Unreal Estate

It’s estimated that as much as half of the world’s wealth is tied up in real estate. The value of the world’s real estate far exceeds the market capitalisation of all the world’s stock markets, futures markets and bond markets. Vast fortunes have been made and lost in real estate, more than a third of Australia’s super-rich derived a substantial amount of their wealth through real estate, a figure exceeding any other individual investment category including shares.

OTOH, it’s likely that more money has also been lost in bad real estate deals than in any other asset class. The collapse of most banks over the last century can almost invariably be traced to unwise property investment. And the suggestion that there is anything in common with the way the rich list got wealthy and what ordinary investors are trying to do at the peak of this property cycle is absurd.

One of the reasons the Reserve bank won’t reduce interest rates is because they fear lower rates will continue to fuel the rise in real estate prices and add to the unprecedented levels of debt to finance residential property investments.

Again I am indebted to Travis Morien for much of the information in this blog.

For most people the appeal of real estate is not a rationally considered option based on economics, it stems from the simple fact that they can touch their investment. Amateur investors seem to be always wary of pieces of paper, certificates and share scrip. The reassuring physical presence of a property is enough to catch many people off guard. Rather than assessing an investment based on how much cash it will produce compared to how much it costs, your average punter prefers to base a decision on what it sounds like when you whack it with a stick.

The biggest drivers of real estate prices are population growth and inflation. All else being equal prices can’t continue to grow indefinitely at a different rate to the rate of inflation, because if they grow faster than inflation for an extended period, real estate becomes unaffordable. A similar argument says that it is unlikely that property prices would lag inflation for long because eventually demand increase pushes up prices. So between the limits of unaffordability and absurdly low prices there is an equilibrium, determined by supply of new housing and demand that keep prices in real terms roughly stable.

Capital gain primarily comes from the land component of the purchase, so those who expect too much capital growth from buying densely packed units, are going to be disappointed.
Historical data on property prices is hard to come by, and most measures in common use are flawed. For example many people use median house prices as a guide, but this is not a good estimate of profits because median house price tables don’t take into account improvements over the years. A press report recently revealed that the average renovation loan was of the order of $74,000. It would be nice if there was some sort of index of property prices that corrects for capital inputs like new driveways, swimming pools, granny flats and other expenses, but unfortunately there is no such thing. Therefore median house prices paint an overly optimistic picture of price growth.

Have you ever met anyone who has lost money by buying real estate ? But how many ‘investors’ take into account the buying and selling costs that add up to about 8% of the purchase price? Who calculates the affects of inflation? What about capital gains tax? The recent alterations the method of calculating CGT won’t disadvantage many until inflation increases again, then it will be interesting to see the devastating affects of higher interest rates and reduced capital gain. Too often the amateur confuses “I’ve rented property all my life and therefore I understand the general concept of a rental property, at the seminar they told me houses go up a lot and that you can save tax!” with “I understand the business of purchasing and managing a real estate property and tenants, am familiar with my rights an obligations as a landlord, can understand the market forces that drive prices, know a thing or two about mortgage finance, know how the tax system works, understand the strengths of weaknesses of property compared to alternative assets and am prepared for the constant paper work and occasional hands-on involved in property management.”

Since the Defence forces moved to Darwin in the early 90’s, one of the most sought after investments has been renting a residential property to the Defence Housing Authority (DHA). The offer appeared to good to be true (where have I heard that before?). Guaranteed rent for up to 12 years, even if the property was unoccupied, minor repairs done by the DHA; just sit back and enjoy the benefits of negative gearing. Every man and his dog got into the deal; I am aware of one policeman on an average salary who bought 5 properties along side each other in Baygon Heights.

Starting in the late 90’s real estate prices fell for about five years running. Not much, 3% one year, 5% another, perhaps a bit more in some areas, a bit less in others. The result was that DHA reduced all the rents paid to landlords. Unfortunately the guaranteed rent contracts didn’t specify the quantum, simply that an amount would always be paid. This reduced the already low levels of income from 4% to less than 3%. Then, when the borrowings had to be rescheduled, because the income was insufficient to service the loan, a registered valuation showed that prices had fallen from 15 to 25%. Because of excessive demand buyers had paid too much; about 10% too much, price deflation took care of the rest. Still no one complained;

“real estate is a long term investment, right? I’ll just hang in there and wait for the inevitable capital gain; in the mean time the tenant and the taxman will pay off the investment”.

Let’s just have a closer look at this example. Assume that the purchase price was $300,000, (i.e. about 10% too high – it should have been $270,000). Purchasing costs were about 4% or $12,000 so the cost base for CGT is $312,000. The bank financed 90% ($280,000) and the investor put in $32,000. When the property was revalued at $203,000 the bank demanded the investor put in another $50,000 to maintain a loan to equity ratio of 75%. Why the reduction in loan to equity ratio? The bank considered the deal much higher risk as a result of the decrease in property prices. What the investor ended up with was servicing a $230,000 loan from reduced income for a property in which he had negative equity. Amazingly, he still thought he was doing all right tax wise because he got a huge tax refund every year. He obviously doesn’t understand negative gearing.

The main reason investors can end up like my mate above is that real estate, unlike other major investment classes, is not regulated by authorities such as ASIC. Unlike what is expected of a licensed investment adviser, there is no legal obligation for a real estate salesman to make sure that the advice given is appropriate to the particular circumstances of the client or that the commission or other incentive payments are adequately disclosed. Very, very few real estate agents are licensed investment advisers. Real estate is a sales profession in the same way as selling cars. There are honest and hard working salesmen out there (both in real estate and autos), but your legal protection is about the same and extends only as far as the really dodgy stuff with the Trade Practices Act and similar legislation. What passes for investment advice in real estate is usually a sales pitch. The same can be said of many financial planners, but real estate people take irresponsible advice to a higher plane. Some of the industry’s harshest critics come from within their own ranks.

Most people in the real estate wealth building crowd aren’t even licensed real estate agents, they are essentially unqualified marketers. I can’t go around teaching people about shares without being a licensed adviser, but anyone can put on a ‘future millionaires seminar’ to a packed audience even if they know nothing about real world property investing and have a criminal record for fraud and multiple bankruptcies. Real estate agents are pretty sus as a group, but even worse, many really high profile property marketers aren’t even real agents! If you want to buy $500 worth of CBA shares you must do so from a licensed sharebroker who is legally required to obtain sufficient personal information to establish that this investment is appropriate for you. Anybody over 18 can buy a $500,000 property without any advice whatsoever. And the CBA will probably lend $350,000 based on a valuation made from the footpath.

Because real estate is not regulated, it is the most dodgy investment sector this side of speculative futures trading. Gurus come to town and play to packed audiences teaching them the ‘secret’ techniques of wealth building, including ‘no deposit’ real estate strategies in particular, but also a bunch of imaginative stuff about buying property for cents in the dollar from ‘motivated sellers’, buying property with vendor finance and lease options. The vast majority of the advice given at these seminars is false and misleading, but ASIC doesn’t have jurisdiction, only Fair Trading – and they are extremely slow acting. If a licensed investment adviser got up and started telling people to borrow to the hilt to buy any other investment (including property trusts), he would be banned for life, but not a real estate promoter.

Where will it all end ? Much like superannuation I suspect. If the average punter continues to risk his hard earned without a basic understanding of investment principles there will always be some one poised to take advantage.