An interest rate rise makes it harder to pay off a mortgage, but does it have any effect on house prices?

Do rising interest rates mean decreasing property prices? If history is any guide, not at all. In fact, analysis of our data reveals that interest rates have no effect on the capital growth of property at all.

At first glance, this claim seems difficult to believe. How can interest rates have no effect on property capital growth rates? We’ll come back to that question after answering a more fundamental one – how do we know that there’s no effect?

The answer lies in the statistical concept of correlation. Correlation measures, roughly speaking, the extent to which two factors move together. For example, one would expect the number of ice cream cone sales that take place at a beach to be strongly correlated with the day’s maximum temperature. In other words, when the temperature is high one would expect ice cream sales to be high.

…an interest rate rise this year… a drop in sales next year. But there’s no corresponding drop in sale prices. Why not?

In the above example, the correlation comes about because one factor (the high temperature) causes the other factor (the high ice cream sales). This is not necessarily always the case. For example, one would expect that ice cream sales in Sydney would also correlate strongly with, say, scarf sales in London. It would be absurd to suggest that high ice cream sales in Sydney cause high scarf sales in London – or vice versa. The correlation arises due to the fact that Sydney and London are on opposite sides of the planet and summer here is winter there.

So, how do we use correlation to show that interest rates have no effect on house prices?

We simply measure the relationship between house price inflation and interest rates to see if high interest rate periods correspond to low house price inflation periods and vice versa. (This is what is known as negative correlation – when one factor is high, the other tends to be low.)

The table below shows the correlation between house price inflation and interest rates lagged a number of years (the lag simply means that instead of comparing house price inflation rates to interest rates this year, we compare it to one, two or more years ago. This allows for the possibility of interest rates having a delayed effect on house price inflation.). The data used covers over 30 years.

Correlation Table

So, what’s this table telling us? Pretty much what was said in the opening paragraph. The correlation numbers in the right-hand column are low and statistically insignificant. In other words, there is no discernible relationship between interest rates and house price inflation.

(Roughly speaking, the correlation number represents the amount of uncertainty that can be removed in guessing the value of one factor, given that you know the other factor. For example, if house price inflation and interest rates had been correlated 100% (perfect correlation), then that means that knowing the interest rate would remove 100% of the uncertainty about house price inflation. That is, you would be able to predict house price inflation perfectly. If the correlation was 0%, knowing interest rates would remove 0% uncertainty about house price inflation. That is, interest rates would tell you nothing about house price inflation. The table shows figures that are much closer to 0% than 100% and, for all intents and purposes, interest rates have no impact on house price inflation.)

A person looking at the graph of interest rates and house price inflation shown below might notice rising interest rates in 1974, 1982 and 1989 and corresponding low house price inflation in following years and claim a pattern. But then, interest rates also rose in 1970, 1976 and 1985 and each time were followed by accelerating or steady house price inflation. The correlation calculations don’t lie. Any pattern ‘spotted’ by the human eye is simply a byproduct of the human tendency to spot patterns in just about anything. That’s why psychiatrists invented ink blot tests.

So we know that interest rates have no impact on house price inflation. How do we reconcile this fact with the intuitive feeling that interest rates and the housing market are closely related?

The answer, we believe, lies in the number of property sales. While we don’t have quite as much historical data on the number of property sales as we do on capital growth, we do possess enough data to calculate some rough correlation numbers.

We see here much higher negative correlation. When interest rates are high, the tendency is for the number of property sales to be low and vice versa. The effect is most significant with a one year lag. That is, an interest rate rise this year corresponds most strongly to a drop in sales next year. But there’s no corresponding drop in sale prices. Why not? The demand for property has dropped, why aren’t prices dropping?

Because supply has dropped also. For home-owners, particularly owner-occupiers, there is a strong resistance to selling a property for less than what was paid for it. There is little incentive for an owner-occupier to sell a property for less than that which was paid – they will still have to live somewhere, and still have to pay to do so, so why add a loss on the property market to their burden? Owner-occupiers will generally do whatever it takes to meet their mortgage payments. Budgets will be tightened, extra jobs will be sought, etc.

