An economic model illustrating
increases and decreases in a nation’s
real GDP over time.
As we have seen the fundamental economic problem is scarcity. There are insufficient resources, globally, nationally and personally to meet all our needs and wants.
Priorities need to be determined and choices made, nationally and individually.
Not making a choice also carries a cost, a lost opportunity.
In a highly specialised economy, your income determines your ability to consume, and income (and ‘wealth’ – a store of income in the form of assets) are unevenly distributed.
Australia is a modified, free enterprise economy.
Economies lie on a continuum from total laissez-faire, free market, unbridled self-interest to the other extreme of centralised planning and control.
While the profit motive and self-interest are driving forces in the decisions about what, how and for whom to produce in Australia, the government plays an active role in regulating, enforcing and incentivising economic decision making and alleviating the most severe excesses of the system.
The market is efficient; the interaction of supply and demand allocates goods and services highly effectively through the rationing device, we know as the price.
In a perfectly operating market, as demand for particular goods rises, supply expands to meet the demand. If supply cannot meet the rising demand, prices rise to distribute the available stock. The reverse is also true. If demand for a good or service falls, producers will run down their inventories and cut back on production, perhaps even cease production and prices may fall. Resources are then free to flow into the production of alternative goods and services.
That’s the theory!
It is, however, a simplistic, textbook version of the economy and relies on the assumption that a ‘laissez-faire’ (meaning to leave alone) strategy is best. It relies on perfect competition’ – but perfect competition is conditional on ‘perfect knowledge’ (amongst other things) which empowers consumers to efficiently ‘shop around’.
In reality, many factors come into play that may inhibit the free operation of markets. Supply is not always perfectly ‘elastic’ or responsive to the heightened demand for a particular good – rather than increased supply; we may simply end up with higher prices for the same product or service.
So, while the market system may be efficient in many ways, it is not necessarily equitable, nor is it always self-correcting!
Modern economies, like Australia’s, are subject to market failure.
The government in Australia manages the economy and its failings through a combination of macroeconomic policies designed to smooth out the worst extremes of the business cycle – the regular periods of instability accompanied by inflation at its peak and unemployment at its trough.
Fiscal Policy influences the economy through budgetary and taxation measures. When the economy is slowing, and unemployment is rising, the government can inject money into the economy by running a budget deficit = spending greater than revenue. (injections > leakages*)
When the economy is overheating, and inflation is rising, a surplus budget will dampen demand and put downward pressure on prices. (leakages>injections)
Remember that every policy decision has trade-offs and unintended side effects.
Running a surplus may reduce inflation, but it may also mean the loss of jobs. Running a deficit may employ more people but at the cost of higher prices.
Nothing is simple or straightforward!
Remember the circular flow of income model or the ‘above ground pool’ analogy? The size of the pool and therefore, the number of people who can get in and get wet depends on the balance between leakages and injections.
Fiscal Policy aims to maintain the level of the water in the pool but it is also deliberately formulated to incentivise participation and enterprise and encourage self-sufficiency.
Tax concessions, grants and exemptions are provided by the government to encourage property investment because of its significant contribution to incomes, output and employment directly and indirectly via the multiplier effect on the economy as demand for complementary goods and services rise in accord with housing construction.
Property investment also provides a means of building wealth and reducing future welfare costs and so incentives are deliberately designed to encourage planning, entrepreneurship and self-reliance.
The government also depends on the Reserve Bank’s implementation of Monetary Policy to help even out the ups and downs in the business cycles.
Monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation. In determining monetary policy, the RBA has a duty to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve these statutory objectives, the Bank has an ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3 per cent, on average, over the medium term. Controlling inflation preserves the value of money and encourages strong and sustainable growth in the economy over the longer term. https://www.rba.gov.au
Interest rates are eased to encourage spending and growth and therefore, employment and tightened to control inflation.
Through a combination of Monetary and Fiscal Policy,
governments aim to even out the extremes of the business cycle.
The interest rate is the cost of credit.
Interest is the cost of credit.
There is no single interest rate.
Rates vary according to the availability of funds and the risk attached to lending for a particular purpose. There is a direct correlation between risk and the premium charged, as risk rises, so does the price of credit.
The investment loan mortgage rate is the one that is of consequence to investors and is relatively low because the asset securing the loan is a physical, ‘bricks and mortar’ asset.
Interest rates are cyclical, they go up, and they go down in line with the Reserve Bank’s responsibility to help manage inflation and unemployment. Interest rates are ‘tightened’ (upward pressure applied) to control inflationary spending, and eased to stimulate growth and employment.
Interest rate rises for the investor are not as ominous as the media would often have you believe. When rates increase, fewer people buy their own homes and more enter the rental market, putting upward pressure on rents. Higher rates mean more tax deductions. The net effect on the bottom line for an investor of a .25% increase or even a whole 1% increase is significantly reduced by the fact that part of every dollar in interest you pay may be returned to you by the ATO at your marginal rate.
“In addition to enterprise-wide stress tests, portfolio-level and risk-specific stress tests of residential mortgage lending portfolios are considered good practice.” Prudential Practice Guide: APG 223 Residential Mortgage Lending APRA 2019
Central to that stress testing obligation is lenders applying a ‘qualifying rate’. They work out if you can afford to borrow even if rates rise by around 2%. They don’t approve loans that are servicing on the current interest rate; they factor in the expectation that rates are cyclical. If you get approval, you are genuinely creditworthy! The idea is that even if rates rise, you can service the debt without undue pressure.
