Real estate decisions should be made on a seven to 10-year time scale, so our current market place looks more like a landscape of good buying opportunities, not one for ill-considered exit selling
Nostradamus, the 16th century mystic-prophet, called the world of finance “the endless sea” – characterised by currents, tides, waves and, on occasion, fierce storms. In this past week, we have seen how volatile these storms can be.
Worst of all, the danger sprang from reckless lending practices in what was previously considered one of the world’s most secure asset classes, American mortgages. Interestingly, John Symond, chief executive of Aussie Home Loans, has now proclaimed the death of the low-doc loan, Australia’s cousin of the US subprime mortgage.
Some commentators described the rampant business failures and subsequent turmoil as a “once-in-a-century event”, a phrase that ANZ chief economist Saul Eslake regards as over-used. “Considering the government bale-outs of banks in Asia, Scandinavia and the Long Term Capital Management rescue in 1998, it may be rare, but it’s not a once-in-a-century event”, he said.
“Nobody saw this market failure coming last year, or that it would last this long, but it has extremely serious consequences. I do, however, think the recent taxpayer funded bale-outs suggest we’re coming close to a bottom.” Interestingly, Eslake asserts that the failure of large companies, while unpleasant, is very necessary; a way for the market to “weed out and correct untenable businesses”.
It was insurance company AIG that became last week’s focus and, given its size, this near failure was bound to create considerably more turmoil. Like most large US insurers, AIG markets property, mortgage and life insurance products, but it also has a diverse set of financial and leasing businesses around the world. To finance these, AIG invested in mortgage-backed securities and complex debt products, the very instruments in which the confidence has evaporated over the last year.
While AIG is not active in the Australian lenders’ mortgage insurance (LMI) market, QBE’s subsidiary PMI, GE’s Genworth and MGIC all provide mortgage insurance in Australia. All would have been exposed to some degree to the fallout from a failed AIG. Even though AIG remains afloat, significant losses to major insurers would undoubtedly affect the cost of all property-related insurance, including LMI in Australia, making it more costly and perhaps prohibitive for some borrowers.
Property owners are an important source of business for insurers, as they need house and contents cover; landlord protection, to cover rental default and malicious tenant damage; and their banks may also need lenders’ mortgage insurance to protect against defaults or non-payments. LMI is a requirement of the Australian Prudential Regulation Authority for banks where a borrower’s loan exceeds 80% of a property’s value.
The upshot is that intending investors will need to take a more conservative equity position. While this eventuality may make property slightly less tax-effective and keep price growth modest for a while, the short-term pause will shore up the strength of the market for property investors in a number of ways.
First, higher levels of equity as a result of more conservative lending practices will create more equity for investors to leverage over time. Lower average debt levels will also provide a greater level of insulation from future interest rate rises and reduce the impact of future market and economic volatility on investors. AIG’s near-collapse last week shows how a corporate failure can place a highly geared property investor in an unnecessarily perilous position.
“The consequences of an AIG collapse were far greater than that of Lehman Brothers, which the US Government let fail,” Eslake says. “While Lehman’s collapse affected the workings of the financial sector, AIG is interconnected right across and through the US economy. Its collapse would have had a striking resemblance to the HIH Insurance debacle in Australia in 2001.”
Owners left without a policy from a collapsed insurer may find that they have a risk – hundreds of thousands of dollars worth – not covered for a period of time. As they scramble to cover their risks, premiums on all property-related insurances would likely rise significantly over the ensuing two to three years, precisely as they did after the HIH collapse. A reduction in available LMI due to a collapse would also see a reduction in loans to this segment, excluding many purchasers from the market, and reducing demand in the residential and commercial markets.
Stuart Wemyss, a property finance expert and director of ProSolution Private Clients, says this is a significant section of the market. “Twenty-six percent of borrowers in late 2006 required mortgage insurance, so they are definitely a significant part of the market. And it’s not just new homes on the urban fringe that fall into this category. Many young professionals have borrowed up to their limit to buy and live in a coveted inner-urban location.”
This drop in demand would be felt as downward pressure on property prices, at least in the short term. Ironically, the long-term effect would probably be favourable, forcing entrants to save for larger deposits before entering the market.
Compared to some practices we’ve seen in recent years such as placing deposits on credit cards and borrowing 100% or more of the purchase price, the eventual outcome of investors and home buyers entering the market with higher equity can only be good. As Alan Kohler pointed out last week, the US housing crisis is really a problem of solvency, so a return to borrowing practices reminiscent of our parents’ generation can only be positive for the market in the long term.
In ANZ’s September property forecast, Saul Eslake’s team forecast a sound position for residential property prices. I asked Eslake this week whether even with the volatility of events, his view had changed. “We certainly think the going will get tough for highly leveraged property management and construction groups,” he said, “as the banks are unlikely to be competing fiercely for highly geared business at the moment. But the residential property market, dominated as it is by owner occupiers, is still fundamentally sound.”
I agree. Real estate decisions should be made on a seven to 10-year time scale, so our current market place looks more like a landscape of good buying opportunities, not one for ill-considered exit selling.
This article first appeared in Eureka Report
Smart Company is a sister publication to The Mandarin, catering to Australia’s entrepreneurs, small and medium business owners and business managers.
