A proper, real downturn hasn’t happened for quite a while.
We’ve had some hiccups over the last 20 years but each of those corrections were short lived and didn’t have all the characteristics of the market downturn we see today.
Dorothy’s famous words in the Wizard of Oz,‘Toto, I’ve a feeling we aren’t in Kansas anymore’, seem rather appropriate right now. It is not just one or two things happening – there are several and with downturns, the more factors pushing in the same direction, the longer and stronger that downturn will be.
My history of trying to explain what is likely to happen next in the real estate market is pretty average. I predicted this market downturn 10 years ago. Trouble was I thought it would happen within a couple of years of the GFC. That makes me off target by at least 9 years. So rather than make predictions, let me tell you some of the things happening in the market that we haven’t seen for quite some time.
The ‘Just Made It’ Price
In booming markets agents talk about the new record price they just achieved. You won’t hear too many of these stories anymore.
Now agents are talking about sales that they were lucky to put together. I experienced it firsthand this month while auctioning a property in Turramurra. We calculated all the numbers correctly. We only relied on sales that had exchanged in the last 3 months (anything older is no longer valid in a market that is coming off). We were impeccable with our analysis looking at every property sold, comparing land size and slope, house size and condition and the closeness of each to the railway station. Our numbers came back to $1.5 million, maybe $50,000 more, maybe $50,000 less.
There was one property though that had sold for a lot more than we expected, $1.74 million. It was an outlier as they say, well above all the other sales. We talked to the salesman but couldn’t find out why it did so well other than the ‘salesman’s personal brilliance’.
On the day of the auction we found out the neighbour was interested. The result was that we passed the property in to the neighbour and negotiated a sale price of $1.65 million which was well above our estimate. So we were wrong with our calculations?
Turns out no.
A couple of nights ago at an awards night I was talking to another real estate agent who I discovered owned the agency that had sold the property for $1.74 million. I asked what the story was. They had a buyer who had to buy having already sold his home. All the other buyers were around the $1.55 million.
In his words had they not found this one-off buyer they would have sold it at $1.55.
These are ‘just made it’ sales, sales that make the market look better than it is. Agents call them ‘just made it’ sales because they know that regardless of all the care and effort an agent can take to make a sale process a success, you also need luck. We had a neighbour bidding and the other agent had a buyer who didn’t know what he was competing against in offers and had to buy. These sales prices only happen in markets that are falling quickly. Their existence and frequency are short lived. Just like a wave coming into the shore, if there is no depth in the market, no volume of buyers at that price, the wave crashes. And people who ride it in thinking it will last a bit longer get hurt. My clients did well, but it was by the Grace of God.
7% Mortgage Interest Rates
No, you haven’t missed an announced increase in interest rates, but then again, unless you recently put in an application for a new mortgage, you wouldn’t know.
The major banks may be lending money to buy property at less than 4% but when they are assessing your ability to repay the loan, they are doing their calculations on 7% interest. That’s means new borrowers must be able to afford an increase of a third in repayments without getting in to trouble.
And this jump is relatively recent. Mortgage brokers are advising clients to get their loan approvals renewed even if they already have an existing approval in principle. A number of buyers who have gone down that path have been told that amounts they had been approved for previously are no longer available.
This change in bank lending has nearly the same effect as an interest rate increase but avoids all the bad publicity and negative consumer confidence. If it had been announced, you would expect the market to crash, everyone would. But because it’s not announced and only there in practice, its effect on the market will take longer to filter through. What we are seeing now is buyer numbers shrinking. First home buyers and investors numbers are evaporating.
Real Cost of Living
Like the interest rates stress testing, the banks are also applying more realistic estimates of what it costs a borrower to live on each month. In the past, banks used a figure called the Henderson Poverty Index to calculate what you needed to live on each month.
To give you an idea, if you were a couple with two kids, you needed $2,726 a month to live on. So, if you had a combined income of $10,000 a month after tax, the banks worked on the idea that you could repay $7,274 per month. APRA has put a stop to this and now the banks must allow a lot more as their cost of living estimates. The less you can pay in mortgage repayments, the less you will be allowed to borrow.
We asked Macquarie Bank what effect this would have on lending. Their answer more than accounts for the drop in the market price of property. Where banks would have lent $1 to a borrower who was going to live in the property, they will now lend 85 cents and if the person is an investor, they will only lend 75 cents.
Remember, a property is only worth what someone can borrow to buy it.
Part of this change has come out of the banking royal commission with banks knowing that they will be questioned about their lending practices. The concern the Royal Commission and APRA have isn’t so much about banks refusing to lend to people but that they lent to people who could not afford to repay the money. That is what triggered the GFC in the US, people getting mortgages with repayments they could not afford to make.
The higher interest rate test and the higher estimates of living expenses are significantly reducing buyers’ amounts they can borrow. And the less people can borrow, the less they can pay for a new home.
The Royal Commission
This commission could change the rules permanently. It will play out to the public in very clear, emotional and practical terms describing how borrowers borrowed more than they could afford and lost everything as a result, be it farmers, small business people or property investors who fell prey to any number of property investment promoters.
It is not that I think the Federal government will introduce a raft of new laws. They probably won’t but that won’t matter: APRA and the RBA are just as much under the spot light and they will be watching very carefully for banking and lending practices that they need to jump on. The Commission has the power to make people testify and make the banks admit to what they have been doing. Without the commission, APRA and the RBA, like every other police force, could only ask questions. They couldn’t compel people to answer and as we have seen in the case of AMP, even when they did answer, those answers weren’t always as truthful as we would hope.
APRA has sent a letter to the various banks titled “Embedding Sound Residential Lending Practices”. The new guideline recommends lending maximums of 6 times annual earnings. Over the years this 6 times income compared to borrowings has actually been a pretty consistent ratio. That is until 2011. With low interest rates, banks have allowed that ratio to grow to closer to 10 times for Sydney houses. Borrowers are getting into massive debt and it’s this indebtedness that I think is our biggest problem.
When I wrote that newsletter 10 years ago saying that we would have a significant property correction very soon, I thought that households couldn’t get in any more in debt.
Boy was I wrong.
Growing markets require people to believe that there is still more upside in the future, more potential, more things that will improve in the future than go wrong. Over the last 10 years we’ve had low interest rates, an economy that has kept on growing and state governments putting money into infrastructure creating a building boom. All this has been keeping people feeling positive and borrowing more to buy more property. That sentiment is changing.
I suspect the banks and the organisations want the same thing, to have the amount of indebtedness that households are carrying reduced. No one wants a crash.
Our country is trying to slowly deflate the debt bubble without it bursting.
Bernard Shaw said, ‘If all the economists were laid end to end, they’d never reach a conclusion’. You will hear over coming months (and I suspect years) a lot of differing opinions on how this market will pan out. I’m not an economist but I’ve reached a conclusion. I don’t think an average new mortgage can be 10 times the average earnings of the person who wants to borrow it. There is no formula that says this is economic law but if you have a 20-year mortgage then you will need more than half your income to cover the loan repayment. Could you convince the bank that you don’t need more than half your salary to live on day to day?
But then again, we could keep increasing our borrowings until the average mortgage is 12 times or 14 times the average income. After all, I’m the guy who said in 2008, ‘This market can’t keep going up’.