The residential property market trap

Property markets are at their most dangerous after they have enjoyed a strong run for many years. First time buyers start to panic as the prices of houses and apartments threaten to move out of reach. They become desperate to get a foot on the ladder. They are egged on by friends who have already done so and are sitting on large unrealized gain. The high level of gearing that mortgages provide accentuates this. Suppose someone buys an apartment for $750 000 with an initial down payment of $150 000, equivalent to 20% of the purchase price. If the market value of the apartment rises by 10% their equity increases by 50% to $225 000. If the market value goes up by 20% then their equity doubles.
Suddenly all the talk at dinner parties centers on how much prices have gone up for particular types of properties and locations. The market develops a momentum of its own with property prices rising well above the level implied by historic affordability measures such as average transaction prices versus average salaries.
All parties have to come to an end, however. The trigger is usually a change in the economic environment. Higher property prices increase the level of mortgage payments for people trading up and for first time buyers. Asset inflation also feeds through in the form of higher rents as landlords try to maintain yields. Employees then seek wage increases to maintain the real value of their earnings. These put upward pressure on inflation.
The usual response of central banks to rising inflationary pressures is to raise interest rates to slow the economy and choke off inflation. Interest rates for mortgages with floating rate loans follow and monthly payments start to rise. In countries where fixed rate mortgages are the norm the cost of new mortgages rises. This makes it harder for first time buyers to buy and for people looking to trade up to afford the payments on the next mortgage.
First, the volume of property transactions falls. Potential sellers are reluctant to cut asking prices. With the higher mortgage payments potential buyers cannot afford to meet the monthly mortgage payments implied by asking prices. The immediate result is that there is no market clearing price, that is a price at which sellers are prepared to sell and buyers to buy. At that time “appraised value”, the value that realtors and surveyors assign to properties, becomes increasingly meaningless.
In time these appraised valuations adjust to reflect the new reality. Sellers are urged to cut asking prices to “realistic” levels. As these agents make their money from commissions based on actual transactions they have a strong incentive to ensure that a clearing level is reached. Their profitability is more dependent on the actual volume of transactions than the absolute prices being paid.
It is at this point that first time and highly geared borrowers begin to realize that they are in a serious predicament. The gearing that works so well when prices are rising now kicks in with a vengeance when prices are falling. The borrowers find themselves facing the “negative equity” trap. This means that the market value of their property is less than the principal outstanding on the mortgage.

Tags: market, ownership, property, real estate