Have we borrowed too much to buy property?

Have we borrowed too much to buy property?

by | Nov 8, 2018 | Property Loans

Buying residential property in Melbourne has been a great way to make money, with an astonishing total return over the 31 years to 2016 of 11.2% per year. The problem is, the majority of that return was capital gain, and almost all of that gain was underwritten by buyers taking on more and more debt, to the point that Australian households are now the second most indebted in the world. At some point households simply won’t be able to take on more debt, and then what happens?

I know I’m venturing into an area where emotions can run high, partly because the average Australian has an awful lot at stake when it comes to property values. I’ll say up front I’m definitely not advocating anybody rushes out and sells their property holdings, I’m simply offering some observations about residential property from an investment point of view. They may be right, or they might be way off the mark.

Property prices and debt

I don’t think it’s especially controversial to suggest there’s a logical relationship between the amount that people are prepared or able to borrow to buy property and how much they end up paying, but I reckon the two charts below kind of prove it.

Chart 1: RBA data suggests house prices have risen in line with the amount of household debt

Chart 1 RBA data suggests house prices have risen in line with the amount of household debt

Chart 2: There’s also a close relationship between loan approvals and house price growth

Chart 2 There’s also a close relationship between loan approvals and house price growth

Investing in property is, by definition, speculative

According to SQM the current ‘gross yield’, that’s the income you receive from rent before accounting for any taxes or costs, on Melbourne residential property is 2.9% per annum.

If you assume the property owner has a marginal tax rate of 37%, that brings it to an after-tax yield of 1.8%. Once you’ve accounted for all the other costs, such as management fees, body corporate fees, land tax, rates, insurances and what have you, you are very lucky to get a 1% ‘net yield’.

That same landlord could put their money in a term deposit paying 2.7% per annum; take out the 37% tax and the net yield is 1.7%, and there are no other costs to pay. Given that return is guaranteed by the government, we can call that the ‘risk-free rate of return’.

It’s a rock-solid law of investing that if the yield on an asset is less than the risk-free rate of return, then the investment is speculative, because the only way you can justify it is through capital gain. In other words, you’re banking on someone paying a higher price than you did.

Over the past 31 years, the capital gain on Melbourne housing has averaged 7.5% per year, so that speculative bet has been well rewarded, and it’s understandable for anybody to think that’s a well-established trend which is likely to keep going. The trouble is, it’s entirely reliant on people taking on more and more debt.

How expensive is residential property?

One way of working out the value of an investment is using what’s called a ‘price to earnings (PE) ratio’. That’s where you take the price of an asset and divide it by the earnings it generates per year; so if a $100 asset generates $10 of earnings per year, it’s $100 divided by $10, which gives you a PE ratio of 10 times.

The PE tells you how many years it would take for that investment to pay itself off and is effectively a measure of sentiment. If you’re pretty sceptical about an asset you’d want to get your money back sooner rather than later, so you might have a low PE of 4-5, but if you’re bullish on an asset you’ll be happier to have a higher PE.

You can use a PE ratio to measure the value of a share (it’s the share price divided by the earnings per share), or a property (the property value divided by the net yield). The current PE for the Australian share market is about 15 times. If we use the 1% net yield on property as above, that’s a PE of 100 (if you had a property worth $100,000 it would yield $1,000; $100,000 divided by $1,000 is 100).

That means Australian shares are currently 85% cheaper than Melbourne residential property. How can they be so out of whack? That would make a great dissertation topic for someone far smarter than me, but my hunch is debt has a lot to do with it. In 25 years in financial services I’ve yet to have a client tell me they’d be comfortable gearing a share portfolio to 80%.

Another comparison is M3 Property estimates the current yield on industrial property in Melbourne is 6.25%. Using similar costs as above you’d end up with a net yield almost four times that of residential property, or close to two and a half times the risk-free rate. Again, they seem way out of whack.

