Property assets – no room for speculation, so rationalise now

Most investment advisers would – and should – urge their clients to carry out an annual “health check” on the performance of their assets, even when conditions are buoyant. The unfortunate reality, however, is that many property investors don’t give a thought to this issue until they hit a rocky financial patch and need to regroup.

Increasingly, I am seeing evidence that this is beginning to happen largely as a result of sharemarket volatility and the impact of rising interest rates.

At times like this, what often follows is a wave of sub-optimal assets being “dumped” on to the market with indecent haste, along with some better-quality stock that has been put into the “must sell” category without being given an adequate chance to demonstrate longer-term performance.

In mid-February 2008, we are already seeing higher stock levels coming on to the autumn market. Last week up to 1000 auctions were listed each weekend in Victoria, a big jump on the 500–700 expected on an average week last year.

The latest figures from the Australian Bureau of Statistics tell us that there was a record influx of investors into housing in 2007, with national borrowing for this purpose hitting $75.4 billion. These figures suggest that the combination of a sharemarket that surged for most of 2007, the Federal Government’s promise of large tax breaks on extra deposits made into superannuation funds and the lure of rising rental property yields proved irresistible, and investors poured funds into all three areas, often borrowing heavily to do so.

However, by year’s end there were two key factors spoiling the party plans for some investors, particularly those who had borrowed heavily to fund a raft of what turned out to be less than winning investments.

The first was the sharemarket correction – which is ongoing – and caused some investors to take a direct hit when margin loans were called in. The second, which is a strong theme in questions coming to me via Eureka Report, suggest underlying fears that rising interest rates are stretching already highly geared investors. Finally came the spectre of investors having negative equity (owing more than the market value) in second-rate properties for which they had paid too much, and borrowed too much to buy.

It is also hard to ignore what I believe is a growing influence on why so many investors are facing the prospect of having to sell assets – both first and second rate – and that is the crippling levels of personal credit debt. The Reserve Bank has been quick to allude to this and its latest look at credit card debt alone placed outstanding balances at about $41 billion. I have to wonder whether so many investors would be in such dire straits if their credit cards weren’t so seriously “maxed out”.

The investor buying frenzy I have alluded to, and which is now being confirmed via the Bureau of Statistics data, is a dangerous climate for the gung-ho novice in search of “bargains” and short-term profits. The greatest danger in 2007 was to have bought “anything” on the basis of rising rental yields at the expense of proven capital growth factors. The 2008 market will almost certainly reveal the folly of this speculative approach. The key is to realise that investing in property is a long-term, location and asset-specific investment.

The first step is to assess the property’s current capital value. Within this process, investors who have held an asset for a short period of time (less than three years) need to add the entry costs such as stamp duty and conveyancing, as well as the exit costs such as agents’ fees, legals and capital gains tax to the equation.

It is not unusual for inexperienced investors to have an over-inflated idea of how well an asset should have done after only one or two years, especially in a market that has been buoyant for some time. This is particularly the case when investors see data that suggests property in their particular investment location has achieved high annual increases and the assumption, therefore, is that all property in that precinct must have performed at this level.

This is simply not the case. Unless the investor has kept in very close touch with the market and constantly assessed current capital value – by tracking sales results for three to five directly comparable properties on a regular basis – then they are in danger of making incorrect assumptions and judgements. The key benchmarks are that a property should double in value every seven to 10 years and its growth must exceed inflation over the life of the investment by 6% to 8% on an average annual basis, provided it has been held longer than three or four years.

Remember too, not every area shows the same level of price movement at the same time. If a property that is not strictly in the high-growth, high-land-value precincts, but has shown some genuine, sustainable capital growth over the longer term, then it may mean it is still a worthy investment, but will display a slower growth journey.

If this is the case, then subject to an independent assessment of the asset, it may be worth holding the original asset, unlocking some equity and redeploying the funds into a better-performing asset, and not losing the long-term capital growth potential. Investors should also explore options such as whether a modest amount of value adding – such as recarpeting or new paintwork – may attract a higher market rent to ease the holding costs.

It is when investors have based their original purchase solely on rental yield at the expense of underlying growth potential that the resale bombshell can hit hardest. This often happens where rental guarantees and tax breaks have been a strong attraction or when investors have opted for assets in more affordable, lower land value, “bargain” locations and have felt secure about the consistent and rising rental yields fuelled by a growing housing shortage. The income might have been rosy for a while, but the resale value is often quoted as being lower than the original purchase price, even before the add-on entry and exit costs have been calculated.

This scenario is also the subject of many questions I receive. Subscribers want to know whether to dispose of a poor performer now and redeploy their funds to a better asset or to hold off in the hope that the area they bought in might suddenly turn into a “gem” and show a price jump in a few months time as housing shortages begin to bite even deeper.

The bottom line is that if the growth and current market value of an asset has shown little or no propensity for longer term capital growth using the key benchmarks – especially over an extended period of such strong growth – then, unlike the high or medium growth asset, there is no magic bullet that will change its fortunes.

In this instance, don’t go on wasting valuable time and money: sell it sooner rather than later. The lost growth incurred by holding speculative, low-growth property will far outweigh the short-term pain of a smaller capital loss.

The article first appeared in The Eureka Report