"When" to buy - The tipping point hypothesis

All,

I've decided to start putting my thoughts on paper and try and pull it together into a bit of a body of work. Who knows, one day someone might be silly enough to publish it for me...

I thought I'd start with my favourite topic at the moment which is the "When" to buy. Ultimately, I plan on fleshing out the whole "Why, what, where and how" as well. And I'll share the whole lot with the team here at InvestEd as I go along. I know there's a lot more experienced investors than myself here so it should help to refine my thinking.

OK, to the "When"...

I've been thinking about a hypothesis related to what I consider to be the Tipping Point Rate. I define this rate as the premium to buy over rent, i.e. the difference between home loan interest rates and rental yields.

I am hypothesising, and substantiating with worked examples, that the property market follows a distinct cycle with booms starting when the premium rate reaches the tipping point premium rate which is zero. i.e. When home loan interest rates are equal to or less than rental yields. When this occurs, owner occupiers move into the market, feed demand and bring about booms in property prices as investors follow them in on the back of potential short term capital gain.

I've written a couple of detailed pages and attached them here for your consideration.

I know there are some out there that genuinely believe "Booms just happen"; or "Its a seven year cycle". For those people, can I politely suggest that this thinking is not for you. I base the likelihood of asset price growth on hard financial fundamentals. I consider that the booms are a by-product of a bull herd following short term gain when certain financial criteria are met.

This is why you will often see me post here that "the financial fundamentals aren't right to support another boom". I don't just tick off years and say, yep, time for another one...

BTW, I differentiate this from Rental Reality in that I consider yields in the context of current prevailing home loan rates. Rental Reality only considers yields in the context of historic yields from that postcode.

Hope this is of interest to some.

Regards,
Michael.

 

Great post Michael.

I'm still digesting your hypothesis. Have you read Kieran Trass' book Grow Rich with the Property Cycle? If not, I reckon it will be very useful to help formulate your view.

I'm still reading it at the moment, but one of his thesis is that interest rates whilst a market influencer are NOT a key driver.

I'm still not sure I agree with him.

Cheers
N.

 

Nigel,

I have got Kieran's book at home but have only skimmed it. I will make a concerted effort to read it cover to cover. I don't agree with him that interest rates are independent of the property cycle. As this hypothesis points out, I reckon they're the key determinant of the property cycle. Of course, demand and supply have a lot of other factors that need to be considered too, but the fundamental economic basis of demand is affordability. To rule it out completely ignores the fundamentals of demand and supply.

I've been thinking about doing a chapter on cycle specifically too. Kieran uses a clock metaphor, but I've been thinking seasons are more easily absorbed. I'll save that chapter for another post...

Cheers,
Michael.

 

Hi Michael,

I like your thinking!

Your hypothesis is something that I've been thinking about for a while now, but maybe for another reason. I don't have a lot of disposable income, so if I want to buy an IP then it will have to be close to neutrally geared. Very roughly this will happen when yield is close to (or above) the interest rate. I assume that a lot of other IP investors have similar restricitions to me in terms of cash flow (I'm earning a bit above the average wage and have a young family), so when this point is reached then others will get on board too (owner occupiers as well as investors).

Does that make sense? I think it is just what you're saying. Seems pretty obvious to me. I'm sure there are a lot of other factors involved in a boom, but it's a good indicator for me.

John.

 

When to buy

I think this is an excellent initiative Michael and I can't wait to read it.

The stories that really stick in my mind are those of the forklift drivers with 20 properties a'la Jan Somers stories, where the timing in the cycle was never a consideration, more so the buy and hold, as long as the bare bones basic fundamentals of the property itself stack up. I doubt if the investors involved would know a 'hard financial fundamental' if it bit them on their multi-million property portfolio'ed behind ;-) The success stories Jan Somers reported happened in times of no 'booms' whatsoever.

It'd be great to compare the "unwavering faith in property for the long term' purchases to the economically-perfectly-timed versions, I don't know if there is a way to do that though ?

I mean this in a productive way - is there such a thing as over-analysis of the financial fundamentals of bricks and mortar ? Rental Reality makes sense to me - anything deeper might be too much for my tiny brain to process Very interested to read on ...