A final indicator of how expensive Melbourne’s residential property market is the Annual Demographia International Housing Affordability Survey, which compares how many multiples of median household income it takes to buy the median family home in 293 separate cities across nine different countries (Australia, US, UK, Japan, Hong Kong, Canada, New Zealand, Ireland and Singapore).

Melbourne is ranked as the sixth most unaffordable city (Hong Kong is the worst and Sydney is the second worst). Demographia rates a multiple of more than 5.1 times as ‘severely unaffordable’, and Melbourne’s is 9.9 (Sydney is 12.9).

Australia’s growing pile of household debt

It’s cliched to talk about how much Australians love their property, and it’s reflected not only in how much they’re prepared to pay for it but that they fund those high prices by going into more and more debt.

Chart 3 shows the amount of mortgage debt in Australia as a proportion of GDP and clearly shows when housing-related lending activity went parabolic. In 1988 the ‘Basel 1’ banking accord was introduced, which was an international agreement partly designed to make the banking system more stable by prescribing new limits for how much capital banks had to set aside as backing for different types of loans. Australian residential mortgages were considered relatively low risk, which meant the amount of capital required for them was set relatively low, meaning the return on equity for the banks from those loans was relatively high, so not surprisingly our local banks went to town lending to people to buy houses.

Chart 3: Australian mortgage debt as a proportion of GDP

Chart 3 Australian mortgage debt as a proportion of GDP

By any measure, Australian households now carry a lot of housing-related debt. The Bank of International Settlements (BIS) ranks Australian households as the second most indebted in the world (behind the Swiss, go figure) and chart 4 compares Australia’s household debt as a proportion of GDP to some other OECD countries and clearly shows the inexorable march upwards.

Chart 4: Household debt as a proportion of GDP

Chart 4 Household debt as a proportion of GDP

Something that strikes me, US household debt peaked at just below 100% of GDP right before the GFC smashed the property market, now it’s retreated to less than 80%. Ours is currently above 120%.

Chart 5 shows another measure: Australia’s household debt to disposable income. The remarkable thing here is it has grown at 10% compound per annum for the past 30 years. As they say, trees don’t grow to the sky; that is a phenomenal rate of growth in debt and at some point households simply won’t be able to gear up any further – everyone has to spend at least some of their income on living expenses.

Chart 5: Australia’s household debt to disposable income (%)

Chart 5 Australia’s household debt to disposable income (%)

The interest only problem

When you take out a mortgage to buy a property, there are two components to the loan repayments: the ‘principal’, which is the actual amount you borrowed, and the ‘interest’ you pay on the principal. It’s been popular for property investors to take out ‘interest only’ loans, meaning for (usually) the first five years they only pay the interest costs and none of the principal.

Why would you do that? There are some sound tax reasons around maximising deductible debt, but it also significantly reduces the monthly repayments. For example, if you take out a $500,000 loan at 4.66% it’s the difference between paying $1,942 versus $2,582 per month. Over five years that $640 per month adds up as a lower drain on your cash flow. The problem is of course, after five years you’ve not made any dent in the principal at all.

From 2008-2017 interest only loans accounted for about two-thirds of all investment loans and over that time the total amount tripled to peak at about $600 billion. Then in 2017 the Reserve Bank got sufficiently worried about the property market that they instructed the banking regulator, APRA, to cut back the amount of interest only lending. Chart 6 shows the sharp drop off in interest only lending when APRA told the banks to limit it to 30% of all new loans.

Chart 6: the % of interest only investment loans fell away in 2017 after APRA told the banks to cut back

Chart 6 the % of interest only investment loans fell away

UBS recently did a study on why borrowers took out interest only loans – see chart 7. To begin with, terrifyingly, 5% of respondents didn’t even know whether they had an interest only or P&I loan; but 18% said they opted for interest only because they couldn’t afford P&I and 11% said they intended to sell the property before the loan rolled over to P&I. Also scarily, 17% said they took out an interest only loan because their mortgage broker told them to. All in all, the survey suggests at least half of all interest only borrowers don’t seem to have a solid grasp on what they’re doing.

