no boggle eyed spittle spraying please, page-50

Lord elpus,
I did not think you fully grasped the implications of price expectations and my comment that property investors are effectively operating a margin loan (ML). This will clarify.

Australian’s love there property. There is a philosophy that roughly goes “dont buy shares (too risky), rent is a waste of money, buy some property, cant go wrong, safe as houses.”. They also believe at best prices grow exponentially and at worse prices go flat or slightly negative in some pockets (but never nationally). These are the fundamental underpinnings of the price expectations. These expectations have been built over decades and are, to be fair, based on the actual data. Add negative gearing to these price expectations and you have potential trouble. You know how it works – negative gear one property, obtain some capital gain, use the additional equity to buy another etc. 1 becomes 2, 2 becomes 4 and so on. The tax man is paying for part of your investment etc. As long as prices do not fall nationally then things are fine.

The problem is if the asset does go into decline on a system wide basis. The exact philosophy that allows you to grow the property portfolio (as outlined above), then works in reverse. Instead of using debt (and the tax man) to grow wealth, the process reverses so that the debt is being used to destroy wealth. So if price expectations ever become negative in any meaningful way there will be a fall out in the property market that has never (and I mean never) been seen before.

My previous post drew a parallel between negative gearing on property and shares (via ML). A ML allows you to borrow a set percentage against a share (max 75% for big companies and less for smaller ones), just as a bank lets you borrow a set percentage against a property. A ML provides a capacity to triple your exposure to shares through debt and thus a capacity to triple your capital gains and dividends. Great if shares are rising. It will destroy you if shares fall in price substantially as everything goes into reverse. You will undoubtedly have seen the fallout recently. Faced with a margin call (debt exceeds 75%) you either inject new equity or sell some shares to repay debt. I will lay you 100 to 1 that the vast majority inject new equity because they wont sell at reduced prices. This is fine if prices recover, but usually more margin calls come and eventually close to 100% of the shareholders initial equity can be wiped out.

The same can happen for property. Yes, shares are more volatile and can fall much more rapidly than property. But there are factors in property that can add to the systemic risk of negative gearing property. The first reason is MLs use 40-75% max gearing (depending on stock, whereas banks will lend 95% on property. The buffer is thus far less for those that aggressively negative gear property. My observation is most do – ie maximise the tax deductibility of interest and get the tax man to pay for the asset etc. I accept you wont get a margin call with property and banks will accept your negative equity on their books as long as you keep up the mortgage payments. As long as vacancy rates remain low and properties are tenanted at reasonable percentages, then mortgage payments get made. But what if vacancy rates or interest rates rise? You cant assume nothing bad will happen to your repayment capacity over a lengthy 5-10yr property downturn.

My 2nd reason is the lack of diversification in property. Most property investors invest locally, some interstate. Run a share ML with one exposure (ie Eddy Groves - ABC Learning) and you are asking for trouble. Conversely, establish positions with numerous companies with global exposures provides diversification that reduces risk with negligable effect on returns.

I am not trying to turn this into a shares vs property debate. Just pointing out you should not console yourself that property is systemically less risky than shares because of reduced volatility. Property has its own set of problems (1-2 above) and unique risks that you need to be aware of. Its the awareness I am seeking as I have found that few property investors even understand their true risk exposure. Property investors dont even comprehend that they are effectively operating a ML. Did you?

Its easy to think you are smart enough to get out before the wealth destruction occurs. The opposite is more likely as the knowledge of past price cycles will lead many property investors to add to their positions. Unknowingly, the investor will leverage further (or use much needed equity) into a loosing position. This compounds their future negative equity position when prices fall further. Investors can sell some properties to improve their balance sheet and repayment capacity, but that compounds the negative price trend and negative price expectations. Expectations build that further property will be sold by unwilling sellers and eventually, it becomes self fulfilling. Prices fall because people delay their planned purchases.

Will the Reserve Bank save the day. Yes they will if this is the only issue in town. They set the cash rate based on their assessment of inflationary expectations (of which house inflation is one). But there is rarely ever only one issue in town. What if food prices/petrol/transport costs/mining labour costs are inflating substantially while house prices are deflating? Monetary policy options could be constrained and then the only hope is fiscal policy. The Government will undoubtedly do something. But will it be enough? Turning inflationary expectations around is not easy. How many rate increases has the Reserve implemented to try and reduce current price expectations and over what length of time?

The Reserve Bank is setting interest rates today, based upon todays price expectations (which are about future prices, not todays prices/inflation) and where they think the economy will be in about 9 – 12 months time. Thus, a rate rise today will show thru in the economy in 9-12 months time, but will also reduce todays inflationary expectations. These expectations are not directly observable and thus the Bank uses proxies (wage demands, latest CPI, house prices etc). I tell you this to indicate the complexity of dealing with price expectations and thus caution those that believe they will exit the property market before wealth is destroyed.

You look like you do your homework which is good. A wealth destroying scenario is well off given the stage we are in the price cycle. However, I personally would be very cautious when adding to a negatively geared portfolio in a declining market. You have to be absolutely certain you can sustain a loosing position until they do(ie stress test on very high vacancy, 3% higher interest rates etc). Forced or even reluctant sales are a no no because your losses will be magnified by the gearing factor.

I have been an economist for 20 years and shut my ML down long ago. I think I understand the economic ramifications of the subprime crisis more than most on HC and advise extreme caution. If given a choice between the 70's supply side shocks (oil prices/inflation/unemployment etc) and the current finance shock - I would take the supply side shock any day. Capitalism can work thru 70's like problems, it has greater difficulty when money flow is inhibited. Whats the saying - "Money makes the world go round." The exact portfolio unwinding effects I have described for MLs/property above is happening in debt markets right now and it is a big time crisis situation when banks start not to trust each other. Trust me this could (emphasis could) get scary in a way it has not yet.

Minor comment – Population growth was the last thing on my mind when I raised the issue of a sequence of dirty bombs explosions in major world cities (unsophisticated nuclear bomb) and human to human transfer of bird flue. It goes to where people will choose to live (rural vs city), where businesses will locate long term and a whole host of ramifications that I don’t even like thinking about.

Sorry about the length of reply. You are the beneficiary (maybe not) of my having a 35 year long friendship with someone who is a massive property investor. I have verbally tried to get him to comprehend his risk to no avail. I've read his books on property he has sent me and they have an incompetent treatment of risk. I've decided to put it in writing (he lives interstate) so that he can read it 20 times (at my insistance) and the above forms most of my email to him. His understanding of issues is less advanced than yours as he assesses his rental yield using the historical cost of the property. Yes, Ive got work to do, but 35 years says it is warranted.