How Property Investors Are Suffering From An Abuse Of Trust

The other night I watched The Big Short for the second time. An awesome movie about a few investors who saw through the lies in the financial system in the US prior to the GFC and managed to step out of the way of one of the largest financial catastrophes of our time.  

What was interesting about the movie was the small picture stuff. In a system as massive as the US financial market, people were only concerned with how they were making money for themselves in the short term rather than thinking about the implications in the greater scheme. It’s like dumping trash in a river without thinking how many people are washing downstream.

While I believe that the Australian markets have weathered the storm well and are likely to continue to do so. I will also preface this article by saying that despite there being some rotten apples in the cart, there are still great buying opportunities out there. After all, there are many different markets that make up the greater market.

However, the rise and rise of inner city apartment construction is becoming more problematic.

There’s no question this type of product is appealing to investors. I’ve seen the most educated professionals lured in by “brand new” and “walk to the city” proximity, not to mention the affordability of getting into an apartment for under $400,000.

While the markets are climbing, off-the-plan can be a great strategy, but let’s look at the reality. If you haven’t been reading my articles or the reports we put out every month, here are some sobering facts.

The supply of apartments in Melbourne’s high-density zones number around 20,000. There are about 20,000 more in construction with more in the pipeline. That is at least twice the amount still to hit the market. And yet as of today, values are already falling by around 10% to 30%.

Let me be clear here, this is only the start. The property market isn’t like the stock market. It doesn’t turn on a dime. It takes a long time to get going and a long time to slow down. Trends are measured in years, not days, and you would have to be blind nelly to miss the fact that buying into the inner city unit market now would be a grave disadvantage.

The same can be said for inner city units in the Brisbane market. Brisbane is trailing behind Melbourne in terms of its building pace but the proportion of apartments is on the same trajectory in relation to its population, with over 9,000 apartments in construction today and vacancy rates in the inner city area climbing rapidly.

The RBA recently put its own concerns front and centre, stating that investors “with tighter access to credit, settlement failure might increase”.

Let me be clear what “settlement failure” is. That means that with the regulations that APRA put in place limiting the amount of money people can borrow, and with prices potentially falling in these areas where supply is an issue, banks are likely to ask owners of off-the-plan units to make up the difference between the price at which they originally purchased it at and the price it’s worth today. Compound that with the fact that banks are viewing these locations in a riskier light and are reducing the amount they are willing to actually lend once settlement arrives, and you have buyers being forced to stump up tens of thousands out of their own pocket.

The likelihood of buyers having this extra cash can be slim. As a result, buyers often can’t settle as they don’t have the extra 10% to 30% lying around to make up the difference. The buyer loses their deposit and the developer (and bank) are left with what otherwise might be looked upon as a mortgagee repossession. The developer can potentially sue the buyer for not completing and they now need to sell that stock at the lower market price in order to regain their build costs and any margin of profit.

So while it might make us feel good to buy shiny and new, and the lure of getting into an affordable property without fronting up any cash is attractive, is this the sort of product that you think would make a solid investment?

This week I had a conversation with a client who had been shown a property for purchase in an inner city suburb of Brisbane. “Close to transport, walk to the city, brand new” was the pitch they had received from the sales agent.

Never mind that the agent was from another city and had no idea about the product they were pushing or that there was a chronic oversupply of units in the area that was only getting worse.

It’s becoming more popular now for interstate franchises to be introduced to inner city stock in Melbourne, Brisbane and Sydney.

Why? Because while interest rates remain low and financial pressure is at a minimum people don’t need to sell. That means stock levels are low, so for agents to make their numbers franchise owners are tapping into a huge reservoir of inner city unit stock in other capital cities.

This certainly isn’t a crime. After all, we don’t set the bar that high for sales agents and they’re just trying to put food on the table. But please, don’t make the mistake of looking to a sales agent for advice of any kind. They are there to make the transaction and move on. The financial implication rests with the buyer.

You can imagine my anger then, when I sit down with “advisors” in the financial space who shun an independent property advisory service like ours because they’re getting paid massive commissions for flogging off-the-plan stock.

Only last week I spoke to a company who was actively pushing SMSF investors into off-the-plan units in the major capitals, a hugely popular product in that space.

Why so popular you ask? Well for the investor they can basically purchase a product without leaving the seat in their accountant's office.

Oh, and did I mention there are huge commissions on this sort of stock. We’re talking 3% to 6% to the advisor, often amounting to $15,000 to $50,000 just for referring their client into it. The developer provides the glossy brochures and the “research” and the trusted advisor uses their position to move the client into a product with no thought as to whether the fundamentals are sound. Or maybe they simply don’t care.

And make no mistake, these commission aren’t paid out of the kindness of the developers heart. The commissions have been factored into the purchase price. Speak to any mortgage broker and they’ll groan at the thought of having to run a valuation on this sort of stock. Valuations consistently come up short because the buyers have paid way past market value in order to justify the commissions that are being paid out.

While I would like to think that with the right education and some truly independent advice clients would steer clear of these sorts of dangers, especially when their own retirement funds are on the line, but reality tells us otherwise.

If we can learn anything from The Big Short, it’s that most people are too busy with their own lives to understand the real implications of what they could be getting into, and that those in positions of trust and power will often exploit that position in order to line their own pockets.

Being aware of these flawed systems is the first step to improvement.

Questioning how your advisor is getting paid is the second.

As a general rule, if you’re not paying them, someone else is. That means they don’t work for you, nor do they have your best interests at heart.