Disclaimer: Nothing is this article is meant to constitute financial advice of any kind, and is the opinion of the author only. Seek professional advice before making any financial decision.
If you’ve ever played the board game Cashflow 101 or 202, you will know that in order to win the game, the first thing you need to do is get out of the ‘rat race’.
The ‘rat race’ in the game is a circle where you keep going around and around and around until you are able to get out onto the ‘fast track’. This is where the game suddenly gets fast, exciting and a lot more money is made, but first you need to escape the ‘rat race’.
How do you get out of the ‘rat race’? You do so by getting to the point where your monthly cashflow without your job (passive income) is greater than your monthly expenses. There are a several ways inside the game to be able to do this, buying investment property is one of them.
You will notice the game is called ‘Cashflow 101’, not ‘Capital Gains 101’.
The ‘capital gains’ game is a game that most people who invest in property want to play.
They think that prices will always go up and that it’s a sure thing.
Why shouldn’t they?
Prices seem to increase about 10% on average every year and have done for the last 50 – 60 years, surely that’s good enough for anyone?
In theory yes, but it doesn’t quite work that way.
Sometimes you will have years when the prices may increase 20% and other years it may be minus 10%. Market prices go up and market prices come down, just like the tide of the ocean comes in and the tide goes out. Warren Buffet has a saying that goes ‘you can only see who’s swimming naked - when the tide goes out.’ How true is that.
Many investors have the idea or belief that some cities outperform others, when in reality any city with 100,000 population or more in NZ most often balances out over time in relation to all other locations. If you look back to 50 or 60 years ago, the correlation between the 20 or so main cities in New Zealand back then is still very close to where it is now. It all balances out over time. As one area gets out of whack with the others, either with prices too high or too low, it doesn’t take that long before it all balances out again. This is kind of what is happening in Auckland right now with demand being way higher than supply for the past several years. Now all the other main cities are experiencing huge growth while Auckland prices have been dropping. It’s just what happens, and it will continue to do so as one area gets to be out of sync with other surrounding areas, as far as prices go.
Another thing to consider about any future growth is that today, we are entering into something we haven’t experienced for a very long time – low or possibly even zero inflation.
This could have significant effects on property prices - as in low to no growth for long periods of time. Especially if you compare things to how they’ve always been in the past.
With zero inflation, we may get many years of very little or even no price increase, nobody really knows for sure. Nor does anyone really know at any other time what the market will do from one year to the next, it is pure speculation and guesswork.
Sometimes you will be right and think that you’re a smart investor, and at other times you will be wrong and may even think you are stupid. Neither of these are accurate.
There are so many variables not only in our country, but things happening all around the world that can affect us here in NZ.
Real estate investing is largely common sense and not something to think about as a short term get rich scheme.
What the majority of people do when starting out is buy for the hope of higher prices in the future. This generally continues as they invest longer term, and so it becomes a habit. They are always trying to pick or guess what the market is going to do, and which locations around the country, or suburbs where they live, are going to do better than others.
Then there are the short term thinkers, they get into property and hold for a short while. Prices may go up 10 – 20% and then they sell! What happens after that? Any profits they have made usually get spent on liabilities and consumables, not assets. Such things as vehicles, overseas holidays, or just general spending. Rather than selling, if they had thought longer term, they would have waited until the tenants pay off their assets for them, and then have the cashflow each and every week - plus still own the asset.
A good investor with low risk strategies and a good sound plan will not care too much about what happens in the future with property prices. Their focus will be more on buying well and buying properties that make sense - at the time they buy. It won’t be dependent on their properties being worth more money in the future. Even if prices drop after they purchase them, it will not affect their investing significantly, and nor should it. If their strategy is sound, each and every property should stand on its own and take care of itself. That is, the rent should cover all outgoings on a P & I mortgage of no longer than 25 years, not an interest only loan! You may have to put in a 20% deposit to make this work for you, as far as cashflow goes. It all depends on your yield - that is the rent you receive annually compared to the cost of the property you purchase.
There are three main ways to buy investment properties, and it all comes down to ‘who is paying for it’, or the majority of it.
1) P & I loan (80 – 100% financed) – In this case the tenant is paying down the loan over time, not you. This is the ideal situation and when you do this, the price of the property going up or going down matters very little. You build equity each and every month by paying down the loan(s).
2) Interest Only loan – Most of the time when people use I/O loans they at least set it up so that it will be break even on cashflow for each property they buy. However the investor is reliant on the value going up on each property in order to build up any perceived equity. Nobody is paying the loan down, the tenant is merely paying interest on the investor’s loan.
3) Negatively geared loan – Can be either a P & I or I/O loan. This is where the investor has a shortfall and needs to top up the mortgage every month. In other words, the tenant and the investor are both paying the mortgage, or just the interest on the mortgage (I/O) and not any of the debt. When interest rates go up, the situation gets even worse as the monthly mortgage payments will be higher on the loan, and now will have to be topped up even more.
The worst of all is a negatively geared loan on interest only.
The investor’s only hope is that market prices increase, rents increase or interest rates drop further to help them. If any of these go the other way - that is market prices drop, rents drop or there are unplanned vacancies/repairs and maintenance, or if interest rates go up, they could be in serious trouble.
What happens in a lot of cases is that things do work out in their favour for a while, it could even be 10 – 20 years that things all go well, and their perceived equity has grown exponentially. The problem however is they keep borrowing up to a high debt level of say 80% or very close to it. And sometimes the valuations they get in order to borrow as much as possible, are totally over the top. That is, they are often leveraged at way higher than the 80% or so they convince themselves they are leveraged at. Sometimes they are 100%+ leveraged and don’t even know it.
