Don't Encourage First Home Buyers To Speculate

A few years ago I wrote a post with a list of reasons that First Home Buyers (FHBs) might consider putting off a purchase, it included the following:

You may quickly outgrow your first home  

One idea that I seem to hear repeated often is that you should just 'buy whatever you can afford' when it comes to your first home, just 'get your foot in the door' they say and work your way up the property ladder. What the older generations might be failing to remember is that you may outgrow your first home very quickly. 

Imagine the situation where you've bought a 2 bedroom unit as your first home. Two years down the track and the casual relationship with your partner has taken a serious turn and you are looking to start a family (have kids). You may then be in a situation where you have to sell the existing property to fund the larger one. That likely means real estate commission costs (usually around 2% of sales price), stamp duty on the new home, possibly LMI (Lenders Mortgage Insurance) on the new loan if you will be borrowing on a LVR greater than 80% again. Not only that, but as per reason 1, you've possibly been paying a great deal more than renting to buy. 

Do the sums. Make sure you consider all possibilities that arise. You may be a lot better off by renting until you can afford a home that will last years no matter what life throws at you.

The general consensus is that FHBs should purchase their first home as a stepping stone. Just buy what you can afford for your first home and the capital growth will get you into your next (long term) home is a common meme thrown around in the mainstream media and by those who have benefited from unsustainable price growth in the past. 

The meme continues in this blog post from RP Data’s Cameron Kusher in which he uses his own personal example to show what is possible:

“Given this, the prospective first home buyer is, in most instances, going to have to make a sacrifice in order to enter into home ownership.  As I see it, first home buyers need to make one of two major sacrifices; either move away from their local area to an area where home values are more affordable in order to enter the market or buy something which is at the lower end of the local market (which will often be a unit rather than a house). The strategy for someone buying their first home should rarely be to buy at the suburbs median selling price; it should be to buy an entry level property.  Of course varying levels of deposit and income will dictate what the purchaser can reasonably afford to borrow and repay.  Over time, the first home buyer should see some capital growth and it would also be reasonable to expect that they should also experience an improvement in their employment conditions (more pay/promotion/new role) which would eventually help in assisting them to upgrade. 

Looking at my   first home buying experience, the above scenario parallels my own experience. I have to admit, the home was pretty horrible but it was in the inner city location I wanted. 

My first purchase was a two bedroom, one bathroom unit in Fortitude Valley in Brisbane.  The location was great but the unit was not so great.  The complex was largely utilised for short term accommodation and although the unit had two bedrooms and one bathroom, outside of those three rooms it had one further room which functioned as a kitchenette, lounge and dining room.  I purchased the property for $248k in July 2005 and sold the property in April 2010 for $334k effectively five years later.  At the time of purchase, the median unit price within the suburb was $309,240 and by the time of sale the median unit price in the suburb was $400,000. 

The unit was purchased at a price well below the suburb median and upon sale the price had increased by 35%.  In comparison the median sale price across Fortitude Valley had increased by a lower 29%.  At the time I was single so I also had a friend come and live with me which assisted in making the mortgage repayments. 

By the time I sold the property I had purchased a subsequent property which was a house, once again it was purchased at a price below the suburb’s median.  I had managed to make a profit on the sale of my first home and purchased a more expensive property, I had also benefited from an increase in salary over the time which made repayments easier.”

In Cameron’s example his home increased 35% over a 5 year period, well exceeding median wage growth even if his own personal situation resulted in a stronger increase. Price growth can’t exceed wages forever so of course there will be low (or negative) price growth periods while wages catch-up. For example the period following Cameron Kusher’s ownership in Fortitude Valley.

RP Data Price Chart for Fortitude Valley Units - Click Image To Enlarge

See above a 5 year period starting in 2005 has treated the owner to a strong period of growth, but a FHB starting in 2009 for a 5 year period is probably lucky to have broken even (on price alone) in the Fortitude Valley unit market, so from a financial perspective (once buying & selling costs are taken into account), they probably would have been better off renting and saving to buy a long term & more suitable home.

