Is Sydney now the rotten apple for investors? Oasis' Gavin McPherson

GUEST OBSERVER

A wise investor once said: “People’s expectation of the future is set by their experiences in the immediate past.” No truer is this phrase than the phenomena of the Sydney market over the past 2-3 years. It’s also unfortunately why I think there is pain ahead for those still contemplating a residential property investment in Sydney or Melbourne.  

Think about it; with between 62% (all NSW mortgages, July 2015 CoreLogic) and 68% (Nationwide: AFG) of mortgages being investment loans, an investor should realise that with only 32% of participants potentially buying property for its underlying utility value (ie: to live in!), investors will happily shun a location if it presents no potential for meaningful growth in the near future.  Investors certainly don’t need to live there!

Now, I am certain of the direction of these changes, but of course the timing is open for debate. 

At Oasis Property we maintain our bias towards a correction of between 7-15% in the Sydney market. In Melbourne...less so (5-8%). My expectation is that this play out over the next 2-3 years. In almost every extended discussion I have with people about this, I find disagreement. But the startling thing about this is the disagreement is not because they necessarily disagree with our experience OR the fact that Sydney and Melbourne prices have outperformed on every metric. No. They are disagreeing only because of sentiment and psychology. No sound reasoning, just emotion built on expectation, based on recent performance. 

As I have cited many times publicly...and almost ad nauseum for 12 months now, the fundamental reason for owning property in Sydney and Melbourne has been exhausted. That is, the baseline amenity (a house) being built for a consumer (owner or tenant) that is ready to live in it...is too expensive. Expensive to the point that a homeowner finds it more logical to rent (at 2-3% yields...this is entirely rational) OR the bank will not extend them the finance to lend. (rational or not...the buyer doesn’t have a choice in this!) 

All this brings me to a tried and trusted logic that has served me well as an investor. From the mouth of legendary investor Rick Rule. “The cure for low prices...is low prices.” And similarly the inverse of this...the cure for high prices...IS high prices.” 

Before you think that notion sounds absurd… hear me out. Rick is a billionaire. You are probably not. Using this narrative below to example this notion, allow me to expand: 

If a developer cannot buy land, build a property and make a profit – they will not build that property. There MUST be an incentive to do it. Or building will stop. It is called a market clearing price. 

For example. If land can be purchased in Lane Cove for $1m, and a new dwelling costs $600k to build (=$1.6m), yet the market price is only be $1.4m, the dwelling will simply not get built. Why would they? Would you?

Exacerbated over an extended period of time, if this incentive is not achieved...the will be no properties built over an extended period of time. Demand will build up (like it has). It’s a predictable outcome. 
 
Eventually, the market will realise that there is a housing shortfall. 
 
Now, with that situation in place as ‘tinder’ for the market, it only took the dovetailing of the low interest rate environment to light a fire under the property. The rest is modern history. 

Hence the saying: “the cure for low prices...is low prices.” It is that simple.

Taking that example of that Lane Cove property I referred to.  We see that at $1.4m the maths doesn’t work. In fact, even at $1.6m it doesn’t; what with stamp duties, borrowing and holding costs. In reality, most developers I know wouldn’t even start the project if it returned a market price of $1.9m. (~12% after costs) Developers will roughly work off a model of 30% and often include contingency in this plan to scale downward or upwards from here. They’d want to see $2.2m to get them started on this project. 

And now we’ve got ourselves a market clearing price! And that’s exactly where Sydney and Melbourne have been over the past 3 years.  Now we’re well past it.    

The problem is of course, that this effect works the same way at the other end of the market...the top! Many more properties are being constructed and have been constructed now that this incentive has been created. This has had the effect of inflating the cost of property well and beyond the affordability of the everyday property owner, which is the benchmark we all must base our assumptions on. 

Do not base it off the overseas/Chinese investor. They will (eventually) only pay what is necessary to beat the next highest bidder. Do not base it on the wealthy investor, they will be subject to, and more likely price in higher interest rates. Do not base it on the self managed super fund purchaser. NO. Base it on the home owner. The person that needs a home and can either afford to pay for it or not. (Hint: do some research...[lack of] affordability is now through the roof!)

What we are finally left with is too much stock on the market and elevated prices for those buyers that are left. I think we are almost there. You do not want to be holding that parcel when that music stops! 

So eventually, the “cure for high prices” is the high prices themselves that make them unaffordable for those that want and need to live in them. 

To combat the claim that people believe that Sydney prices will still keep surging, I cite a most recent, but now almost daily occurrence whereby people actually argue with me that they do not believe that Sydney prices will ever go backwards. After convulsing in a fit of laughter, I then reply, with a cheeky grin on my face;

“If that occurred (non-stop growth), it would be the only time in history, in any region, in any mature market - that this has occurred. Ever. Let me repeat...EVER!”

On that note, I’ll leave you with one last reminder. “the cure of high prices...IS high prices!” 

Gavin McPherson is chief executive officer of Oasis Property Buyers Agency and author of "Value Investing in Property: What would Warren Buffet do if he was investing in property in Australia?" He can be contacted here.