When Market Crashes, Who’s Crashing With It?

60-Minutes has released an episode about how Australian property market will crash. It’s not IF it’s going to happen, but rather, WHEN. That episode has drawn a lot of attention (obviously), as most people either invest in or own properties. And not just that, imagine the ripple effect towards Australian economy in general. 

Some people label it as fear-mongering and choose not to believe it, but some actually do believe. Either way, based on historical data, market correction always happens. And when it happens, prices will drop. I remembered a good quote about shares investing which it said, “A company’s shares is only worth by how much people are willing to pay for it”. How also true is that for property investment?

What drives property price is supply and demand, basically, it’s how much the buyers are willing to pay for the properties that are selling on a particular area. Bubble or not, nobody knows. As long as there are buyers who want to buy a particular property at a particular price, so will it become the price of the similar properties in the area.

So, what’s causing the market to crash then? Is it the property prices that are getting too expensive? Like I mentioned earlier, as long as there are buyers who are willing to pay for it, no one can say it’s too expensive. What’s causing market to crash in my opinion is mortgage stress. Humans are humans, there are always greed and fear. We often bite more than we can chew. We buy first and worry about the repayments later. People are always jumping into the money bandwagon ie. where the money goes, so go the people. And many will do anything to get a slice of that “promised equity”.

The problem is, in NSW and VIC especially, property prices are very-very expensive. If you go to realestate.com.au and look at their heatmap, literally 40kms radius from the CBD, property prices are in the $800,000+. That’s just crazy! I for one wouldn’t live further than 20kms let alone 40kms+. I would say I’m lucky I live in Western Australia where there are still a lot of $300-500k property within 20kms radius. But for NSW and VIC, my God…are they expensive!

Let’s take a $800,000 Principal-of-Residence (PPR) property. Let’s say you have 80% loan on it eg. $640,000. At 4% interest, your annual repayment would be $25,600 = $2134/month. And you would need to pay this using your after-tax income. Then on top of it you have annual water rates, land tax, etc. So before you know it, property expenses alone are around $3,000/month. Depending on how much you earn, to some people this can represent 30-50% of their household income. That’s very risky. And this is if you own an $800,000 house. Imagine if you own a $2-3mil house, which in NSW and VIC are not a rare occurrence, the mortgage stress risk will even be higher.

What if you have an investment property and receive rents? I for one won’t buy an investment property for more than $500,000 simply because the risk of negative cashflow is too high otherwise. You can argue all day long about the capital growth and such. But, betting on capital growth alone is very risky. If you can’t service the loan, you’ll be in trouble. How much do you think a $800,000 can rent for? There is only so much a renter would be willing to pay. Unless you start getting creative ie. renting it per room, etc then the yield would be very small, thus, your negative cashflow will be too great, so much so it puts a lot of pressure on your monthly repayment.

As soon as someone is going through a mortgage stress, he/she will no longer be able to see the “light of capital growth”. Why? Because capital growth is all “on paper”. It’s not liquid. What’s liquid is, your monthly repayment. That’s what you can feel straight away. And when this happens, people begin to get worried and wanting to get out straight away. Thus, start selling properties at cheaper price. This is when crash happens.

Now imagine the snowball effect. People around the area will start noticing their neighbours are selling their properties at a lower price which they have paid $100-200k more at the start. This would be a psychological blow and causing people to be in fear. When fear grows, panic grows. When panic grows that’s when crash happens.

So, in this opportunity I would like to share with you the type of investors/owners who will be mostly affected by a crash, and how to mitigate the risks ourselves.

THE MIDDLE CLASS

Who are these people? These are the ones who bring in 6-figure household income but also live in a relatively-high lifestyle “on loan”. They’d be driving in BMW and what not, but not fully paid off. They would live in a $800,000-$2mil house but  have 80-90% mortgage on them. They may own investment properties but all of them are negatively geared. I had friends who bought a $600,000 investment house which was rented only $450/week at the peak of the market! Now the rent went down to $350.