Investors are a slightly different story. A loss can be taken on an investment property without sacrificing the investor’s place of residence. If interest rates increase, then the viability of maintaining the investment property will usually be reconsidered. However, the self-sustaining nature of the housing market also has an impact. Lower numbers of property purchasers implies a higher number of renters, which in turn implies higher demand for rental properties and the potential for the investor to increase their rent. In many cases, this rent increase will compensate for the increase in interest rates, removing the source of the original impulse to consider selling.

Obviously, each individual case varies. Some people simply cannot make the increased mortgage repayments and will have to sell. The general trend however, historically speaking, has been for people to do everything they can to hold their properties until the market can pay them at least what they paid for it.

Will this historical trend hold in the current round of rising interest rates? Or will the Sydney property market see price decreases as a result of the interest rate increases?

We usually expect the future to perform similarly to the past, unless there has been some fundamental change in circumstances. One could argue that current lending practices have placed borrowers in a more leveraged position than they have historically been and this may make the housing market more unstable than it has historically been.

The counter-argument to that is that if borrowers are more leveraged than they have been historically then there is arguably more incentive for them to not sell at a lower price than that which they paid.

Overall, one can reasonably say that Sydney property values are as safe now as they’ve ever been. And a property investor need not lose money on their investments – provided they are in a position to decide when to sell. As long as their financial structurings are such that they are not forced into a sale, the current rising interest rate climate need be no more than a temporary glitch.

Sourced from residex.com.au- 1-May-2000 – D Liebke

Getting your Initial Strategy right (especially in regard to property choice) in the beginning can make all of the difference in the long run to building a large property portfolio.

For as long as I can remember, property investors have battled over the capital growth vs rental yield or positive cash flow argument.

As you can see in graph 1 & 2 where there is a clear difference between a property purchased at $500,000 which achieves 5% per annum compounding capital growth and a property purchased for $500,000 which achieves 14% per annum compounding capital growth (thanks to better research and strategising, negotiation etc ).

Just look at the difference in 10 or even 20 years time buy buying in a better capital growth area!

Source: Capital Property Advisory

Source: Capital Property Advisory

So when thinking should I buy with a capital growth focus, or a rental yield (generally positive cashflow) focus , the above graph and table will help outline the large difference in the long run by concentrating on one rather than another.

It is important to assess upfront whether your gain of an additional 1-2% rental yield is actually worth it if you forego capital gain by 3-4%. The gain in rental yield is generally a few %, you rarely see rental yields into the 10-15% range like some capital growth areas have experienced.

So if you are looking to gain as much wealth as you can in the long run, you should research this heavily before embarking on your property search brief. At Capital Property Advisory we see this as being one of the most important parts of the pre buying process research phase, as we have a research committee whose sole focus is to analyse which areas have historically performed above the capital growth average of Australian Capital Cities, and to identify those with the right combination of characteristics to suggest that they will likely outperform moving forward.

However, planning the right Initial Strategy in order to buy the right property is only one step in the holistic process towards investing in property – imagine if you get the other seven steps of the process right!

For more information on how Capital Property Advisory can grow your portfolio , feel free to give us a call on 1300 227 360.

Question: Your Investment Property Reader

“I’m looking at investing in property at the moment, but the share performance is also enticing me to put my money in that asset class. At this stage of the cycle, is it better to put my money on shares or property? I already own shares but I don’t have investment property. Any advice on how I can get started with property investing?”

Answer: PINO TEDESCO, Director of Capital Property Advisory

Property Vs Shares

This debate has been argued on both sides for years, and will continue to be discussed for years to come.

Property spectators argue that property is the way to go, whilst financial planners and share market enthusiasts generally argue shares and managed funds are the trail to the Holy Grail.

What is agreed, however, is that whichever path you choose; diversification is the key to developing a safer, and most likely, better performing portfolio. Share market enthusiasts recommend investing in different shares from many sectors to diversify one’s share portfolio, whilst Property gurus preach of buying property in different states and different price ranges to diversify.

