If you're confused, uncertain and even frightened about the property market in Australia, you're not alone. Most investors feel that way. They also feel angry and even betrayed.
During most of 2008, property investors across Australia didn't fair too well, some couldn't sell their properties at the right price to exit, others couldn't refinance on a good valuation to get out of their existing mortgages provided by those defunct non-bank lenders. Many developers couldn't sell their stocks or obtain proper development finance, and you name it.
We've seen some relief, in the first few months of 2009 at the low-end property market due to the first home owner grant and lower interest rates. We all know this won't last, especially when Australia is officially included in the 'Great Recession' by IMF.
I believe that in tough times you should revisit your strategy, purpose and assumptions continually - especially when you're experiencing resistance or frustration of any kind in the accomplishment of your investment and lifestyle goals.
Now more than ever, it's especially important that you anticipate market shifts, control risk and create powerful strategies that move you in the direction you want to go.
1. Re-position your leverage level on properties
The current recession is mainly caused by financial crisis, a good percentage of the economic growth and asset value have been contributed by over-leverage. Deleveraging across the world will see credit tight for many years to come, even after the economy recovers. Hence we will see tight credit markets for at least another 2-3 years if the IMF's prediction of the global economy recovery late 2010 is correct.
You should consider at least 3 factors when you look at leverage:
1. Return on investment: this is comparing your deposit money sitting in a bank vs. being invested into a property.
2. Safety: this is to avoid negative equity or loan recalls.
3. Your own circumstances: how close you can achieve the ideal leverage level.
Ideal leverage level:
• If residential property prices were going up at 7-10% each year, higher leverage (such as 80% or above) will give you higher return on your capital invested and still relatively safe.
• If residential property prices were to be flat or even slightly down each year, lower leverage (60% or below) will give you a higher return on your capital invested and it is also safer to keep your leverage lower.
In my opinion, our current property market trend is likely to be suitable for 60%LVR or below if your circumstances allow you to do so.
If you must stay at higher leverage, your income should at least allow you to pay down your mortgage principal on a monthly basis. Because paying down your mortgage is similar to lending your money to the lenders. The lender is paying you the interest rate your mortgage is costing you; you have effectively become a lender. Lenders make more money than borrowers in a deleverage economy.
Many people are concerned about lenders recalling their mortgages if they show negative equity. For most private property investors and homeowners, negative equity will not be the main reason why the lenders would recall your loans. Lenders would usually recall loans when the borrowers fail to make repayments.
However if you are one of those property investors with a very large property portfolio or run a business with credit facilities with the same lender, you may want to separate the business credit facility from your mortgages and reduce the exposure to a single lender. This can avoid the unnecessary risk of your mortgage being reviewed by the lenders at an inconvenient time.
2. Re-set your minimum cash reserve
Cash reserve is not a new concept to most property investors; most of us know we must have them to cover our rainy days.
How much is sufficient is quite a personal matter, but the general idea is: how many months you would like your cash reserve to last if you experience severe loss of income and overrun of cost at the same time.
• Loss of income can be loss of your job & business income, default of debtors, loss or decrease of investment income such as rent & dividends;
• Overrun of cost can be increase of interest repayment from your mortgage, unexpected expenses.
One thing worth mentioning is mortgage interest rates. We are around 5-6% at the moment; the average mortgage interest rate over the last 30 years is around 10%. So if you don't fix your interest rates, you may want to add another 5% to your current interest rate to calculate your debt repayment.
Many property investors leave their cash reserve with their Line of Credit, because most the Lines of Credit offer the flexibility to not make any repayment as long as the limit has not been reached.
Line of Credit can potentially present a problem for you if the lender decided to freeze it due to a drop in your property value or simply lack of credit available. While this hasn't quite happened in Australia, it has definitely happened in other countries such as the United States.
In such cases, you will lose your cash reserve overnight without warning, so the better alternative is a Redraw with an Offset account, and keep your cash reserves in the offset account.
The aim of a cash reserve is not to cover your cash flow short fall forever, but only temporarily. Hence the strength of your cash flow has a lot to do with the length of the coverage.
For example, if your cash flow is positive and very unlikely to be reduced, then you may want to consider a 6-month window for the worst-case scenario. But if your cash flow is negative or very likely to be discontinued, then you may need sufficient reserve to cover quite a number of years or at least to the point you can safely sell the property at a price greater than your mortgage.