As I said in a recent post:

While renting is suitable and preferable in my situation, I would never discourage others who want the stability of ownership and are prepared to treat housing as a consumable (rather than an investment) from buying. If you have a healthy deposit (preferably one that will help you avoid LMI), fixed interest rate (or able to service higher interest rates), protect yourself (income protection, cash buffer, etc) and expect to stay in the property you purchase for the long term (until mortgage paid off), then it shouldn't matter what prices do (rise, fall or stagnate). 

Some people are happy to pay a premium for the stability and enjoyment they get from home ownership, perhaps down the track when starting a family my priorities will change and I will make the same decision. For now I will continue renting, it is far cheaper than the interest repayments would be for a mortgage if buying the equivalent, it provides more flexibility and there is a good chance that my housing requirements will change at some point in the next few years (so it's pointless buying now if I will only be looking to upgrade in a few years).

When I queried Cameron on Twitter about his decision to purchase a first home with a short term view, he said:

"I purchased assuming I would get some capital growth, build some equity and my financial position would improve."

The bottom line is that we shouldn't be encouraging First Homer Buyers to speculate. They shouldn’t purchase a home with a 5 year view that they will see capital growth and be able to flip the home for a profit as a stepping stone to a more suitable house in the future. 

Even if they see a little capital growth, it needs to exceed both the significant buying & selling costs along with the difference between the cost of renting vs buying to have been financially worthwhile doing so. They are the most vulnerable (financially) in the housing market, using high leverage and often have a poor understanding of financial products in general. We should be careful not to coerce them into taking unnecessary risks.

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BB.

 

Does Australia have a housing affordability problem?

There are a few key words that get thrown around time and time again when it comes to property in Australia. 

Take "shortage" for example. Someone bearish on Australian property as a whole might argue that with 10% of Australian homes empty (according to the latest Census statistics) we don't have a shortage of property in Australia (this level of empty homes has been relatively consistent for the last several decades). Another person who invests specifically in some Perth or Sydney suburbs where prices are rising sharply might argue that a shortage of homes in this specific area is driving rents and/or prices higher. Both of these individuals might be right (in the context of their own views), but they will probably squabble with each other for hours if you lock them both in the same room and tell them to discuss whether or not we have a shortage of property in Australia.

Another one of these key words is "affordability". It has been a very hot key word as prices rocketed to their peak on a national scale in early 2010 (using the RP Data/Rismark indices) and have slowly deflated since.

Some would go to the dictionary and grab the first definition of the word and throw that into the face of the property detractors who say Australian property isn't affordable:

"Afford: To have the financial means for; bear the cost of."

The "affordability problem" deniers will say things like "If Gen Y stopped spending all their money on iPods, LCD televisions, laptops, overseas holidays and widgets, then they would be able to afford a property" (and sadly this is almost a direct quote of the sort of rhetoric I see get thrown around). 

The "affordability problem" deniers will argue that younger generations are expecting too much for their first home. They will argue that living 40km out from the CBD is a reasonable expectation for First Home Buyers, when outer suburbs at the time they purchased meant 8km out from the CBD instead of 5km. They will argue that First Home Buyers should just buy whatever they can (even if it's a run down 2 bedroom hovel which the buyers will grow out of in a few years) to use it as a stepping stone in order to build equity and buy a larger home later down the track. 

The "affordability problem" deniers will argue black and blue that if a buyer can live off two minute noodles, take a cash handout from the government, leverage their savings (and handout) 20:1 (95% LVR) in an environment where interest rates are near historical lows, to buy the worst house on the worst street in the worst suburb of the city they live in then property is still affordable.

Personally I would use this definition for affordability of housing:

"Afford: To manage or bear without disadvantage or risk to oneself."

