Perhaps a softer property market will allow you to buy a future home now for below intrinsic value – especially if you plan to upsize or downsize in the next few years. Purchasers are in a stronger position in a softer market – especially with a backdrop of lower median property prices and lower auction clearance rates. This blog considers the financial merits of this strategy and what to look out for.
What’s the benefit of doing this now?
The advantage of buying at the bottom of the market (or close to it) is the probability that you will pay less for a property than you would if you purchased it in a more balanced or buoyant market. I wrote a piece for The Australian (here) in December stating that I believed we were close to the bottom of the market. And I still hold this view (e.g. auction clearance rates picked up over the weekend). So, if you agree that the market is unlikely to fall materially from here, then now might be a good opportunity to purchase a future home.
In addition to the benefit of buying below intrinsic value are lower transactional costs (stamp duty) and lower reoccurring holding costs (i.e. lower borrowings means a lower annual interest expense).
Buy now and rent it out
One strategy could include buying a replacement home now and tenanting the property until (1) you are ready to occupy it and/or (2) the property market improves and is more of a sellers’ market. This might help you to ‘buy low and sell high’ thereby maximising your equity and financial position.
An additional benefit to this strategy is that you will ‘lock-in’ your entitlement to benefit from negative gearing. This is important if you believe that the ALP will win the federal election in May and implement their ban on negative gearing.
In order to do this, you must consider two factors:
- Does your borrowing capacity allow you to buy now and sell later? As I have written about in the past, borrowing capacity has contracted a lot and just because you think you can afford a loan, doesn’t mean a bank will share the same opinion; and
- Can you afford the debt from a cash flow perspective? Typically, I test affordability at an interest rate of 7% p.a. – to ensure debt is still manageable in a higher interest rate environment. Obviously, interest rates are a lot lower than 7% p.a. at the moment. And the market has priced in an RBA rate cut this year – although we’d probably need to see the unemployment rate increase for that to happen. So, there is a reasonable argument to be made to say that rates will remain low for a while. But don’t get seduced by the lower rates and risk over-borrowing.
Market arbitrage has its risks
Market arbitrage refers to buying and selling in different markets. This strategy is not without risk. Obviously, the key assumption behind this strategy is that buying today will cost you less than say buying in 5 years’ time. And it’s also assumed that selling your existing property in 5 years’ time will yield a higher sales price than selling now. However, this is merely an assumption and it could turn out to be wrong. Therefore, the lowest-risk approach is to buy and sell in the same market (i.e. this year).
However, for some people, the risk is worth taking i.e. buying now and selling in a few years’ time. This depends on your risk profile, financial position, location of properties and so on. If it’s acceptable to do risk-wise, and the market turns out how you expect it, the benefits could be significant (see below).
What are the financial merits?
If you have been a long-time reader of my blogs, you will know that I never resist the temptation to crunch the numbers! (Nerd!) So, I have considered two situations; one upgrading where the homeowners buy and sell in the same market (now) and a downsizing strategy where the homeowners buy now and sell later.
Scenario: Upgrading through buying and selling in the same market.
Here’s the scenario I considered:
Rick and Karen own a family home currently worth $1.5 million with a home loan of $450k. In a stronger market, their home might sell for close to $1.7m. They always planned to upgrade their house/location in the next 5 years so that they resided in their desired school zone for their kids. Rick and Karen have identified a perfect house that is currently for sale for $2.25 million. They anticipate that they’d have to pay a lot more for the same house in 5 years’ time and feel that its intrinsic value at the moment is over $2.5 million.
I have compared two options:
- Buy now for $2.25m and sell for $1.5m which results in a home loan for $1.365 million; versus
- Buy in 5 years’ time for $3.3 million (being current intrinsic value of $2.5 million plus 6% p.a. growth) and sell in 5 years’ time for $2.0 million (being current intrinsic value of $1.7 million plus 4% p.a. growth – lower growth because of inferior location). This results in a home loan of approximately $1.5 million.
In 10 years’ time, I project that buying and selling now (option 1) will result in $240k more wealth (net) in today’s dollars i.e. almost 10% higher net wealth. In my opinion, the key determinants are:
- Is your desired location intrinsically undervalued by the same amount (or more) than your current location (in dollar terms)?
- Is the growth rate in the desired location over the next 5 years expected to be higher than the growth rate in the current location?
If the answer is yes to both questions, then this strategy might be worth implementing now.
Scenario: Downsize through buying now and selling later
Here’s the scenario I considered:
Ian and Robyn own their home which is worth $2.75 million and have a home loan for $950k. They would like to downsize in 5 years’ time (as a home repayment strategy). They have identified that they could buy a suitable smaller home in a blue-chip location today for $1.6 million. In a normalised market, this asset would cost more than $1.8 million.
I have compared two options:
- Buy now for $1.6m and put a tenant in the property. Then, in 5 years’ time, sell the current home and move into the smaller property; versus
- Don’t do anything now and instead downsize in 5 years’ time. I have assumed that the homeowners sell for $3.75 million and buys for $2.45 million at that time.
The first option (i.e. buying now and putting a tenant in the property) is projected to be better by over $800k in today’s dollars over 10 years. That is a significant benefit. It makes logical sense that buying in a softer market and selling in a stronger market would generate good financial returns. Especially since no Capital Gains Tax is involved.
Make sure you undertake careful planning and be realistic
These strategies take time to analyse and organise – so don’t rush into it. You must be fully aware of all the risks and ensure its affordable from a cash flow perspective (now and in the future).
One thing to note is that, probably due to emotional attachment, most people over-value their home. It’s an easy trap to fall into. So, the best thing to do is obtain third-party evidence (real estate, bank valuation, etc.) in respect to your property value. Undertake some research into growth rates of both locations and similar due-diligence.
Finally, loan approvals will obviously need to be organised (pre-approval) and, if you have read anything about banking and mortgage approvals at the moment, you would know that approvals take more time to organise. Make sure you allow for this.
It is possible that available stock will dictate when you transact
Having a great plan is one thing. But the value in a good plan lies in its correct implementation. Sort-after locations sometimes do not turnover often. That is, an area can be tightly-held and properties rarely come onto the market. Therefore, whilst analysis might suggest that now is a good time to buy, it’s definitely not worth compromising in order to do so. If there aren’t any properties on the market in the location you desire, have patience. Don’t rush. But make sure you are ready when the right property comes up.
Property is a long-term asset – so think long term
Just to be clear, I am not advocating short term thinking. I am not suggesting you can perfectly time the market and as such everyone should buy property now. Not at all. Property is a long-term decision and as such you should be mostly influenced by your circumstances and goals rather than “the market”. I am merely suggesting that if your goal is to upgrade or downsize in the short to medium term, then the current market might present a great opportunity to do so.