KEY POINTS:
One of the most puzzling things about investing is that you can be reasonably confident that the sector or asset class which is the most popular with investors will, sooner or later, be the most reviled.
At the time, it's not obvious what is going to spoil the
party but something usually does.
Buying the house next door and renting it out has enjoyed an extended bull market despite five years of warnings of an imminent downturn in residential property prices but, as 2008 gets under way, it seems that the golden years of "buy to let" investment are at last over.
Westpac in its latest quarterly economic review cites falling sales volumes and surmises that house prices could go nowhere for five years.
Although widespread investor revulsion about residential property investment is likely to provoke "three cheers" from those financial planners who still have clients with money left to invest, a serious fall in residential property prices is likely to be bad news for just about everyone.
Residential property is the classic illiquid asset - wide bid/offer spreads, high commission, insider trading are rampant and there are all sorts of murky dealings regularly reported. Price discovery is anything but transparent and it's hard to get a consensus on historical prices let alone the future.
However, while everyone has their own view, the future direction of the residential property sector is today a little less clouded than it has been, thanks to innovation in the overseas derivatives markets.
Tim Bond, head of global asset allocation of Barclays Capital in London, notes in his regular "Global Speculations" comment for hedge funds and institutional clients that in Britain and the United States there are now futures markets which effectively forecast where residential and commercial property prices will go over a two-to-three-year period.
Those forecasts are pretty scary. In Britain, residential property values are forecast to fall by 15 per cent over three years. In the US, housing futures markets imply a further 15 to 19 per cent fall in house prices in the 20 biggest cities to 2010.
According to Bond, "these projected losses match or exceed the worst property declines seen in the past half century". These falls, of course, follow some golden years as residential property's elevated prices are, in the US anyway, largely due to the Federal Reserve's recent policy of ultra-low interest rates (to ward off deflation), which made mortgages available to sub-prime borrowers who previously couldn't afford them.
Unfortunately, or perhaps fortunately, New Zealand doesn't have a property futures market but Bond suggests that, as most Western countries' residential property prices have gone up together, they will go down together too.
Well, you might think, so what. A 15 per cent or 20 per cent fall in house prices is not the end of the world.
The significance of the residential decline is that the fall will be generally magnified for the average Mum and Dad by leverage. If you put down a 10 per cent deposit then all it takes is a 10 per cent fall in prices to wipe out your equity. If you think prices will go lower still "walking away from it" is an option. Suddenly having no equity in your house will affect how individuals feel about the world and, more particularly, decisions as to whether they should spend or save.
Combine this with high levels of debt generally, an already fragile banking sector and the downturn produced by the "wealth effect" - whereby people spend less because they feel less well off - could be deep and long. No doubt this is one of the reasons the US Federal Reserve was so quick off the mark to lower interest rates last month and why stock markets have been so volatile.
Bond sees the impact of a housing slump spreading well beyond the value of Mum and Dad's house: "Overall, the derivatives markets are effectively forecasting the worst real-estate bear market of the post-war period."
He notes that the banking system's exposure to real-estate lending is the highest it has been since the war and that material declines in the collateral underpinning the banking system (house prices) will increase risks of delinquencies, defaults and write-offs.
So, armed with Bond's prognosis, what should Mum and Dad, saving for retirement, do? Everyone needs a house and if you are happy where you live and can afford the mortgage a drop in price is not the end of the world. But in New Zealand many seem to have an extra home on which they have pitched all their hopes for retirement. Some apparently have portfolios of residential property financed entirely with debt.
While everyone must look at their own unique situation, the clear implication of the Barclays research is to sell ahead of the dip.
Having all your retirement savings in one asset class has never made much sense. But it must be said that while concentrating one's portfolio on residential property is not ideal, it is still a million times better than a diversified portfolio of finance companies in receivership.
* Brent Sheather is an Auckland stockbroker/financial adviser. His adviser/disclosure statement is available on request, free of charge.