I would agree with both, but to choose one over the other is not generally a recommended solution for anyone. The goal for most should be to build a well balanced and well diversified investment portfolio, which invests across many asset classes.

The first step in deciding the composition of your portfolio will be to consider the time frame you wish to hold your investments for, what return you wish to receive and how much risk you are willing to take on.

Shares and property are very different investments, with extremely different features, particularly in terms of growth, tax implications, volatility, liquidity and leverage, and it these factors that stop me from speculating exactly what is best for any one person. This depends wholly on the investor’s personal circumstances, constraints & view/goals of income.

Since you already have shares, I would recommend adding residential property for a couple of reasons. First, to achieve more diversification in your portfolio. Second, that residential property (done well) is a very powerful wealth creation tool. I firmly believe that residential property has a place in a balanced investment portfolio, and below I note the rationale for this:

• Historical pattern of steady growth (prices doubling on average every 7-10 yrs)
• Less volatility than shares or similar investments due to approximately 70% of the housing market being owner occupied (Ie. Home owners are less likely to sell their homes throughout times of financial turmoil. Conversely, shares, due to their great liquidity, can be quickly and easily divested – and frequently are – often resulting in reduced share prices and volatile investments)
• Historically, shares can fluctuate by 30-40% in any one year, offering the investor a pretty bumpy ride at best, and at worst very little clarity or comfort in the value of their investment
• Unlike shares, a property is individual and unique, meaning there’s less competition. When you purchase shares on the stock market, you must buy at the market price at that particular time, whereas a property may be negotiated below market price through strong negotiation. To an emotional or uninformed seller, often price is secondary to other terms, such as time or access to deposit funds, allowing you to buy below market price.
• Property allows the investor more control, through the ability to add value (eg. renovate or redevelop) and the choice of how your property is utilised (tenanted, vacant or personally occupied) – shares are controlled by the company’s management team and their performance, not by you!

For me, the most compelling argument for property over shares is that banks will lend generally 80% to investors in property, sometimes up to 90 or 95% of the investment. This means that people can increase their return on investment due to the leverage factor. This can also be achieved with share investing using margin loans, but generally only at levels of 60%, so on a same % returns basis property will return more as it can utilise more leverage. The risk to be noted with shares is that on margin loans have margin calls. This can occur when the share reaches a certain price, and if the investor doesn’t want to sell then there is no choice. The simple way to avoid this is not to have margin loans, but this would be the most unleveraged option.

The fact that banks (which are conservative by their very nature) allow higher loan-to-value ratios with property investing should be comforting to an investor, because if the bank is willing to give you a higher percentage of the investment value as a loan, then what does this say about the banks thoughts on property value and risk?

If you only have a small amount of equity or cash to put in and you are considering shares for this reason, perhaps you could consider investing in property through a retail investment trust (where you share ownership in the property with others by buying units in the trust). Such ‘residential funds’ can be found on Morningstar in “unlisted / direct property” category, like the Ironstone Fund – Australian Residential Real Estate Investment Trust . These can provide relatively new and effective alternative to access residential property as an investment for as little as a $10,000 investment.

Remember, though each individual has a different set of needs and is looking for different outcomes, so it is best to seek independent advice from a financial planner or similar, to discuss the best plan for your particular circumstances.

Written by PINO TEDESCO, Director of Capital Property Advisory – Property Investment Strategists & Buyers Agents. Pino is a Licensed Buyers Agent and Qualified Valuer.

For a FREE Property Portfolio Review call us on 1300 227 360 or send an email to info@capital360.com.au

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Most people I come across astound me with how little time they spend on buying their first home, an upgrade or a new investment property.

I often hear how overwhelming it becomes that people either ‘pass’ because its too hard or even worse overpay or buy the wrong type of investment out of haste or annoyance of ‘missing out’ over and over.

Many people spend more time on a purchase of a new car then they do on a property? Does this make sense when it can be 20 to 30 times more valuable! Depending on your type of car and property you’re looking to buy it could be more?

