Linda Phillips reveals the number one game changer that she thinks will have the most significant impact on your property portfolio, and what’s the best- and worst-case scenario.

Two decades of prosperity and uninterrupted growth are coming to an end in 2015. It’s a game changer, and for property investors it has never been harder to forecast the future and decide on the right strategy.

Though the economy might struggle and the stock market retreat, property investors are in a sweet spot. The right market will ride out the storms of 2015. For investors, there is only one real question: in 2015, when will interest rates fall further?

Every fall in interest rates is good for property investors. As of December 2014, RBA governor Glenn Stevens didn’t want to play ball and was downplaying the idea of further cuts, but the markets were already pricing in two more cuts totalling 0.5%, from a cash rate of 2.5% to 2%.

Assuming no change in interest rates, the table below shows the Propell National Valuers forecast of value changes for 2015:

Propell National Valuers forecast of value changes for 2015

It’s still a story of Sydney versus the rest. Melbourne growth will be second place in high single digits, while Brisbane is expected to come in third. The other markets will have little real growth.

What happens if interest rates fall?

The impact will be positive.

• Firstly, the more interest rates fall, the better the impact on the economy, and economic growth will be positive for real estate.

• Secondly, lower interest rates reduce funding costs, and while the impact may be tempered by the imposition of macro-prudential controls, nevertheless they should act to enhance property values further.

How much higher prices will rise is a ‘how long is a piece of string?’ exercise, with so many variables. With strong interest from foreign buyers, whose real entry cost would be lowered by a lower exchange rate, the net effect could be that Sydney house prices increase by 15% instead of 10% and Melbourne prices by 12% instead of 7%. The other capitals will be more modest, but growth of 5–8% might occur, instead of 3% or lower.

Realistically, if Sydney prices started growing faster than 15% p.a., we’d expect to see APRA strengthening the macro-prudential controls, so in practice we think growth of 15% in Sydney would be the upper limit.

What happens if interest rates increase?

One day they will increase; at least everyone expects so. There is a school of thought that says the current level of interest rates is the new normal; they have certainly endured for longer than anyone expected a few years ago.

The impact of interest rate increases will depend on the way they happen. In a future that is predictable, as the economy starts growing, interest rates will nudge upwards at a careful and controlled pace until the old ‘normal’ is achieved, and this is the plan for rates in the US.

One of the intents would be to not destabilise the real estate market, and from the point of view of the economy, a period of time in which house prices did not change much would be welcome. On the other hand, if some ‘left field’ or ‘black swan’ event caused a precipitous increase in interest rates over a very short period, then the impact on home prices would be sharply negative. However, the impact of such an event would affect the entire economy – another game changer.

What’s the best-case scenario for 2015?

This would be based on:

  • Continuing peace in the world, even if fragile in places
  • The Euro area not fragmenting
  • Oil prices staying below US$60 a barrel
  • World growth actually improving a bit

Domestically, we’d like to see this flow through as:

  • The RBA capitulating and dropping the cash rate to 2% or below
  • The exchange rate faling to US70c or less
  • The lower exchange rate making some fields and mines profitable enough to keep exporting
  • The lower exchange rate lifting export industries, tourism, education and agriculture
  • The non-mining economy starting to expand and unemployment peaking and starting to fall
  • Home prices increasing at the higher end of the range, up to 15% in Sydney

The cost to Australians would be in lower terms of trade, more expensive imports, and fewer holidays abroad, but we’ve been there before and can cope with it.

Worst-case scenario

We already have the worst-case domestic scenario:

  • Relatively high interest rates
  • Unprofitable mining sector
  • Declining and uncompetitive economy
  • Rising unemployment
  • Slowing inflation
  • No wage growth
  • Super fund investment in property might be limited or stopped, with some edging up of stamp duty and land tax

But the real worst-case scenario? It could get a lot worse.

Forecasts for the future tend to assume the future will be steady and predictable. But our experience is that, every year, something unpredictable, and usually negative, happens that knocks the forecasters off their perch. In practice, our economy seems to manage a period of five to seven years of predictable and steady-ish economic conditions, followed by a year in which a sea change happens.

Around 2001, a sea-change year of record low interest rates, and the start of the resource expansion, led to an unprecedented boom that lasted around six years.

In 2007/8 the GFC hit, a sea change that threatened the boom. We responded with record public borrowing and a spending spree. While most other nations went into recession after 2008, Australia seemed to have escaped it and carried on booming. The exchange rate hit new highs and Australians felt rich.

In 2015 we are back in sea-change territory: an economy that is slowing, unemployment rising, hard decisions on the economy, no matter where you look. While no one is forecasting a recession, for the first time in decades a recession is not entirely out of the question, especially if the RBA doesn’t act, or, worse still, it increases the cash rate.

The worst-case scenario for 2015 depends on the interplay of a number of domestic and global factors:

1. Lower petrol prices and a lack of wages growth are deflationary and likely to lower inflation, though this has to be offset against higher import costs from a lower dollar. We may see inflation fall well below 2% or even risk deflation later in 2015. The worst scenario would be if the RBA did not reduce interest rates to match the new circumstances, which would push the economy into recession.

2. For home buyers, the virtual cessation of wages growth is the main worry as it makes home buying less affordable for a longer period of time.

3. There is a total of close to $300trn of debt worldwide. Some $6.1trn of that is short-term US-denominated debt to emerging economies in Asia, South America and Russia. As the global risk appetite reduces, and the US economy strengthens and the US dollar with it, banks may be reluctant to roll over that debt, leading to a liquidity crisis in emerging economies that could lead to a repeat of the liquidity crisis of 1998.

In 2015 there is an increased risk of global conflicts getting out of hand, leading to larger military conflicts. This risk includes that of Russia invading Ukraine and other neighbouring countries, escalation of conflicts in Iraq and Syria, conflict in the South China Sea between China and Japan, and the ever-unpredictable North Korea.

4. If some or all of these factors come together, it could spell trouble for Australia, both in terms of the economic outlook, and potentially for Australia having to choose which allies it will take sides with in a conflict – the USA, China or Japan.

5. A year ago, it would have sounded silly to forecast that oil prices would fall by half, Russia would invade Ukraine, interest rates would fall further, and our dollar would fall 20%, but all that has happened.

Investors don’t like uncertainty

So, if 2015 unfurls in a predictable pattern, and perhaps with the bonus of lower interest rates, and the world muddles through another year without war or defaults, then it could continue to be a good year for Australian property investors. If the worst case does happen, then investment returns might be the least of our worries.