3. Re-establish better income status
Many property investors have been using low-doc or no-doc borrowing to acquire properties in the past, but this lending space has changed significantly since 2008.
No-doc loans are technically not being offered by any institutional lenders, low-doc loans are sitting at 60% with a few exceptions still at 80%. Overseas experience shows that it is possible that low-doc loans will be completely taken off the market soon, especially when there is not sufficient credit. Lenders would lend to the best quality borrowers, and low-doc borrowers are considered lower quality than full-doc borrowers.
Borrowers get into low-doc borrowing for many reasons, some due to employment status such as self-employed, others due to complicated financials, and we also see some borrowers simply couldn't be bothered to provide financials because the interest rates difference was quite small between low-doc and full-doc loans in the past.
The trend is that low-doc loans will be at a higher premium if they are still to be offered in the future. For property investors who are still actively acquiring properties, there will be financial benefit to get full-doc loans rather than low-doc loans in the near future, hence looking after your income status can become important in the next few years.
We have seen situation where a client who is currently a contractor being unable to refinance his loans from low-doc to full-doc, and some of his low-doc lenders have gone out of business. For him to take advantage of the current lower full-doc fixed interest rate, he needs to become a full-doc borrower again, which means he needs to go back to a full-time permanent job position with less income. However the mortgage repayment savings created from the refinance will substantially outweigh the loss of his work income.
4. Re-work your cash flow with contingency
Living off equity is one of the reasons people invest in properties. Many property investors have selected good growth properties and have been using the equity to cover expenses.
The potential issue with this is that we may get into a spending pattern that can be a bit out of control if we don't pay attention to it. When property stops growing for a while and finance is hard to get, we may get into a negative cash flow position with no end in sight.
Many property investors told me that they couldn't figure out where they have spent the money, but they only noticed that their money in the Line of Credit is disappearing faster than they anticipated.
Let's face it, most of us only act when we really need to, so there is no need to beat yourself up if you haven't taken the time to manage your cash flow carefully, but I do think this is the time to start doing it if you haven't already done so.
To manage our cash flow, we need to be clear about our income and expenses, and make sure that income is greater than expenses if you want to have positive cash flow or any surplus. Because we always tend to spend what we make or more, we will need to treat the surplus almost like the highest priority expense, so that you guarantee to have it.
The Superannuation idea is to 'force' everyone to put aside money we can't touch, because most of us cannot be relied upon to do so, especially when we have a family and the financial responsibility is divided between family members.
When responsibility is given to more than two people, no one is responsible; hence a group of two or more people looking after money will usually have little money left. Putting aside your surplus (or profit) before you pay any other expenses is probably the safest way to ensure positive cash flow, and you can always adjust your remaining expenses according to your income. It is not how much you earn; it is how much you can keep.
5. Refine your rules and policies on future property investment
When property prices have been on the rise in most areas most of the time, it is less obvious to many property investors to follow some sort of systems. A system usually consists of a set of rules and policies; a system is to be followed strictly during execution.
A good property investment system should have policies in at least the following areas:
• Policies on financial position and money management.
• Policies on market conditions.
• Policies on property selection & disposal.
Taking the time to define these policies can help you to review what has worked in the past, and what may work in the future, especially with all the changes happening in the market place.
6. Re-define your circle of friends and influence
People have different attitudes towards the same situation; this will become more obvious during recession.
We all have friends and family who are not doing what we are doing, that is perfectly fine in my view; people are entitled to their preference and opinion, and we are not here to change them without invitation. I would just be more careful at whom I am listening to and whom I am getting advice from when it comes to property investing.
Henry Ford once said: "Whether you believe you can do a thing or not, you are right". So
• If you believe you can make more money from properties during recession, you are right;
• If you believe you cannot make more money from properties during recession, you are right too.
It is also very easy to hear the not-so-good news and why you can't make money from properties, they are plenty of them around during recession. It will take some effort to find those who believe the opposite, but it will be worth your effort.
This article was written by Bill Zheng, founder of Investors Direct (investorsdirect.com.au), an award winning Mortgage Company specialized in strategies and finance for residential property investors since 2001. Investors Direct was a finalists in the 2008 Australian Mortgage Award for Brokerage of the Year (Over 12 Staff Category) & Best Customer Service from an Individual Office.
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