When you think of it in terms of $ invested , if you bought a car worth $20,000 and it took you 4 weeks to buy, say 48 hours in total. Compare this to buying property worth say $800,000, that’s the equivalent of 1920 hours or 240 business days in $ value in comparison to car searching. Did you perform 1920 hours or 240 business days of due diligence when looking to buy property, I would say most don’t….and that’s just the buying, what about the rest of the process , as I believe this is just 1 step of many steps that should be taken to making Super Property Wealth.

So as to help readers better understand what we go through for our clients as a minimum on each and every purchase, we take a look at every stage of building a Super Property Portfolio. It is important to understand the fundamentals, but also to cover off on some steps that most people don’t fully undertake or even worse, skip all together.

Capital Property Advisory – 360º Residential Wealth Creation.

Step 1 – Initial Property Investment Strategy

You should review your specific situation and property investment goals to develop an overall property investment strategy blueprint and an action-oriented plan to help you realise your goals.

Step 2 – Structure Strategy

You should liaise with an asset / property investment structuring specialist to help determine and implement the most appropriate property buying and management structure to build your property investment portfolio (trusts, SMSF, etc.). An accountant and/or legal advisor is best to talk to regarding this step.

Step 3 – Property Finance Strategy

You should liaise with a property investment finance specialist to help evaluate your property finance options, determine the best property investment finance strategy and help secure the finance you need to execute your property investment strategy. It is best to talk to a property finance firm to make sure your obtaining the best advice. If you go to a finance broker rather then a bank direct then you are able to evaluate all the banks and financiers on offer that best suit your property investment strategy, rather then solely one banks offering. The more choice the better.

Step 4 – Buying Strategy

You should develop a property acquisition brief, focusing on the assets which will help you build real wealth. It is crucial to buy properties with high capital growth, as this will create super property wealth in the long term. Buyers Agents have countless hours in researching, sourcing, negotiating and securing investment property, so using a buyers agent that concentrates on this as their job is probably best then trying to learn and achieve yourself. If for investment purposes its best to seek a buyers agent who specialises in building large property portfolio’s for their clients. Also with all your professionals, its important to make sure that they perform this not only for their clients but its always comforting if they have invested themselves in property also.

Step 5 – Add Value Strategy (Property Renovation and Development)

You should always begin with the end in mind, identifying opportunities to add value before you purchase. A detailed due diligence enables you to provide upfront profit estimates for every property investment transaction, prior to starting. This is an important step that most people forget or don’t dedicate enough time or worse a structured approach to. It’s important to do this upfront to avoid emotion investing and overcapitalising when the property is bought.

Step 6 – Property Management Strategy

You should identify the most appropriate property managers for your investment properties and monitor their performance frequently. Ideally you want a specialist firm that just conducts property management & has rent reviews they conduct every 3 months. Also it is important to find a property manager that not only looks after the landlord, but likewise the property tenant so that rental vacancies are minimised.

Step 7 – Property Portfolio Review

You should review the performance of each of the properties in your property investment portfolio and tweak them frequently. This may include new property portfolio additions, disposals, refinancing, depreciation schedules, rent reviews, calculation of re-allocation of capital and associated costs in doing so etc. The larger your property investment portfolio the more frequent this should be done. At Capital Property Advisory we conduct this free for our clients, with some clients having their whole portfolio reviewed quarterly. Recently this gained $140 increase per week in rentals across 2 properties for a client and reduction of property management fee’s from 7%+ to 5.5% ongoing, saving our client money ongoing. This gained the property investor increased cash flow from their property investments from increased rental and reduction of property management expenses.

Step 8 – Property Disposal Strategy (Selling Property Investments)

Should you choose to sell a property, then you will need to identify the most appropriate real estate agent for the disposal of your property. It is important that you understand your options before selling. At Capital Property Advisory we assist property investors and home owners with the real estate sales process, providing objective advice throughout and helping you achieve an optimal sales price with minimal hassle, free of charge to our clients.

Written by PINO TEDESCO, Director of Capital Property Advisory – Property Investment Strategist, Licensed Buyers Agent and Qualified Valuer.

p : 1300 CAP 360 (1300 227 360)

w : www.capital360.com.au

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