I think a lot of how this comes about is because people like to invest close to home, or at least in the same city where they live. This sounds reasonable and sensible, but it’s only sensible if the properties they buy close to them are suitable as rentals. Also they should fit into the 1st example above of ‘who’s paying for it?’
In at least 80% of cases, the city where they live will not work well for investing. So they must choose a riskier strategy because for them, investing close to where they live is of higher importance than having a good sound strategy that will work! They try to make it work, and it doesn’t. Not immediately but eventually it fails. That is, unless they are constantly reducing their LVR by paying down debt – and 95% who invest this way, do not.
Some investors in NZ are perfectly happy with a 4 – 5% yield and live in the hope of low interest rates forever, and ever increasing prices. In Australia, investors will happily accept 2- 3% yields. These people will be in for a huge shock sooner or later. People have very short memories. Many people I know don’t invest anymore because they got wiped out financially with only a small drop of 5 – 15% in market prices around 2007 – 2010. And that was when interest rates were going down!
For this typical type of investor, which is the majority of investors - their main focus, thoughts and attention is all about ‘what’s the market doing?’
They will say things such as ‘this is a good capital gains area’ or ‘this is a potential good capital gains property’ and talk as if it’s an actual real thing!
If you look at property chat forums, look at what the property coaches/mentoring organisations are doing, or if you talk to real estate agents, or read agents’ news-letters and articles, read news-papers, or watch the News on TV, or even when you go out to socialise – people all want to talk about property prices! It’s just so ridiculous, and it shouldn’t matter at all.
I find the coaches and mentors the worst culprits of all. Their whole livelihood depends on convincing their victims that they should ‘buy as much property as they can, because property will only ever go up in value’.
They are sales-people most of them, not investors. Ask them where they make most of their money from – is it from investing themselves, or charging hundreds and hundreds of people $10,000 - $30,000 a year to mentor others? Many of them who coach or mentor others stopped investing a long time ago. Some of them have been lucky with market prices previously going in their favour, and so the newby, numpty type investors think they are smart and will therefore listen to them intently and believe everything they are told.
So, going back to prices, if you’re a private owner and simply wanting to sell your home and then buy another property, your property may have gone up in value, or not - just like all the other houses in your area would have done. There is no gain or loss either way.
Despite this, it remains the topic of conversation for so many people, even regular home owners. Even when I’m out walking every morning, I often hear people saying something like ‘did you hear what so and so down the road from us sold their house for!!?”
And the investors who talk about it excessively continue do so, as their strategy for investing is so risky that everything they do with their investing is dependent on it. They often get very defensive if you tell them prices don’t always go up, or say to them ‘what happens if interest rates go up, or prices go down’? They can’t hear it or block it out, thinking they don’t have to worry about it and it will never happen to them.
It would be like a game of rugby, or other such sport.
Before the game, all the build up is not talking about the actual game itself, but all about the weather for the game! It would be endless and mindless chatter and commentaries about what the weather might be like for the rugby game. Will it be a nice day, will it be cloudy, will it be windy, will there be a chance of showers or rain, or possibly even snow? Nothing about the game itself.
That’s how ridiculously stupid it is to talk about prices of properties. It has nothing to do with the game itself or investing. The market is just doing what’s it’s doing and has always done, and there’s nothing you or anyone else can do about it. There is no way you or anyone else knows from one year to the next what will happen, just like nobody knows what the weather will do from one week to the next. Sometimes it’s fine, other times it rains, but it’s all just weather! The same with property, sometimes it goes up in value, sometimes it changes only the smallest amount for many years and sometimes it goes down in value. It’s just what happens, the way it is and always will be.
So knowing that, your role as an investor is to create a sound strategy that will work in all markets - not some markets. Also a basic plan of how to get there, and then look for properties that will fit into that criteria.
As I mentioned, most of the time it will not be in the city you live. It’s usually outside the big main cities where the yields are so low that it doesn’t make sense to invest there. It only seems to makes sense if you’re a speculative gambler who likes to take huge risks, and at the same time - think they are intelligent investors. In 99% of cases they are not.
Do some people make it doing such risky things?
Yes, but I’ve only ever met 3 – 4 people that have done so long term.
They are very smart people and keep their LVR low (60% or less), way less than around the 80% as the majority of other investors do.
Before you even start investing, ask yourself “what do I want real estate to do for me?”
Do I want just one or two properties that eventually are all paid off, and I live off the income from the rents? Is it to supplement my current income? Is it so I can eventually give up my day job? Or is real estate something I’m passionate about and want to make it something I do full-time and as soon as possible?
After you’ve done that, start to develop a low risk strategy to use in order to achieve it. Not a strategy that relies on property prices going up in value in order for your plan to work. Having the belief that prices always go up and so you can either use the equity to keep buying more, or sell ½ of them when they eventually double in value, or any other plan that involves prices going up - is not a strategy!!
When buying your very first rental, you want to buy well.
Do your research and get to know market prices in the area very well - before you buy.
Go out and look at 100 houses or so and find out what they sell for, and previous sales that are similar to ones you are looking at to buy.
You only need one good deal to start. By buying well on your first property, it will set you up well for any future purchases.
If you don’t buy well on your first one, it can cost you a lot of lost time (as well as money) like it did for me, 7 years in fact. So take your time to get to know the market well, before you rush out and buy something.
In summary, stop talking about what you think may or may not happen with property prices, it’s not what investing in property is all about. Focus on using strategies that work all the time, and in all markets.
For me if anyone asks the following questions, here are my answers –
Do I know what prices will do from one year to the next? No
Do I care what prices will do from one year to the next? No
Does it matter to me what prices do from one year to the next, as far as investing goes? No
Do I care what agents or News Papers or anyone says about the market, or what they think? No
Will the strategy I use work in all markets - up, down, or sideways for many years at a time? Yes
And that’s all that really matters.
Graeme Fowler