Both of the above definitions were from the same dictionary, yet both put a fairly different spin on what affordability means in the context of buying a home.

The first definition suggests that if it is financially possible then it is affordable, the second if you can manage it without putting yourself at risk then it's affordable.

Affordability of Australian property cannot be calculated on a mathematical equation alone. 

Some historical measures of affordability have attempted to formulate an affordability measurement based on the percentage of your income which is taken by housing costs. Typically 30% has been a level to gauge affordability (e.g. if you're having to spend more than 30% of your income on housing then it's not affordable), but the problem with this is spending 30%+ on housing could have a much larger detrimental effect on someone with a low income.

Another issue I see with this type of measurement is that the calculations today are being made in an environment where interest rates are near historical lows and pose a pretty big risk if/when they start to increase again.

Take a mortgage holder in the mid 1990s for example who may have had a mortgage rate of 12%. A 1% increase in rates for this borrower is an 8.3% increase on interest costs for the loan. With current low rates a 1% move higher where the borrower is on 6% is a 16.6% increase in cost of interest. For a new borrower this will increase the repayment by a significant amount and poses a significant risk, especially where they have borrowed with a high LVR.

One of the arguments made by housing commentators such as Chris Joye is that the low interest rate environment has allowed for appreciation of house prices and that the price rise can be justified almost completely by the fall in interest rates. Take for example this quote from an article he posted on Property Observer yesterday:

There is a sound explanation for this innovation: the long-term cost of mortgage debt in Australia declined by north of 40% between 1980 and 1995, and 1995 and today. This was largely a function of the long-term reduction in realised inflation and measured inflation expectations, which in turn allowed Australia’s central bank, the RBA, to permanently lower its cash rate.

The radical reduction in the day-to-day cost of mortgage debt permitted Australian households to significantly increase the amount of debt they were servicing without a noticeable rise in underlying mortgage default rates.

Although this argument holds water on a serviceability level, if we look at the effects that a doubling price and halving interest rates have on a mortgage holder over the term of their loan it's a real eye opener (use this mortgage calculator to run your own scenario):

$300,000 borrowed @ 6%

Repayments of $2000 per month

23 years, 2 months to payoff loan

Total repayments = $555,903

$150,000 borrowed @ 12%

Repayments of $2000 per month

11 years, 7 months to payoff

Total repayments = $278,643

The initial interest costs on a $300k loan at 6% is the same as a $150k loan at 12%, however the smaller loan is repaid at a much faster rate if the borrower has the capacity to repay either loan at the same rate.

So are lower interest rates making property more affordable? Not if prices rise to fill the serviceability gap.

By taking on a larger amount of debt, even if the interest rate is half of some historical levels, borrowers are taking on significantly larger amounts of risk and hence by the second definition perhaps can't be considered as affordable as some would make them out to be.

Many bullish housing commentators have been talking about falling interest rates bringing back buyers to the market, but I think that buyers are starting to smarten up on the whole "lower interest rates makes property affordable" lie. Even following two cuts in late 2011 and two more this year (including a 50 point cut in May) we have buyers sitting on the sidelines waiting for lower prices. As Leith points out on MacroBusiness today:

CLICK CHART TO ENLARGE

What is most worrying about this result is that it follows the RBA’s -0.5% cut in official interest rates in early-May. While it is only one-month’s data, these figures imply that this rate cut had absolutely no impact on mortgage demand which, in fact, took another leg down over the month.

Housing credit growth continues to remain at very subdued levels, which ties in with the very low volumes of sale (from RP Data):

CLICK CHART TO ENLARGE

It seems that even if buyers could continue to buy prices at current levels, they are choosing not to afford property (given the risks). A wise choice in my opinion as the short term downside is a much greater risk than missing out on upside.

In my opinion the best thing that Government could do to help any perceived affordability problem is to step back and stop meddling with the markets, let them deflate.

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BB.

 

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