Chart 7: Reason for taking out an interest only loan

Chart 7 Reason for taking out an interest only loan

 

The same UBS survey also asked borrowers how much they thought their loan repayments would increase once it rolled over to P&I – see chart 8. The Reserve Bank reckons the average increase in monthly payments will be 30-40%, but worryingly, more than half under-estimated how much the increase will be, and again concerningly, more than a third had no idea, suggesting they’d not paid anywhere near enough attention.

Chart 8: Borrower’s estimate of the increase in mortgage repayments

Chart 8 Borrower’s estimate of the increase in mortgage repayments

The Reserve Bank estimates there’s a total of about $480 billion worth of interest only loans outstanding and $360 billion of those will roll over to principal and interest (‘P&I’) over the next three years. It also estimates that one-third of mortgages have less than a one month payment buffer. If all those numbers line up, that would imply one-third of the $480 billion of interest only loans have less than a one month buffer, so $160 billion worth. Of that, 18% say they won’t be able to afford the 40% jump in loan repayments when the loan rolls over to P&I, which is about $30 billion worth of loans. In a worst case scenario, that could point to a lot of forced property sales.

The banks have tightened credit standards

Until recently if you applied for a loan you would have to provide evidence of your income but not your expenditure. If the expenses in your loan application were less than a minimum amount the banks would simply use the so called Household Expense Measurement (HEM), which assumed $32,400 of expenses per year, to work out the amount they’d be prepared to lend to you.

After the recent Royal Commission into the banking and finance industry uncovered dodgy lending practices, the banks have been moving to tighten things up. Now they’re starting to require verification of both income and expenses, insisting on seeing things like bank and credit card statements. The upshot is the amount the banks are prepared to lend is estimated to drop by between 20-40% from previous levels – see chart 9.

Chart 9: New estimated borrowing limits based on revised expense estimates

Chart 9 New estimated borrowing limits based on revised expense estimates

Obviously, that simply translates into less money people can spend on buying a property, which you can only presume will feed straight into lower prices.

The washup

I know there have been calls for years that Australian housing is overvalued and dire predictions that our banking system is overexposed to it. I’m not making any such forecasts, I’m simply pointing out that there’s a limit to how much debt Australian households can take on to buy a house. Chart 10 shows the general trend of Australian mortgage rates has been downward for the last 25 years, which has underwritten a steady increase in borrowing capacity. If interest rates have indeed bottomed, will that cycle reverse?

Chart 10: Australian fixed interest rates have been on a downward trend for 25 years

Chart 10 Australian fixed interest rates have been on a downward trend for 25 years

The Reserve Bank has kept cash rates at a record low of 1.5% for more than two years and there’s no sign they’ll be raising them any time soon. However, Australian banks source a lot of their funding from offshore and rates there have already started to move upwards. We’ve already seen three of the big four banks raise mortgage rates a couple of months ago and there’s every chance they will do the same again. When borrowers are so stretched any tweak to rates has a very real effect.

I should emphasise, I’m not forecasting a crash in housing prices, there are a lot of arguments that the majority of Australian borrowers are well positioned to weather a downturn (though sometimes it’s hard to unravel where those arguments might be pushing someone’s barrow). Also, the Reserve Bank is acutely aware of how important the housing sector is to the overall Australian economy and will almost undoubtedly move to support it if necessary, and as the market adage goes, it’s unwise to argue against a central bank. What I am wondering is how sustainable the increase in household debt is, and if the answer is it has to slow, stop or even reduce, then what happens to house prices?

Why your credit rating is going to become a lot more important

Why your credit rating is going to become a lot more important

by | Oct 22, 2018 | Property Loans, Wealth Management

There has been a lot of media around the findings of the recent royal commission and how the banks have now made it significantly harder to apply for a loan. Another change, that was mandated prior to the royal commission, is set to place a much greater importance on keeping your credit file squeaky clean.

