this is the way the big boom ends

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    A unit oversupply and price drop could have disastrous results for investors, writes Ross Gittins.

    Make a note of the date - July 2003. Why? Because as late in the piece as this, a bank as big as Westpac is still distributing advertising brochures asking, Why stop at one investment property? It's an act that, in his former life, Westpac boss David Morgan, PhD would have called "a courageous decision, minister".

    One of the biggest economic and political questions of the new financial year is whether the boom in (mainly) inner-city rental apartments will end with a whimper or a bang.

    Apartment prices are falling already in inner Melbourne - where the oversupply of newly constructed apartments seems far greater - but are still rising in inner Sydney.

    Most of the financial market professionals I know are appalled that punters could still be piling into the apartment market at this late stage.

    There's an old sharemarket saying that when you see the bellhops buying, it's time to sell. But this rental apartment boom has been dominated by bellhops from the outset.



    The property developers, insurance companies and banks have developed new financial products to spread the opportunity to invest in rental property from the more sophisticated and well-lined to ordinary mortals with nothing but a bit of equity in their own home.

    To these new products the institutions have added mass-market advertising and invitations to attend dubious "investment seminars".

    The salespeople stress two points. First, you can buy apartments without putting up much, if any, of your own money. Second, thanks to the miracle of "negative gearing", you can oblige your fellow taxpayers to pay almost half your interest bill.

    So investment in rental apartments - often bought "off the plan" using "deposit bonds", which mean you even borrow most of the deposit - is the latest new and exciting get-rich-quick scheme (unlike all the old ones, which didn't work).

    The first factor that makes the inner-city rental apartment market more likely to be accident-prone than the market for free-standing owner-occupied houses in the suburbs is that the number of newly built apartments constitutes a much higher proportion of the total stock of inner-city apartments.

    When the supply of apartments (new plus existing) grows faster than the demand for rental accommodation, vacancy rates rise and landlords have to cut their rents in the hope of keeping their place tenanted. It's already happening in both cities.

    So why are investors still piling in? Partly because of the long delays in property development. The lambs coming to slaughter today are goats who bought off the plan 18 months ago or more.

    And this means supply will still be increasing long after the slowest learner has realised there's a problem.

    The other factor that makes the rental apartment market so potentially unstable is the central role of negative gearing. A negatively geared investment is a business you've deliberately structured to run at an operating loss. (You do this by borrowing so much that your interest payments exceed the rent you receive.)

    Why would you do such a thing? Partly because the loss is tax deductible. That means your fellow taxpayers carry up to 48.5 cents in each dollar of your loss.

    But, of course, that still leaves you covering 51.5 per cent or more of the loss. So, for as long as you keep the apartment, you have to keep shelling out more and more of your hard-earned. And, should you have to cut the rent, or go for a time without a tenant, the never-ending drain on your pocket gets bigger.

    Obviously, there must be more to it. In the end, you enter a loss-making investment because you're hoping to sell the apartment for such a huge capital gain (taxed at half the normal rate) as to make it all worthwhile.

    But what happens when, as your outflow of funds to service your investment keeps mounting, it finally occurs to you that apartment prices are falling rather than rising, so that the prospect of capital gain has turned to capital loss?

    Because it's only an investment - not the home you live in - I think you become terribly tempted to cut your losses by selling out.

    But the more people who do this - the more people who head for the exit at the same time - the bigger the losses become.

    And the trouble is, it's like someone shouting "Fire!" at the theatre. You know the rational thing to do is stay seated, but all your animal instincts tell you to join the herd pressing for the door.

    That's the scenario that ends the rental apartment boom with a bang - with, say, a 30 or 40 per cent fall in prices that leaves many "investors" with nothing to show but a big debt to their bank.

    The scenario that ends the boom with a whimper - with only modest price falls, but continuing over the next three or four years - says that property investment leaves more room for self-deception.

    With investments in shares, you know exactly what they're worth from one day to the next. With real estate, however, you don't know definitely what your particular property is worth, so it's easier to convince yourself it's worth more than it is. Then you tell yourself (like the share investors) that the market's set to turn back up "in the second half of the year".

    But let's say we do get a full-blown collapse in apartment prices. The banks aren't likely to lose much because of the belt-and-braces approach they've adopted of getting a mortgage over the apartment plus a mortgage over the investor's home. Even so, they'd end up foreclosing on a lot of family homes (something they rarely do to ordinary owner-occupiers).

    Can you imagine the field day the media would have? All the heart-rending stories about families turned into the street by a flint-hearted bank (with only a fleeting mention that these "ordinary battlers" were trying to get rich quick with three rental apartments)?

    I can feel another round of terrible publicity for the banks coming on.

    And if all the media angst were to put the frighteners on a lot of owner-occupiers with big mortgages, the Howard Government's reputation as incomparable economic managers might be looking pretty tarnished.

    If so, it would have only itself to blame. Why? Because it left open the negative-gearing loophole on which this whole rocky edifice has been built. And then it compounded its failure by halving the tax on capital gains. I call that asking for a property boom.

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