – although they appear to have completely ignored that in the case of many mining areas.  However for a lender the ideal property is a 3 bedroom brick & tile house within 20 kms of the CBD or a large regional centre.  As you deviate from that either way, such as a one bedroom bet/sit or a $5 million harbour-side mansion the size of the market for these properties decline and that makes lenders nervous as when things go wrong they want to be able to sell easily and the bigger the market the easier the sale.  As a result lenders will lower the equity share on property that has a restricted market by as much as 50% and in many cases lenders will decline to accept a security.
Typically regional areas offer higher rental return over metropolitan areas however the cities ( Melbourne & Sydney ) offer better capital growth.  You have stated that you are looking for a positive geared strategy with good future income flow.  In my experience any ‘residential’ property with a return in excess of say 6.50% starts to ring alarm bells.  I am not saying they don’t exist but let’s look at some of the common scenarios:
  • serviced apartment or student accommodation – management or zoning restrictions limited market results in 60% LVR (loan valuation ratio) at best
  • studio apartment under 40 sq metres – again restricted market, LMI ( mortgage insurance) not available further restricting market expect 60% LVR
  • hobby farm > 5 ha – restricted market 60% LVR
  • retirement village – restricted market and management restrictions – unacceptable security
  • converted hotel/motel – unacceptable security
  • guest house / student housing where tenants share common areas – usually unacceptable
  • remote locations dependent on single industry – case by case
  • rural/ regional towns under 10,000 pop – case by case but typically 60% LVR
  • resorts / holiday letting – strictly speaking they are not ‘residential’ ie: people do not reside there, usually unacceptable
  • display homes – very restricted depending on agreement may get 70% LVR
  • property with rent guaranteed  – these are usually a managed arrangement or an incentive from the developer, will be assessed at market rent and equity probably discounted
While all of the above (and many others) offer good rental yield you have to keep in mind that the equity restrictions mean that you have to use more of your money and  this will ultimately reduce your ability to acquire more property.
While Melbourne struggles to make a 3% rental return, Sydney around 4% there are parts of Brisbane and I am sure other major centres where 6% on standard property is achievable. If you are looking for property that pays its way and makes a real profit, you will probably be forced to look at the higher risk options above.  If you are looking for property that can start to pay itself off, gradually becoming more genuinely positively geared over the longer term and capital growth is not your focus then larger regional centres may be your best option.

First Home Buyers Endangered Species

While there has been a lot of hype regarding the current growing property wave in Sydney, Melbourne and Perth.  The  investor driven bubble is very much a metropolitan event with many regional (non-mining) areas still deep in the doldrums.

The other market showing no improvement is the first home buyers market where despite a 4.4 percent seasonally adjusted rise in finance commitments for September – the proportion of first home buyers are at their lowest since statistics commenced in 1991.

There has been a growth in new home commencements and it is possible that the few first home buyers in the market have been driven to this segment as it is the only area where serious incentives are still available.

What about Co-Ownership?

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 in property, 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.

Your Number One Enemy: Sometimes it’s You!

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.

Urban Myths of Lending

In our work with borrowers we come across a lot of ‘urban myths’ about borrowing – things which drive people’s behaviour which are fundamentally misinformed. So as the first in a series which I’ll put out in subsequent newsletters, here are some urban myths exposed.

Don’t mortgage your own home.

Perhaps the most frequent myth is the idea people have that if your own house isn’t mortgaged, it’s safe from any financial action. Wrong!

The law is that if you owe money to someone, they can come after you and sell any assets you own until they get their money. So if you have a house, it’s effectively on the line any time you enter a contract – for instance for dry cleaning or telephone services. Of course, most small debtors won’t go to the trouble of selling your home up – it’s not worth it to them for such a small debt.

Having said that, if you can keep your own house unencumbered that’s a nice thing to do, other things being equal. But given what I’ve said above, it’s throwing good money after bad if you need to bear additional costs to keep your own house free of a mortgage. People often have to pay mortgage insurance – no small amount of money – to keep their own house unencumbered.

Take the following example. The Smiths have an unmortgaged house worth $500,000 that they live in and want to purchase an investment property worth $300,000. They have $60,000 as a deposit for a house in Sydney. But buying the house without encumbering their own house will cost them more than $3,000 in mortgage insurance. But what if they can’t meet their bill? Say a terrorist act blows up their house, that the house cannot be insured against terrorist acts, that it’s now unrentable and they cannot meet their repayments. The lender can – and probably will – sell up not just their investment property. Since its value is well below what they owe, the lender can then – and probably will sell their home. Remember the law is that generally a debtor can sell your assets till your debt to them is fully repaid.

Now you could argue that not mortgaging the house could at least affect the order in which the assets were sold. Thus, not encumbering your own house improves the likelihood that your investment property would be sold first. As a legal observation, this is true enough. But it seems to me very likely that if the investment property would clearly yield enough money to repay the mortgage, a lender would happily allow you to sell that in place of your home: That is, it would let you behave as if your investment property was the one with the mortgage.

Why would it do so? Firstly because, provided that this can raise the money it needs, it’s no skin off the lender’s nose. Secondly there is in fact something in it for the lender. Lenders don’t like selling people’s homes because every now and again it ends them up on a TV current affairs program playing the role of evil villain. Part of the reason banks are conservative about people being able to service their loans (even when their loan to valuation ratio is very low) is that they hate those current affairs stories. Lenders hate throwing people out of their homes. Of course there is the chance that you run into a really unreasonable lender, but I’d be very loath to pay thousands of dollars of mortgage insurance to have so little effect on the final outcome.

In this example, in most cases the best approach would generally have been to mortgage the home and leave the investment property unencumbered – leaving it available for the raising of more finance if that was desired at some later time.

If you really do want to keep creditors’ hands off your family home then you need to consult an accountant and have the property title put in a different name to your own. Thus generally speaking (though there can be exceptions) a spouse owning a home can hold onto it even if her husband is bankrupted (and of course vice versa). And if you hold your own house in the name of a company or trust this may protect it also (though of course creditors may be able to access the asset through the company if you own shares in the company).

You shouldn’t do any of these things without getting the advice of a professional you trust. Another option is ‘non- recourse’ lending where the lender has recourse to the security backing the loan – they can sell the house that is mortgaged – but their rights end upon doing so. You can get access to this kind of lending, which is standard in the United States because of government regulation. But you shouldn’t be surprised to find that it costs more – because it’s higher risk for the lender.