Economic cycles are a fact of life and it pays to take a realistic view on the future costs of the type of home you want to buy, as well as the possibility that home values can sometimes “go down instead of up”.
ECONOMIC cycles are a fact of life and it pays to take a realistic view on the future costs of the type of home you want to buy, as well as the possibility that home values can sometimes “go down instead of up”.
If you manage to qualify for a 100 percent bond, and buy a property without fully considering the financial implications of the additional and often ‘hidden costs’ of homeownership, you could at some stage find yourself in a rather precarious position.
It is important that buyers adapt and make informed decisions, advises household and property strategist at FNB Home loans, John Loos. In what seem to be tougher economic and financial times arriving, it appears to be “time for a more conservative home-buying approach” for many South Africans, he says.
So how do you guard against unforeseen risks and what do you need to know before rushing out to buy your dream property?
Yes, home values can decline
“One of the big myths surrounding the residential property market is that house prices always go up,” says Loos. “This is absolutely not true. Granted, in a country such as South Africa, which has a significant general inflation rate with regard to consumer prices and wages, house prices over time should go up more than they go down.”
He says looking at the Absa National House Price Index for its almost 50-year history, there has only been an annual average nominal house price decline in 3 of the last 48 years. “National ‘corrections’ in real terms, where prices still inflate but at a lower rate than consumer price inflation, are more common occurrences.”
Downward corrections, either in real terms only, or in all-out nominal terms, should not be seen as a bad thing, says Loos, and ideally asset prices should reflect the economic fundamentals of the country and of specific regions or areas. If those fundamentals, such as economic performance, deteriorate, asset prices should correct accordingly, he says, and this is a healthy, well-functioning market situation to have.
But homeowners are not usually prepared
The problem, Loos says, is when homeowners are not prepared for an event such as a home value decline, often because they make their buying decision based on the “fallacy that the value can never drop”.
This means they end up being “over-committed” financially, often taking out a 100% loan-to-value bond plus, sometimes, more debt to finance transaction costs or furniture and appliances for their new home, he says.
“While the other debt is unsecured, the assumption behind the 100% loan-to-value bond, made by both the lending institution and the home buyers, is that the home’s value will hold, and even increase in time, thus providing ‘cover’ should financial tough times arrive and the household not be able to service the loan.”
It would follow then, that the home could quite easily be sold and the home loan debt be settled. The household could then either downscale to a smaller and cheaper home, where smaller bond costs and lower running costs would become affordable, or it could move into a smaller and cheaper rental home, he says.
“And while many of us may think ‘it will never happen to us’, even in these current low interest rate times, our FNB Estate Agent Survey estimates that 13% of sellers are selling in order to downscale due to financial pressure,” says Loos, and this is a significant number, and was far more significant around the 2008/9 ‘financial crisis’ period.
However, he explains that the big problem arises when home values fall, because it limits the financially pressured households’ ability to “trade out” of their properties. This results in “negative equity”, where more is owed on the home loan than the property is worth.
In this instance, the home can still be sold, but if it only fetches a lower price, this can mean there is still some bond debt outstanding. This is the key reason why banks and homeowners alike would almost always like to see home values rising, says Loos.
So what’s there to worry about?
With the FNB House Price Index still rising year-on-year at 4.9% in August, there would appear little to worry about because home values are rising, right? Well, not quite, says Loos.
The reality, he says is that the index’s pace of inflation has been gradually slowing for over a year-and-a-half, the natural response to a weakening economic growth rate over the past few years as well as rising interest rates.
“Whether the index turns to all out decline or not in the near future will depend much on whether the 2nd quarter’s contraction in the economy will continue into full blown recession or not, and much of that depends on outside forces such as China and weak commodity prices.”
But even if the house price index does not decline, it is important to understand the index represents the national average house price growth trend. “When a nation’s index reaches even low positive growth, the chances are good that there is a portion of homes with values in decline, because not all areas perform exactly the same.”
Secondly, Loos says the probability is that home values of households’ that do come under financial pressure are more likely to decline, because part of the response to financial stress is often to cut back on home maintenance, speeding up building depreciation.
“And in a weakening economy, which is where we are right now, job security deteriorates and incomes become less secure, raising the chance of financial pressure.”
On top of this, we are in an interest rate hiking cycle, he says, so it is important that home buyers understand the risks and act accordingly.
Cut back and buy within your means
Loos says apart from limiting borrowing and spending commitments, it is wise to also consider how certain credit-driven purchases can impact on non-credit driven spending commitments.
“One can do this by considering limiting the size and value of one’s home,” he says. “The house is the one item that influences spending commitments more than any other single item. The implications extend to home maintenance, the rates and tariffs bill, insurance, and of course all of the furniture, fittings and appliances that we fill our homes up with.
“Think about it, the smaller the home, the less space for ‘stuff’ and possibly the less the electricity consumption. The lower the value, the less the rates bill ‘should be’, and the less the frills such as garden and swimming pool, the less the water needs and, of course, the less the maintenance needs and insurance costs.”
Loos says the more we “buy a home within our means, with this myriad of future costs in mind”, the higher the probability that the home won’t exert pressure on our household finances.
“This, in turn, heightens the probability that home maintenance can be kept up, and thus reduces the probability that one’s home value will fall.”
But the positive impact of home maintenance can only go so far, he says, and “if the market is against you”, a home’s value can still decline.
This is where there are potential “safety” benefits to buying well within one’s means and being able to afford a sizeable deposit, thereby borrowing at less than 100% loan-to-value, perhaps at 90% of 80%, he says. “A lower loan-to-value provides something of an extra safeguard should home values decline, increasing one’s chance of being able to ‘trade out’ of a property should tough financial times hit.”
Loos says people often ask him, when the right time to buy is, which is an impossible question to answer. “People don’t buy homes purely to maximise financial gain. The majority buy homes because they want a place to live in, and don’t necessarily want to wait for years for the market to be exactly right.”
But with tougher times appearing to be on the way, a more conservative approach might be the best way for many home buyers.
Is a more conservative approach starting to happen yet? “For some, the answer would appear, yes, and we see certain hints of this in our FNB Estate Agent Surveys of recent quarter. These signs include a recent decline in the percentage of sellers selling to upgrade to better properties, and a rising percentage of sellers selling in order to downscale due to life stage.”
In addition, he says there has been some decline in the percentage of buyers deemed to be first-time buyers, as well as in single-status buyers. “These, often younger buyers, can remain in the rental market for a bit longer if need be, or in their family homes.”
Of the sellers downscaling due to financial pressure, he says estate agents are also starting to indicate that more will “rent down” as opposed to “buying down”
“Such an apparent recent shift in home buying and selling patterns towards greater conservatism comes at a time when consumer confidence has plummeted,” says Loos, and such a shift currently seems entirely appropriate. Property24.com