Most people who apply for a loan, from a mortgage to a credit card, accept that the lender will perform a credit check on them. Whilst these credit checks have always played a significant role in whether the application was accepted or declined the data that was historically available was limited to three items:

  1. The date of the last credit enquiry for the applicant.
  2. The name of the credit provider that made the inquiry, e.g. ANZ bank
  3. If there were any credit defaults or bankruptcy registered against the applicant. A credit default includes a repayment in arrears for a period of 60 days or more.

The lender would then rely on the applicant to include the balances and structure of any outstanding loans in their application and back them up with the relevant statements.

On 2 November 2017 the government announced it would legislate for a mandatory Comprehensive Credit Reporting (CCR) regime to come into effect by 1 July 2018. So by 1 October 2018 the four major banks were required to report that 50% of their credit data, including home loans, credit cards, car leases, etc. are shared with a credit bureau and made available to other industry participants. By 1 October 2019 this figure will grow to include 100% of all credit data.

Whilst the government’s mandate only applies to the four major banks, to gain access to the data a lender must also be a participant so it’s expected the smaller lenders will follow.

What does this mean?

Under the new reporting regime, the number of data points contained in a credit file would be significantly increased. In addition to the three listed above, the information available to lenders would include far more detail around the balance and limit of any loans you have outstanding or closed, the type and structure of those loans and their month by month payment history for the previous two years.

All these factors will then be considered to produce a credit score for the applicant of between 0 and 1000. Clearly this will provide lenders access to a lot more data, enabling them to better assess a borrower’s true credit position and hence their ability to repay a loan.

How will this affect me when applying for a loan?

As more Comprehensive Credit Reporting (CCR) information becomes available, it should drive competition and result in lenders offering a better deal based on your unique credit circumstances. In short you could be rewarded for a good credit score with a lower interest rate or punished for a bad one. The race will be on to best utilize this level of data and introduces the possibility of nimble fintech start-ups to enter the marketplace.

It may also result in a reduction in the documents you need to provide the lender with your application. If a lender can view your current balances and repayment history, then there may not be a need to provide this information in the form of paper statements.

Whichever way you look at it, the change will place far more importance on maintaining a clean credit file and will ultimately result in a more competitive risk adjusted lending market.

Things to think about before gifting your kids money

Things to think about before gifting your kids money

by | Aug 2, 2018 | Financial Planning, Investments, Wealth Management

It’s natural that a parent would like to be able to help their kids out financially, especially if it’s to get a foot on the property ladder when even that first step can seem so out of reach these days. But you need to think carefully before you hand over a couple of hundred thousand dollars because if things go pear shaped a big chunk of that money could disappear.

Let’s imagine you give your child $100,000 to put towards buying a $1 million house, then not long after your child meets a partner and they move in together. If they end up marrying or the relationship becomes de facto, which according to the Family Law Court is after at least two years, but the relationship falls apart, your child’s ex can make a claim for a financial settlement. It’s possible your kid’s ex could get half the house, including half the money you gave your own child.

And if it’s your son and there’s a child involved the financial settlement can be a long way from 50/50. Within a few years of a very generous gesture, a big chunk of the money could well have gone.

It is apparently possible that a Family Court Judge will make an allowance where the relationship didn’t last very long and they conclude the spouse doesn’t really deserve to share in the money the parents gave. But that is far from certain.

There are two things you can do. First, rather than gift the money to your child, lend it to them. The value of the loan will be excluded from financial settlement proceedings. You want to make sure the deal is characterised as a loan from the outset and the smartest way to do that is going to the trouble of getting formal loan documentation drawn up by a lawyer so if there’s a dispute the courts will be left in no doubt what the arrangement is.

You can even lodge a mortgage against the property, with specific clauses requiring that any partner must enter an agreement with respect to the money.

The second approach is to have your child’s new partner sign what’s referred to under family law as a “Binding Financial Agreement”, pretty much the equivalent of what is popularly referred to as a ‘prenup’. Your child’s partner would have to acknowledge the money you’ve given and agree that it’s not to form part of any financial settlement in the event of divorce or separation. This is much easier if the money is used for something readily identifiable, like a house deposit, but it can get more complex if it’s intermingled with other money.

