How to survive a falling property market and higher rates

Rates are rising and prices are falling … and this time round the property downturn will be different.

Demand for rentals remains at historically high levels, especially in Sydney and Melbourne. Picture: Jenny Evans.

It’s the worst combination for property investors — falling prices mixed with rising rates — and this month we got a taste of it.

In the weeks ahead we are likely to see more of the same. In fact, the latest lift in official interest rates in the US is hard evidence the global trend is for higher rates across the board.

Most investors have some notion that house prices are falling, after all, evidence of recent price falls in the major cities have been widely reported.

But there is less appreciation that interest rates in this market are moving higher fast. That’s largely because the RBA official cash rate remains unchanged month after month at 1.5 per cent.

But RBA setting are increasingly irrelevant when mortgage rates — the rates that matter — have been climbing for months. Indeed this week’s poor consumer confidence reports reflect the mounting combination of high household debt and rising rates now taking hold.

For many investors this may be the first serious downturn they face. Certainly, it will be the first of this nature where household debt is at record levels and a staggering 40 per cent of investors are on interest-only loans.

Worse still, two of the key traditional defences employed by investors for facing tougher property markets are not available this time around:
Inflation
Strong inflation allows investors to literally “inflate” their way out of trouble as the dollar value of their mortgage shrinks as a proportion of the property value. There’s no sign of that now.
Rising wages
Higher salaries help investors to service loans but wages are rising at their slowest in a generation. In recent readings they are not even keeping up with our modest levels of inflation.

What’s more, as fund manager Roger Montgomery has pointed out, the rush of initiatives by federal and state governments to impose punitive taxes on foreign investors has come way too late.

GRAPHIC: Property price falls

Our last downturn in the local residential market was off the back of what is called an “external shock”: back in 2010, as the Rudd government’s post-GFC stimulus package wound down and prices across the combined capitals fell by more than 7 per cent.

This time a downturn is happening in the absence of an external shock. The only sensible observation here is that an external shock will accelerate an existing deterioration of conditions in the residential market.

Future Moves

One crucial difference between the downturn we face now compared to reversals we have faced in the past is banks have split investors out from owner-occupiers and are treating them in an entirely different manner — interest rates for investors are roughly 1 per cent above those charged to owner-occupiers.

This segregation of investors also mean property owners — or anyone keen to enter the property market — have to keep financing costs top of mind when reviewing residential investments. (To read more on dealing with the banks, see James Gerrard elsewhere in Wealth today).

According to property and wealth professionals, there are five common suggestions for dealing with this changed market quickly and effectively:
1. Refinance
Banks are under pressure to reduce their volume of lending to investors and particularly to push investors back towards principal and interest loans. But they remain open for business. A refinancing package that resets your loan — or multiple loans — may open cheaper terms, especially if you move or threaten to move banks.
2. Fix
The banks have been pushing their rates higher despite no change from the RBA.

But on a historical basis where rates regularly move between six and 9 per cent, and can go into the teens, it may still make sense to fix your mortgage rate at current levels. It can be useful to split the mortgage package — say 70 per cent fixed — leaving a residual amount on a variable rate, which can allow you flexibility in the unlikely event rates move lower, which is unlikely but not impossible.
3. Rent review
Rental yields have dragged considerably behind price movements in recent years and the demand for rentals remains at historically high levels, especially in Sydney and Melbourne. Rent reviews can ease financing costs.
4. Manage the property yourself
This is an extreme option for many people who have full-time jobs. Nonetheless, property managers take on average 9 per cent of the annual income from a property. The savings from running a property yourself may go a long way to covering higher mortgage costs on a rental property.
5. Use your SMSF fund
One of the few items left unchanged in the government’s sweeping changes to super due to begin on July 1 was the ability of SMSF funds to borrow.

This is an option strictly for investors who are confident they have a property opportunity that will weather a wider downturn.

In every city the game just got tougher and it’s going to be made tougher still as investors are now separated from the wider public with higher rates and tighter conditions.