Crazy to sell now? Not if the maths works

By MoneyQuest
In Home Loans, Investment

Wary investors across Australia and the rest of the Western world have been throwing their hands up in disbelief during the rollercoaster ride the markets have taken the past few years. The mantra ‘safe as houses’ has been heard across the land, though recent months have made the chants significantly less confident.

The housing market across most of Australia is ‘soft’, ‘flat’, ‘down’, or ‘ominous’, depending on which commentator you listen to. With those adjectives ruling the day, an investor’s first impulse, understandably, is to head for the hills. Sell. Get out of Dodge. But like most first impulses, following it might just get you into big trouble.

“The problem in this kind of market, and it’s the same in the share market and the managed fund market, is that now is not the time to be selling,” says Philippa Sheehan, managing director of My Advisor, an independent network of financial planners. “You’ve got to hold on if that property is part of your long-term strategy to achieve income and asset positions.”

But she says it always boils down to the individual’s situation – do they need the money quickly? Are they close to retirement? Have the rents tanked in the area and wiped out a needed source of cash flow? Would another asset class or property investment get an investor better returns? Sheehan says these all may constitute reasons to break the golden rule and sell on the downside.

Don’t get spooked

Donald Ross of Australian Catholic University in Sydney warns investors against getting too spooked, and to really do their homework before deciding whether to sell. He says that property, even more than shares and other asset classes, tends to have much higher transaction costs, so investors need to be especially wary of being too hasty about dumping a property, because dumping tends to be expensive.

Ross says sometimes that expense might be worth paying if it saves, or earns, you more money in the long run. He says the problem is that many investors do not like to know that they were wrong, and many times avoiding that can cause them to hold onto an asset for far too long. Ross says this is especially the case in real estate where there is no ‘ticker’ to tell you the current price of the asset. He says the property market is more opaque, therefore allowing investors to fool themselves into believing that things are not really that bad.

But selling would kill the fantasy, Ross says, “because they may have said to themselves that I bought it for $500,000, it’s still worth $500,000, even if they know full well that they couldn’t get half a million for it today.”

The key, say scholars and advisors, is being objective about your property investment and treat it just like any other investment, and to subject it to the same kind of scrutiny and performance expectations.

With that in mind, there are two clear scenarios where advisors agree that dumping an investment in a soft market could make a lot of sense: in order to stop the bleeding, or when your returns just are not what they should be.

The first case is generally a lot easier to spot than the second. Think of it like spotting a metre-wide hole in your roof versus a slow leak. The hole is a lot easier to spot, but either way you have a problem.

When you need to stop the bleeding

If you got caught up in the hype and bought at the top of the market and were looking to make a short-term flip, then chances are you may be faced with no choice but to sell. This scenario is the equivalent of having that metre-wide hole in your roof.

“The first challenge is to admit that you made a mistake and bought a property that hasn’t performed the way you expected it to,” says Stuart Wemyss, director of Melbourne-based wealth advisory firm ProSolution Private Clients.

If you were expecting big capital growth through a negatively geared investment, you may be looking at just digging yourself a bigger hole if your local market does not look like it’s going to recover quickly.

In this case it really breaks down to running a pretty simple set of numbers. If you’re not going to be able to afford making those payments every month, then sell and sell quick, Wemyss says. Having a cash flow problem now could turn much worse down the line if interest rates creep back up or if you have trouble renting the place. What is a slow drain now, could turn into a deluge later on.

When not bad isn’t good enough

But Wemyss says even investors who are not in such dire straits may find that it is time to move on from an asset that isn’t performing as well as the alternatives. A lot of investors, he says, underestimate the returns they should be getting.

“So a client might say, ‘I bought a property for $200,000 10 years ago and now it’s worth $300,000 so I made $100,000. I’m feeling pretty good.’

“Well, I would say to that client, had you made a better decision 10 years ago your property should probably be worth more like $500,000, so in actual fact you’ve lost $200,000.”

Of course, it is also important to take into account the rental yield and possible tax benefits such a property produces in order to determine its overall yield and investment potential. Wemyss says past performance is the first indicator he checks in order to determine whether an investor should consider unloading an asset. “If a property like that has only grown $100,000 or 50% over a 10-year period, well to my mind you’ve got to make some really strong arguments about why that performance is going to change,” he says. “Because if it’s not going to change, you’re going to continue to fall behind in comparison to investment-grade assets.”

So Wemyss says take a look first at what your property has done in the past, and see if it has kept up with the state and local medians. Also, he says, it is a good idea to check those returns against other investments over the same period. If it has not kept up, he says, an investor should do further analysis and be really sceptical about what the future will hold.

Projecting growth

Real estate researcher and advisor Michael Blight warns that you should be conservative about the capital growth you may expect in the coming years especially considering the current slowdown.

He says he typically puts together models that incorporate key variables like income levels, CPI, population growth, and local investment in order to project the short to mid-term growth prospects for a region. But he says we shouldn’t be too scared off by all that because, in most cases, we can find someone else who has already done much of the work.

Several of the major property data and research firms like Residex produce their own growth projections even down to the suburb level. Though Blight cautions that these predictions should be used very conservatively, he says they can serve as a good guide.

Sheehan says her company’s advisors treat property just like any other investment asset, and use the best available information to put together a picture of future performance. “Our advisors who work in this space would hop on to RP Data to see what properties have been valued at in the area recently and would couple that with the history of the rental income they have received on the property,” she says. “Also they’d have a look at interest rates and take into account the projected view on interest rates that the advisor might have in relation to mortgages.”

But Sheehan says she cautions her clients to remember that real estate investment is a long-term game, and that any analysis should take into account the fact that they should be looking to invest through a cycle.

Again, she reminds investors to keep in mind what their long-term investment objectives are and how a particular property fits in their overall portfolio. If an investor expected greater returns out of a property, and 10–20 year projections show that property will not meet those expectations, then consider moving on to something else.

But David Johnston, a financial advisor and director of Property Planning Australia, says investors also need to consider where they are going to put their money if they pull out of a property investment now.

“So certainly in a poorer market you are going to consider the prospects of the investment in the short term, and if there is fear or the writing is on the wall you may take a speculative move and remove that risk,” he says.

“But when you enter into a typical long-term investment strategy, you do it knowing that you are going to be investing through a cycle, where you’re going to get good times and bad.

“So when you’ve got to the point of re-evaluating the strategy on an ongoing basis, ask yourself if you did sell today, what are you going to do with those funds and evaluate what you expect to get from the alternative, being mindful of the transaction costs required to do so.”

He says many investors that have property as part of a diversified portfolio including several different asset classes might be looking to re-invest those funds right back into property, perhaps in another state or region that is performing better.

“If that is the case, then you have to factor in transaction costs into the decision,” he says. “Also, since it is outside your local market, costs could include getting a buyer’s advocate and some other additional expenses that go far beyond the cost of selling your current property.”

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