Again, the wording of such an agreement has to be quite specific and certain protocols have to be met, like having the signatures witnessed by a lawyer or Justice of the Peace, so it’s pretty much a necessity to use a lawyer.

It’s worth bearing in mind that it’s not just a relationship breakdown where the money you gave can end up in someone else’s hands, if your child goes bankrupt their creditors can end up with it too. Here again, having the money tied up in a formalised loan should protect it.

There are two other considerations: if you’re receiving a government pension, under the so-called ‘$10,000 rule’, Centrelink will look at gifts and transfers exceeding $10,000 per year, or $30,000 over five years, when calculating whether you qualify under the assets test. This includes paying school fees.

Secondly, if your child is taking out a loan to buy the property a lender is likely to want to know if the deposit is being part-funded by someone other than the borrower, and it would be a really bad idea to fudge things in an effort to make it easier for your kid to get the loan.

Helping your child out financially should be a heart-warming experience, taking a few precautions can help stop it turning into a gut-wrenching one.

Getting a home loan is getting a lot harder

Getting a home loan is getting a lot harder

by | Jul 18, 2018 | Investments, Property Loans, Wealth Management

Most people don’t apply for a home loan many times in their life. Even if you’re just renovating or refinancing, it may have been 3–10 years since you last applied for a home loan and there have been a lot of changes in the lending market over that period so that what used to be a relatively straight forward application process can now be a frustrating, and potentially costly, experience.

What has caused the changes in the market?

In 2014 the Reserve Bank got concerned about the sharp rise in house prices and requested APRA, the government watchdog for the banks, to tighten the ‘prudential’ lending regulations and hopefully slow the market, so APRA limited the banks to a maximum of 10% growth in investor lending over a 12-month period.

To meet these new requirements the banks raised interest rates on investment loans in some cases by as much as 1% almost overnight, as well as significantly tightening their loan application assessment policies. Chart one shows the impact that this has had on the growth rate of investor lending.

 

Chart1: Investor lending slowed sharply after APRA tightened regulations
Chart 1: Investor lending slowed sharply after APRA tightened regulations
 Source: JP Morgan

Then in April 2017 APRA introduced additional macro-prudential measures which capped interest-only lending at 30% of all new loans issued. Around six months after that was introduced, home prices in Australia’s major east-coast housing markets began to decline. Chart two shows the significant fall in year on year house prices in Sydney and Melbourne particularly.

 

Chart 2: Melbourne and Sydney home prices started to decline after APRA restricted interest-only loans
Chart 2: Melbourne and Sydney home prices started to decline after APRA restricted interest-only loans
Source: JP Morgan

Throughout this period APRA has also been working closely with banks to develop stricter underwriting standards for both investor and owner-occupied loans. This tightening, combined with the public shaming at the Royal Commission into Financial Misconduct, has forced banks to take note.

How has this affected the lending process?

There is no doubt the regulatory changes have been introduced to make sure our financial system remains unquestionably strong, however, for anyone intending to apply for a home loan there are consequences you should be aware of.

1. More paperwork – In the past lenders have been able to accept that what you entered on your application was correct, but today they will require you to verify much more of your financial situation with documentary evidence in the form of bank statements. Often the submission of one statement leads to further requests which can be frustrating for all involved.

2. More questions – Banks are required by their regulators to keep evidence explaining why they assessed your application in a certain way. While something may seem obvious to you as the borrower, the banks may request an explanation in writing to ensure they have documentary evidence.

3. Living expenses – Currently banks ask that you estimate your living expenses and then take the higher of your estimate or the Household Expenditure Method (HEM). HEM is a national standard based on a few things, including where the borrower lives and the number of dependent children, and then assumes a basic standard of living. History has shown borrowers generally have a surprisingly vague understanding of their monthly living expenses and tend to underestimate this figure, and banks are now starting to require more evidence in the form of transaction or credit card statements to prove actual expenditure, rather than simply taking an estimate. A review of the HEM model is also underway.

