Forget The Property Crash & Focus On Tangible Risks
July 8, 2020
When people contact us about property investing it’s usually for one of two reasons.
“Can you help me get into property investing?”
“Can you help me get out of property investing?”
On the first question the answer is always no.
The high transaction costs. The lack of diversification. The need to use quite extreme leverage. The hope capital gains will wash away losses on income. New properties that can be loaded with fees. Older properties needing maintenance. Uncertainty on locations and rental returns, even within a booming city.
These things don’t sit within an evidence-based investment strategy. The level of risk is significantly higher than most investors can conceive. But how would they know? Most of us are fed a one size fits all boom. Something perpetually peddled by some of Australia’s largest media companies who have a not so small interest in major real estate listing portals Domain and Realestate.com.au.
On the second question, our response is, “what went wrong?” What we hear should be the lesson to those wanting to get in.
Inevitably, the high transaction costs, the lack of diversification, the extreme leverage, the fees on a new property, the maintenance on an old one, poor rental returns or buying in a location that turned ugly, have conspired in some way to deliver a poor outcome. In some instances, it has wiped their deposit away and left them owing money to exit.
An unfortunate story popped up on the financial section of the Ozbargain forum recently. Ozbargain is a popular money saving/finance focused internet forum. The story was an extreme version of what we view as the risks associated with property investing. It was exacerbated due to COVID, but it’s illustrative, nonetheless. A warning, it does include a disturbing incident.
The set up: Two brothers decide to invest in a Melbourne property in 2018. 3-bedroom, house high $600k range. With stamp duty, plus fees and initial maintenance they’re out to $730k. Their deposit was $80k. The house comes with tenants, couple with kids. Weekly rent not noted. Brother 1 earns $100k pa. Brother 2 earns $80k pa.
The problems begin: Pre COVID there’s $12k in maintenance; plumbing damage from trees. COVID hits and the tenants both lose their jobs. Rent reduction to 80%, then 60%. (WARNING) The investors hear the female tenant may have attempted suicide. They don’t push for rent and don’t receive any.
Work issues arise: Brother 1 is put on Jobkeeper at $1500 (pre-tax) per fortnight and advised by his boss he won’t be kept on when it ends. Brother 2 has his income cut 30%. They apply for and receive a six-month mortgage holiday from their bank.
The reality: They consult with some unstated ‘professionals’, their bank, and discus with friends and family. Professionals say sell now rather than later. Bank says no further mortgage holiday beyond six months, suggesting the pair will only be digging a hole. The conclude it’s best to sell. Agents say no chance they’ll get what they paid. They start with a 20k discount. Nothing. A 30k discount brings tyre kickers and lowballs. A month later the best offer is $60k less than what they paid. Offer accepted. This brings their loss over $100k and wipes out their deposit.
The admission from Brother 1: “This whole thing also made me realise I don’t think I am cut out for the responsibility of being a landlord.”
Goals: The brothers may have had goals, but they were never mentioned. We would guess there was no goal behind this investment. Why do we say this? Firstly, the pair invested together. Odds are they wouldn’t have exactly the same financial outlook, yet they ended up pooling their money to buy a property. Secondly, people who contact us wanting to invest in property have always put the property at the forefront.
They say: “I want to invest in property.”
We ask: “Why?”
Generally, there is silence. What follows are some in the moment rationalisations. They’ve decided on the investment they want before deciding upon their financial goal. They don’t know if the investment is right for them, their circumstances, or will it even fit their goal when they figure it out. Essentially, they’re launching a boat without any reason why and without having checked the weather.
Liquidity: Many property investments lose money on a cash flow basis in the hope of a big pay off at the end. Holding the investment generally requires both the investor and the tenant have cashflow. The investor is also at the mercy of someone else’s liquidity.
In a situation where money is needed in a short space of time, property isn’t a good place to be. What makes this even more illiquid is investing with another party. Thankfully on this occasion they were in unison on the exit. Had the brothers invested in separate liquid and diversified portfolios, they have few issues. An income downgrade or job loss and they immediately have options available. Sell a portion of the portfolio, the transaction fees are minimal and it’s in their bank account in 2-3 days. You can’t sell a bedroom.
Price Movements: A lot of the focus on property prices in Australia revolves around valuations. There is always discussion about overvaluation and the potential for crashes. There is too much obsession with momentous events instead of more tangible risks.
We freely admit to having no idea where any market will go, property included. It’s somewhat irrelevant. Expensive property in relation to wages means it’s tougher to save a deposit. In turn, investors often enter the market with small amounts of equity. The highlighted story shows the feared, and often talked about potential catastrophic plunges in price aren’t required to do serious damage to an investor.
With the high transaction costs and gearing needed, investors can quickly be put to the sword. It only takes a cashflow issue and a slight shift in the market, or more specifically, a slight shift in the property location, and equity can evaporate.
It’s all very well to say, “well they should have held on and property eventually goes up”. But that requires preparedness for the worst. An investor in distress generally doesn’t have a plan, nor a handle on the risks. The moment the storm rolls in, their boat is taking on water. Given the deposit, the brothers couldn’t afford the property separately. Arguably, they couldn’t afford it together either.
Property is a necessity because we all need to put a roof over our head. Trying to get rich putting a roof over someone else’s head? Set aside the emotion and excitement that fills our property obsessed nation. Weigh the downside risks first.