Confused etc
Carl

 

I don't think Michael's analysis is too much - IMHO it's no more complicated a proposal than rental reality, just a different focus. It's a pretty simple idea and he has just put a few numbers behind it to illustrate his point.

 

Michael,

If I am not wrong you are trying to calculate bottom of the real estate market
Questions:
What investors will do if interest rate is say 7% and yield is 6.2%.
Do you allow for any tolerances in your Tipping Point Hypo, between interest rate and rental yield (say + - 0.5% or more).
Also, do you consider that market can move even when the Tipping Point Rate (TPR) is say 1.0% or 1.5% lower than premium rate payable on home loans?.
I guess that Real Estate investors mentality is comparable with Stock Market players.
Your TPH is interesting, but I am not sure if it is going to work in the real life.
Anyway .... it's something to think about.

 

Actually I think Michaels hypothisis is part of the boom equation but probably is more to do with investor psychology rather than FHO's. I suspect that FHO's buy simply because they feel they can afford it. " rates are down, beauty the banks want to give us a loan.. and there in. After a while it just gets to expensive..the loans are too big.
Mostly I think booms are driven by investors and when they stop buying the boom is over.
Interest rates has alot to do with affordability for FHO's but yeilds and the "tipping point theory is more about investor confidence, not wanting to be too heavily neg geared.

MJK

 

Hi Michael,

I think your theorm would be a good explanation if the property market was an isolated system, and probably isn't bad in forcing the recent end of the boom, but I don't think that is entirely the case. External events such as gov't policy and lending criteria and the stock market also have an influence.

Investment in IP has had highs and lows from CGT changes. At the start of the last boom the govt needed to stimulate jobs growth and the economy, re-enter FHOG. I know of builder's who's prices went up $15-$20k a week later, but that didn't slow anything becuase FHO's had a deposit (a barrier in addition to the interest vs yeild premium). Perhaps the govt didn't expect a large number of people (mostly Baby Boomers) who were putting all there extra cash into super, didn't like the negative returns in super (who can blame them), saw house prices rising and jumped into the market.

Now I don't know if the premium got too high and the market cooled, or if a large number of BBs thought, I can't pay for any more negative gearing if I retire in a few years, this property investment has to stop at one? And the FHOs left as well for the reasons you say.

Another change: zero interest loans for 20% of the value of your property, at the expense of future capital gains - refer my post under the "article" thread. Will this change the underlying market forces a little (like the FHOG)?

A good post and a good theorm, and in a steady state environment it would probably stack up. Perhaps it is the stabilising force that corrects both booms and busts?

Dave

 

Great post Michael, I like your thinking. I don't have any tricky formulas in my head, or on paper for that matter, but there is one reason I currently rent my PPOR and not own - it's cheaper!

One day, maybe in 2 years time, when prices have dropped and rents have gone up and yields have gone up, with interest rates perhaps similar to what they are now, then we'll reach your tipping point which will indicate to me it's time to buy a ppor. And maybe an ip or two

 

Nice Post Michael,

Not sure I agree that the rent never exceeds the repayments on that house as this regularly occurs in the UK and US. There are other factors that preclude home ownership, the biggest being minset, many communities have always rented, will always rent and could not stand the risk of borrowing such a large amount to actually buy a house - this is very prevalant in parts of the UK.

I think that there is something in what your calculations show, but that it doesn't cover off all parameters.

Before the last "boom" there were positive cashflow properties in outer Brisbane, including all costs not just the mortgage payments (wish there were now!).

I think that you can get a good buy in most stages of the market (except the "hump"), if you are carefull and do your homework. We bought in Parkinson because our research showed that it was $20-30K undervalue for the meduian of the suburb and it was an above average house. Recent comparable sales show that it has between $50-90k in equity.

Some 10% rental returns are re-emerging in Oz but most are still in 2-bit towns that are too high risk for me.. but I am still "looking, lookin, lookin" until "Beauuuutifull!" but it might take "a cuppla daze"

 

Tzaki,
Just got one, not really 10% only 9%, not a 2-bit town but not then really Oz either. Definately more return than outgoing and not fussed on the reasons why. Beauuuuutiful!