They can be a small business owners running a consulting or service businesses. When market is good, they can be paid high hourly rate. But when market is slow, their rates would have to go down a lot. This happened a lot in WA during the mining downturn where they used to charge $150-200/hour, now they can only charge $60-70/hour. As soon as interest rate goes up, or their employment becomes unstable, these people would be the ones to experience huge level of stress.

Basically, the repayments on mortgage will be very high, 50%+ of their household income.

THE NEGATIVELY-GEARED AND THE NEGATIVELY-CASHFLOWED

How many times do people buy property with the pure basis that “it will double in value long term, and, you can also offset your tax”? The problem is, if it keeps bleeding money out of your pocket, you’re running a losing business there. And eventually, you’d be running out of cash.

When the interest rate goes up, this can push you way even further down in the red and people who own this kind of properties would be experiencing a lot of mortgage stress.

HIGH-RISK AREA PROPERTIES

Properties in mining town and regional areas have a very high risk of collapsing in value. The reason is, as with properties in general, price is often determined by population and job growth. And as soon as there are no jobs, which in the case of a mining town, as soon as the the mine closes and the project is finished, the population and job growth will quickly fade away. In this instance, you can see a property value slashed by at least 50%. That’s just madness! And not just that, the rent price will quickly fade away also and it would just leave your investment properties down in the super negative cashflow territory.

COMMERCIAL PROPERTIES

Commercial properties are only as good as there is someone willing to rent. Yes leases will be longer, but as most of the renters are small businesses, the chance of them collapsing in the first 5 years is great also. During market downturn (such as in WA, during the mining downturn), a lot of small businesses couldn’t survive. Thus, leaving the vendors in limbo with their rent income. Thus, if you have a lot mortgage remaining in your commercial property, you’re in it for trouble. Not only will you find it hard to find the next tenant, even if you do, you might have to reduce the rent price by quiet a lot. Thus, reducing your cashflow.

MITIGATING RISKS

So, what can we do to mitigate the risks of market correct or collapse or whatever you want to call it? I’ve got few strategies:

1. Buy positive cashflow property. And I’m not talking a regional property where you would receive super high cashflow, but I’m talking about a normal passive investment property which you can receive positive cashflow after your tax return. Even better, as interest rate is at record low, if you put in a bit more deposit eg. 20%, you can potentially get a positively geared property.

2. Don’t buy high risk properties. Or at least if you do, milk it during the good times and have the courage to sell as soon as you sense the market is about to have a correction. Just because you’re milking it currently, you’d be thinking it will always do it for you in the long run. These high risk properties only exist for a short period of time, and you have to keep monitoring it to ensure job growth still exists in the area.

3. Don’t buy a property that costs you too much. Keep the mortgage repayment of all your properties to 30% of your household income (inclusive of rent income). Remember, interest rate can always go up and you have to be prepared for it. If it goes down, treat it just like a bonus.

4. Have a buffer account. Always save for a rainy day. When money is good, things are easy. But the season is not always sunny everyday. Sometimes it becomes windy and rainy. Ensure you have at least 6-12 months worth of money staying in that buffer account to cover all your costs.

5. Don’t live beyond your means. The middle class always have the tendency of showing off with all the luxury stuff. The thing is, nobody cares. I used to be the same person whom thinking too much about what people say about me and all the stuff I have. I have now found out that no one actually cares. No one actually cares what cars I drive and all. If anything, it’s me who is carrying the burden of the loan and stress!

CONCLUSION

Eventually things will bounce back. The thing is, it would take years before it does. So, until then, you have to have enough buffer and mitigate the risks as much as you can. As for me, I like it low risk. Who cares if I’m not making millions of dollars fast, as long as I can live my life with a lot of peace.

I love my life, my job, and I have passive investing on the side which I know, through it, combined with the super I keep building, by the time I retire, my financial future is secured. I ask nothing more of this life.