Gloomy prospect of negative equity

The following article, written by Eureka Report Editor Tony Kaye, was published in The Australian on Tuesday, 30 October 2018.

The cracks across Australia’s property market are widening, especially in the two biggest housing and apartment markets of Sydney and Melbourne.

And those cracks should be concerning for direct and indirect property investors in general, as well as anyone with a self-managed superannuation fund (SMSF) holding residential property and any person considering establishing one primarily for that purpose.

Market downturns in any asset class are inevitable, and property investors have a number of important decisions to consider right now: sit tight and ride things out; reduce sector exposures where possible; and plan strategically, preferably with a longer-term focus.

Most property observers see the residential sector as the most susceptible to a large decline at this stage of the economic cycle, although other areas of the market such as retail property are directly linked to consumer spending. (And of course, not everyone agrees with some commentators suggesting the current concerns are overdone — see Don Stammer’s column below).

The current picture

Australian capital city home prices have fallen for 12 months in a row now and are down 4 per cent from their peak, with Sydney and Melbourne recording the biggest falls.

AMP Capital has revised its property outlook, predicting a 20 per cent top to bottom fall in prices in these two cities (from 15 per cent before), spread out between now and 2020, which would take average prices back to first-half 2015 levels.

Separately, investment bank Morgan Stanley has released a report predicting a fall of up to 15 per cent in Australian house prices, based around reduced demand, rising rates, tighter lending restrictions, and potential changes to negative gearing and capital gains tax laws.

If that level of decline eventuates, many investors who borrowed to buy residential property — either directly or within a SMSF structure — could find themselves in a negative equity position.

In other words, the market value of their property asset could fall below what is owed on their loan, which of course is a major problem if someone needs to sell.

The pressures for property investors may well be at their sharpest among SMSF trustees who may already be in a negative equity position because they overpaid for apartments built by property developers and marketed by spruikers, who actively promoted the “benefits” of buying direct property through a SMSF using a limited recourse borrowing arrangement (LRBA) for the funding.

Under the Superannuation Industry (Supervision) Act, SMSFs can only use a LRBA facility for borrowings because the loan liability under this type of structure is limited to the asset alone.

If there is a repayment default, the lender only has recourse to the singular asset, not to other assets in the wider fund.

While their loan recourse is limited to the market value of the property, in taking out a LRBA over a property, SMSF trustees are generally required to sign personal guarantees on the loan documentation, meaning the lender can still pursue them individually for any loan repayments if they default.

For those needing to sell a property because they need to use the realised funds for their pension, there are various things to consider.

To meet mandatory annual pension drawdown requirements, and where there are insufficient cash funds within a SMSF, trustees with a direct property asset in their fund have two options. The first is to sell the property and repay any amounts owed to their lender if applicable, or a second option is to keep their SMSF property in accumulation phase to avoid mandatory pension drawdowns.

Negative property equity will become a growing issue in the more vulnerable parts of the SMSF market, but it will only be a problem for individuals needing to sell their property in the current environment. Those able to meet their loan repayments need not be concerned, and nor should those with a long-term property holding strategy.

Property price downturns are certainly nothing new, and for those investors meeting their debt repayments — if they have them — and not needing to sell urgently, the best strategy is to sit and hold.

The more immediate danger is for investors who do need to sell now or even in the next few years. The prospect of a prolonged downturn in residential prices could even catch out people with a three- to five-year property sell-down time horizon — especially those needing to liquidate their SMSF property assets then as they head into pension phase.

The biggest problem will be for those investors who borrowed for property on high loan-to-valuation ratios (LVR). For example, investors who obtained a LVR of 80 per cent or higher, and who bought a property which has since suffered a sharp fall, such as in a regional mining town, may now have a negative equity position of 30 per cent or more.