How To Approach The Next Phase Of The Property Cycle?
By Bill Zheng

Understanding Where We Are In The Property Market

The total value of all residential properties is one of the best indicators to represent the wealth of a nation.  When a country is producing more than what it is consuming, the surplus is called accumulated wealth, it works just like an average family, hence a country’s increased wealth in theory will show up in the increase of residential property prices.

If a country is consuming more than what is producing, the wealth of this country will decrease, just like a family would, we should see residential property prices falling in those countries over the long term, but this is apparently not so, if you look at countries such as US, UK & Australia, you still see residential property prices going up over the last few decades.

This phenomenon is mainly due to the increase of total money available in those countries is much faster than the decrease of the total wealth, so we see our residential property prices artificially increase within those countries in their own currency.

Take Australia as an example, the increase of money available to Australians comes from the increase of our own money supply and the increase of foreign debt.  While our real wealth as a nation has not gone up in real term over the last few decades, our property prices measured by Australian Dollars continue to go up on paper value.

There is no secret that Australia’s residential property prices will continue to increase in prices as long as we can:

1. Continue to have inflation (by increasing money supply).
   There is a limit on how much money a country can print before the rest of the world start dumping its currency as trash, and disable its import/export and very few countries survive without trades in the world.
2. Continue to borrow money from overseas (to increase money available for home buyers domestically).
   There is a limit on how much a country can borrow from other countries depending on the country’s cash flow to repay its debt, and this limit was reached in some countries such as US & UK the last 2 years and you have seen the impact to their property prices when that limit is reached.

The better way to ensure our property prices increase is to see the real wealth of Australia increase, which means positive cash flow for the country.  So far we seem to struggle to do this over the last few decades, even during the greatest commodity boom this country has ever had, and I haven’t found any major economic drivers in Australia that can create massive difference in this area over the next 5 years. 

In short, I wouldn’t bet on residential property prices increase coming from positive cash flow from Australia in the near future, but it is in Australia’s national interest to continue to increase money supply and borrow from overseas to keep our asset value stable.

In other words, stability (or modest growth at best) is the primary focus of Australia, and many other debtor countries such as US & UK.  Any spectacular growth will be highly discouraged and intervened by their governments as it will shorten the time on their credit line required to rebuild their production capacity.

Should you still invest in residential properties?

The true value of a residential property is measured by the price of labor (e.g. wages), how much someone is willing and able to sacrifice out of their labor to keep a roof over their head.

For example, if you are a home buyer, you may be prepared to sacrifice 30% of your wages to pay for the mortgage for your home.  If you are a tenant, you may be prepared to sacrifice 30% of your wages to pay for the rent, etc.

So when you invest in a residential property, you can think of the property not as something with a price tag that may go up and down in value, but a right to secure the future sacrifice of someone’s labor.  This way regardless of whether the world is in inflation or deflation, or even when money becomes worthless in a country, you are always going to get a portion of someone’s labor that is meaningful to you in that particular environment at that particular time.

If you have only two options: investing in residential properties and not investing at all, I would definitely pick the first one.  Here is why.

1. The whole world has been fighting this global financial crisis by increasing money supply, this is in the middle of decrease of production, when you have more money to measure less assets, you will see asset prices on paper increase, just a matter of time.
   
   Just take a look at the last 30 years in Australia, we have modest inflation about 3% and ever increasing foreign debt, our residential properties are rising in prices in general, if you have left your money in cash for the last 30 years, you would have been so much worse off as they are losing value due to inflation and increased foreign debt.
   
2. The very minimum you will get from buying an investment property is to give yourself a manipulation-proof saving program, and you won’t be worse off.
   
   One of the advantages of holding a residential property is its inconvenience to sell; it costs a lot in taxes and fees and can take easily 6 months to complete the transaction.  This stops investors from thinking about selling the asset when they need the money. 
   
   This is the main reason why property investors tend to benefit more over longer term than investors who mainly put their money in other more liquid assets such as cash and shares.
   
   Money sometimes is like children, they will wander off to anything interesting unless you make it hard and painful for them to do so.  Hence money parked at residential properties tends to hang around longer, and the compounding effect on money over time can be extremely powerful in your wealth creation.

So what should you do as a property investor?

Coming off a very high leverage era which eventually led to the global financial crisis and the current severe recession, the sentiment of the financial world has shifted to more prudent and conservative lending and deleverage, regardless of when the current recession is over, lending will not be loose again for at least 3-5 years and possibly longer. 

In other words, the main driver of property price increase for the last 10 years, i.e. easy credit, will not be there to push property prices up for at least the next 3-5 years, you will see modest growth with higher yield as a result during this period.

During this period of modest growth, high leverage does not produce optimum return on your money; around the 60%LVR (Loan to Value Ratio) would be better than 80%LVR, if you purely look at the return on your capital.  You can always increase the leverage when the market goes back to higher growth (7-10%).

If you are unable to bring your LVR down to around 60%, you would at least make sure that your cash flow can cover your debt repayment so that you do not run up your mortgage balance.

This is a period when paying down your principle of your mortgage makes good sense because every dollar you pay down is a dollar you lend to the bank, and lending makes more money than borrowing when there is little growth.

While there may be little growth over the next few years, you can definitely focus on getting better income from your properties.  One way to do so is to purchase an older property at say 5% rent, and renovate it to attract better tenants, I have seen examples that rental yield can go from 5% before renovation to 8.5% after renovation (including renovation cost as part of the purchase price), the renovated property becomes cash flow positive immediately.

The traditional buy and hold strategy is still my favorite as it reduces transactional costs and doesn’t take up too much of our attention to move in and out of the market, so that we can focus on what we do for livings, such as being a teacher, medical doctor, lawyer or business owner, and you can enjoy the benefit of this at your retirement age.

For those who can spare more time to do property transactions and love the deal making part of the game, you will find lots of property opportunities due to difficulty people are experiencing from getting finance or urgent need for money for whatever reasons.  In other words, you can make it easier for others to buy if you are selling, or you can make it easier for others to sell if you are buying, all you need is to keep an open mind and stay active in the market.

For those who have limited financial resources or may be forced to sell properties at inconvenient times, you might want to pick your price range carefully. I have noticed that majority of the property buyers and tenants in metro areas seem to handle properties up to $500k quite comfortably, the sub-500k market in metro areas seem to be more liquid than the more expensive properties (you will adjust $200k down for regional properties).

If you are a property developer who hasn’t gone through a credit challenge period in the past, you may need to re-examine your finance parameters before your next project.  There is still good money to be made in development, but you need to pay a lot more attention to acquisition cost and the speed of execution, it is more important than ever that you stay close to your buyers, investors and financiers.

Finally, regardless of whether property investing is your core business or just a side activity outside of your main work, it is important to remember that we are in challenging economic times, and whoever loses focus on what they do will find themselves in difficulty very soon, so this is more so the time to do fewer things, but do them well.


This article was written by Bill Zheng, founder of Investors Direct, an award winning Mortgage Company specialized in strategies and finance for residential property investors since 2001.  Investors Direct is the finalists in the 2008 Australian Mortgage Award for Brokerage of the Year (Over 12 Staff Category) & Best Customer Service from an Individual Office.