Nathan's View: How will you deal with zero interest rates?
If I said you could buy a stock priced at 33x earnings where the value was falling, that paid a ~2.5% unfranked dividend yield that isn’t growing and has barely grown for years, and that you had to borrow at least 80% of the purchase price to buy the stock, would you invest? Hopefully you wouldn’t, yet that’s one way to frame the current value of Australian residential property.
Obviously, it’s not quite that simple, as there are depreciation and taxation benefits to consider, but usually investing in lousy or over-priced assets based on a taxation benefit is a bad idea. Just ask anyone that invested in the managed investment timber schemes that blew up during the GFC.
Australian residential property is looking like an increasingly ugly investment for property investors and speculators, despite the small falls in property prices we’ve seen in the major cities. The only reason anyone would invest in property at current prices is because they believe capital gains will eventually produce a decent total return (i.e. capital gains plus rent plus any tax benefits).
That’s why the people whose behaviour I’m thinking about most are those with interest-only investment loans. This group is around 1/6th of all mortgages, with another similar-sized group of people living in their home with an interest-only loan i.e. roughly a third of all mortgages are currently interest-only.
Property investors are usually motivated by potential returns, unlike someone who lives in their home who often buys a home for non-financial reasons. As property prices fall, more of these investors will sell and invest where they can get higher returns. The small falls in property prices we’ve seen recently suggest most investors are currently staying put, as they believe property prices will rebound.
There are two important points I want to highlight. First, around 1% of Australian properties are sold each year i.e. a tiny figure compared to our country’s total housing stock. That means property investors have a disproportionate impact on the marginal price of property, as anyone who’s ‘lost’ an auction would tell you. If investors no longer see property as a road to riches, their selling will have an equally large impact on the way down.
The second key point is that if property prices start falling faster or further than the RBA and politicians believe is consistent with keeping their jobs (keep in mind our politicians are amongst some of the largest property owners as a group in Australia*), then the RBA will likely cut interest rates (close) to zero. Sacrificing the retirements of savers is the politically acceptable thing to do, as we’ve seen elsewhere around the world where property crashes have wrecked the economy.
So how do you invest in a zero-interest rate environment, where the safest historical investments, such as fixed income securities and bank deposits, yield next to nothing? Our approach at InvestSMART doesn’t change. We find the most attractive dividend-paying stocks and let the magic of compound interest do its work.
Though it’s not well publicised, around half the Australian sharemarket’s return over time comes from dividends. Dividends are also relatively reliable during downturns, which means you can still pay your bills or use the cash to reinvest in cheap stocks.
The dividend yield of the recently listed InvestSMART Australian Equity Income Fund (ASX:INIF) and Intelligent Investor Equity Port is currently around 5% (well above the ~3% rental yield of Australian property), and that doesn’t include franking credits. With the Australian sharemarket currently trading around its long-term average valuation, the prospect of capital gains from the sharemarket looks much better than it does for property over the next five years as growth in mortgage debt levels slows.
Right now, though, I’d guess that the most common financial discussion currently going on around Nick Scali cement dining tables across Australia is how far property prices will fall, and what people will do if interest rates increase. While this may be the most likely scenario, it’s also worth considering the alternative of even lower interest rates.
Markets tend to surprise us on the upside and the downside, which is why markets spend much of their time going up and down rather than trading at fair value. When considering your investments, whether it be property or otherwise, you always need to think about the probability of a wide variety of outcomes. Zero interest rates aren’t that far-fetched given Australia’s world-beating mortgage debt levels and will have serious repercussions for unprepared retirees in particular.
* Charlie Munger explained the power of incentives best in his speech, The Psychology of Human Misjudgment; ‘Well, I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.’