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13: What do investors commonly do when property prices fall? – some advice..


08-30-2004

I would like to give a few insights and pieces of guidance to fellow investors with regard to what ideas and strategies you could adopt if house prices fall.

 

Some Options to Consider

 

If house prices fall by say 20%, many investors that are highly geared (say 80%) can get into difficulty because they no longer have any equity in their portfolio. This makes it very difficult to borrow additional money. If rental income does not cover mortgage payments and costs (e.g. the investor has a negative cashflow), then capital and income funds can dry up – leading to financial stress and even bankruptcy. If you believe this scenario might play out – then it is best to either:

 

 

What is your true asset value?

 

Remember, the costs of selling a property are typically 3% of the asking price, and the amount you might achieve compared to the asking price in a depressed market could be as low as 85-90%. So to be conservative, your assets should be valued at some 15% below likely asking price. If you are 80% geared to asking price, then you would be 95% geared to actual (post costs) asset value. The bottom line is – make sure you do not over-extend yourself. Try and make sure that even at higher interest rates (say 5.25% base rate, 6.75% buy-to-let mortgage rate) your rental income covers your mortgage payments and costs. Those who are employed with a regular income will be able to survive such a period of higher interest rates and low capital value increases better than most, because they will be able to ride out any period of negative cash-flow.

 

What happens in the long term?

 

Remember, in the longer term, rental prices will likely rise and catch up with capital values – at least keep up with inflation, so normally, the longer you can hold on to your property the better. Also, because of inflation, the real terms value of the borrowed money goes down, meaning your equity value will increase. Property investment has been seen to be a successful long term investment, and there does not look to be anything that would change this significantly in the UK and US. An exception is when there is deflation, as was experienced in Japan from 1990 to 2003 – deflation meant that debit actually increased as time went on and commercial property values crashed as stayed depressed during this period – residential prices did to fair much better.

 

Should I move my money around?

 

For some investors, when they see the market reach a peak, they sell up quickly - either the whole or part of their portfolio - and put the money into the bank, then start investing in another area or country where they predict high capital value increases. The costs involved in buy and selling, plus the 40% capital gains tax on most of such sales precludes this as a good strategy for most investors. It is a strategy for the investor who wishes to keep their money moving quickly, who have the time and energy to buy and sell, and enjoy managing the risk of moving their money into different regions. Investors who can plan to reduce capital gains tax liabilities on such sales can make very high value gains in short periods. An example of such a strategy would have been:

 

 

This strategy would most likely achieve very high return on investment by end 2006.

 

However, most property investors invest locally – they like to renovate and manage their properties close to where they live because in doing so they can add a lot of value. So buying then selling out of the area you live in would not be optimal for many people. The lack of control, legal complexity and ability to cheaply add value to their property portfolio precluded such a strategy for most property investors.

 

How can I be proactive?

 

Many investors, when they see a property market just about to “turn” – just before they anticipate prices to start coming down - decide to sell a few properties to free up capital for when bargains are to be had. Some experienced investors have already done this in the UK by mid 2004 – though if prices flatten then start to move up again later in the year or next year, this strategy would probably not generate any value.

 

What do most investor do – how can I test a scenario?

 

The bulk of investors will sit tight, ride out any storm and concentrate on keeping their rental void periods to the minimum, their property is good order and well decorated, and costs to a minimum. They will also go slow on further investment – to see how the market will play out. Most property investors will not panic, since they view their investments as a medium to long term financial commitment. Only if prices drop by say 20% or more is their likely to be a significant panic. This is the threshold that many first time buyers and investors are geared to (80%) which would send them into negative equity – and thence mean they cannot sell their properties without getting a loan out to repay the debit. This scenario is possible, but it seems unlikely without a trigger (e.g. higher taxes, high unemployment, high energy prices, consumer confidence disappears).

 

In summary – before prices fall, it is best to do an economic scenario whereby you:

 

 

Then ask yourself the questions:

 

 

What’s the outlook in the UK?

 

A final comment is that as of late August 2004 in the UK, it seems unlikely now that rates will rise above 5% base rate since the economy is slowing and house prices seem to be declining slightly. Some commentators even believe they will not rise above 4.75% - hardly surprising since CPI inflation is a meagre 1.6% (in Euroland, CPI inflation is 2.5% with ECB rates at 2%!). So the “lean period” may be short-lived if we look to Ireland and The Netherlands for comparison – despite a recession in The Netherlands in 2003, prices still rose by 5% – UK house price crashes have not been experienced without a trigger and it seems the UK economy is doing well. So do not be surprised if prices level off or fall by say 10% in the south of England by end 2004, then the interest rates drop and prices start moving up again. Remember that the UK rates will most likely converge with Euro rates at some time in the future, and if UK rates were at the 2% they are in Euroland (or say 3% in a few years time) – you can imagine prices would likely rise again.

 

I am personally still investing in the England – selectively – I have slowed down but not stopped, and I have not sold a property as yet.

 

PropertyInvesting.net  30th August 2004

 

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