4. Inflexible – Each bank has a list of criteria that need to be met to gain loan approval and these are documented in the bank’s lending policy. Banks have been instructed by APRA to strictly adhere to these policies and make very few exceptions. As a result we have seen an increasing number of declined applications for circumstances that may seem like common sense to the borrower, but unfortunately do not meet the specific requirements of the lender’s policy guide. Each bank’s policy guide is different, and it pays to speak to someone who has knowledge of these subtleties.

5. Principal and Interest (P&I) repayment – with such a regulatory emphasis on investment and interest only loans, it doesn’t take much to realise that much of the recent lending growth has come in the form of P&I repayment. Depending on your personal circumstances and lending objectives, you may consider paying principle and interest (P&I) instead of choosing an interest only loan.

These are just a few examples in which applying for a home loan has become significantly more difficult in recent times, but they highlight the importance of speaking to a professional to ensure you have the right structure and preapproval before you make an offer on a property. Where appropriate, we can also help you to apply with a non-bank lender that is not affected by APRA’s restrictions.

Do Australian investors need to worry about the banks’ exposure to residential property?

Do Australian investors need to worry about the banks’ exposure to residential property?

by | Oct 16, 2017 | Financial Planning, Investments, Markets and Economy

This is a great article from Tim Farrelly, the principal of farrelly’s asset allocation consultancy. Tim is one of the clearest thinkers I know and specializes in tackling popular misconceptions. The article was published on his Linked In group, Just Saying.

Between them the big four Australian banks account for more than 25% of the ASX200! So what happens to the banks is a big deal for the whole index and over the past few years hedge funds from all over the world have lined up to bet against them on the basis that they have a disproportionate exposure to overpriced Australian residential property. To date, those hedge funds have turned out to be wrong.

Notwithstanding residential property accounts for around 60% of the banks’ loan books, the average Loan to Valuation Ratio (LVR) is only about 47%. As Tim points out, while a correction in property prices is never great for banks, but with that level of equity buffer built in it doesn’t necessarily mean a disaster. In the meantime, they consistently pay attractive fully franked dividends.

The banks’ exposure to residential property. A perfect storm… in a teacup.

Time and time again we hear that the Australian banks have a huge vulnerability to a downturn in the residential property market. The shrillest commentators suggest massive losses await – even insolvency. Look what happened in the US! Look at Ireland!! Look at the liar loans!!! Look at the record levels of household debt!!!!

We suggest they may be better served looking at the real life stress test being conducted right now in Western Australia. 

Since 2012 we have seen the WA economy contract by 17%, unemployment rise from 3.6% to 6.5% and, according to CoreLogic, median Perth property prices fall by almost 12% since their peak in October 2014. Property prices in WA mining regions have fallen much further.

What has been the impact of this perfect storm on the banks’ loss rates on residential loans? 
Well, Westpac has reported that the losses on their WA resi loan book has doubled from 0.02%pa to 0.04%pa. To put this in perspective, if this result was reproduced nationwide, it would reduce WBC profits by an almost invisible 0.6%. This result is in line with the results of farrelly’s own bank stress testing model. 

What if things get much worse? What if we test for an implausible fall in nationwide housing prices of 35% and a 10% default rate on resi loans? Our stress testing model predicts that this may reduce bank profits by around 18%. Not pretty, but a very long way from life threatening. A one-year 20% cut in dividends reduces 10 year returns by less than 0.2%pa. 

Despite all the talk, the fact that Australian banks loan books are heavily concentrated in low risk mortgages rather than high risk corporate loans should be a source of comfort not fear.

Which begs the question, why do the equity managers, bond managers and other commentators continue to perpetuate this myth? Self-serving lies or ignorance? Neither explanation does them any credit. We should call them out.

Just saying.