When considering finance options, the best lender is the one who will do the deal for you! Some promise low rates but if a conservative valuation falls short of the package price, forcing you to contribute more or to withdraw from the purchase, the ‘comparison rate’ is a price too high to pay.
It can be their informal way of securing themselves. Insisting on saving .25% on a $300,000 loan over 10 years = $7,500. But, if that lender’s criteria are so strict and they won’t allow the deal to ‘work’, as an investor you may potentially forgo capital gain for ten years, traditionally 7.2%pa or in this case $300,000 profit!
A variable interest rate fluctuates in line with the Reserve Bank’s Monetary Policy and more recently, the retail banking sector’s discretion!
A fixed-rate is set for a specific term of the loan. If borrowers can pick the bottom of the market, this can be a beneficial strategy. Keep in mind, though, if the bank’s fixed rates are falling, they are expecting them to go even lower in the future.
Even though the official cash rate may be as low as 0.1%, the price charged by lenders is higher because they add a margin on top – this is how they make a profit. So, housing mortgage rates may be 2.1-3.0% while the cash rate is as low as 0.1%.
Monetary Policy is RBA action to influence the availability and cost of credit by adjusting the cash rate. To be effective, banks need to pass on the reductions in rates to their customers. In recent times the banks have been accused of ‘hijacking monetary policy’ by either not passing on the rate cuts or by increasing their rates outside the policy cycle.
This why the Governor of the Reserve Bank has suggested that customers compare lenders and products, not be complacent and ‘shop around’!
Competition is a powerful motivator for lenders to keep and win new business.
Interest rates, what if……… Interest rates are defined as ‘the cost of credit’; in other words, it’s the price we pay for using other people’s money. Household debt in Australia is close to $2 trillion, around $200,000 per household. Some of us owe a lot less, and some of us owe a lot more! Finance is crucial to economic activity; for households, corporations and government. Few of us have all the money we need at our disposal to buy or build the big-ticket items like houses, factories or bridges and so we have to borrow and pay it back over time.
At a micro or household level, credit allows us to create wealth by purchasing assets that appreciate over time. It also allows us to buy assets that depreciate over time but enhance our standard of living, the cost we incur is the interest we pay.
For most people, the single largest purchase in their lives will be the family home, and so it’s not surprising that the lion’s share of private-sector debt is for housing and the rest is predominately credit card and vehicle debt. Housing debt includes owner-occupier liability and to a lesser degree housing investment debt.
Credit card debt is considered ‘consumption debt’ because we buy things with credit cards that get used up quickly or fall in value over time, typically it’s classified as ‘bad’ or unproductive debt.
As a nation, we are by and large committed and reliable repayers. Housing loans in default hover around the less than one per cent mark, and a significant proportion of borrowers are ahead in their payments. It seems a lot of us are not necessarily ‘great savers’, but we are ‘great payers’.
So how does all of this relate to an investment property purchase decision? Given that our lenders, with strict prudential supervision, are comfortable lending up to 100% of an investment property purchase is a strong endorsement of the safety in bricks and mortar as an investment. Borrowing to invest allows you to access the power of leverage and purchase assets much more significant than you would be able to if you had to fund it using your own money. The cost will be the interest you repay to the lender, but that cost like all associated with owning an income-producing (rent) asset is tax-deductible. The cost of borrowing is weighed against the opportunity cost of not investing now.
Time in the market is important when investing in property, so any recommendations need to be based on the idea of ‘sustainable investment’, can you afford to hold the property for the long term, allowing for reasonably predictable changes in circumstances over time and movements in interest rates? Why? Because interest rates will change over time as sure as night turns into day.
Monetary Policy is the Reserve Bank action designed to influence both the availability and cost of finance in the economy. Interest rates are pushed up to slow the economy and limit inflation, and they are eased to encourage spending and activity and therefore, employment. So, as economic circumstances change so will the prevailing cost of credit.
When calculating out of pocket costs for an investment purchase build in a buffer, ask to see the figures at an interest rate of 1-2% higher than currently on offer. Keep in mind though that given the RBA typically adjusts the dial by .25% at a time you have many adjustments before you reach the 2% mark.
The upside of a rate increase is that your tax deductions increase and more people may delay buying their own home and continue to rent and put upward pressure on rents.
Remember, ‘profit is the return to risk’ so you do have to take some risks if you are to build wealth for the future but make it a calculated risk.
The property cycle is divided into 4 phases
The property cycle is a recurring pattern of upturns and downturns in the market for housing influenced by economic, political, social and psychological factors.
Periods of growth are inevitably followed by periods of reduced growth and market ‘corrections’.
While property cycles can vary in length, pace and the height of the peaks and the depths of the troughs, they follow the same long term positive trajectory. Variations around the trend line are to be expected, but it is the overall direction of the trend that is important.
This is why a property is not considered a short term investment or a ‘get rich quick scheme.’
It is worthwhile noting too that while recovery periods typically match the length of time, it takes to go from peak to trough, it is not always the case.
Investors need to commit to sustainable levels of debt that will allow them to ride out the downturns.
Investment in real estate like any other asset class is subject to market sentiment and the performance and management of the economy as a whole. Returns may fluctuate depending on factors such as supply and demand for housing, population growth, interest rate changes by the RBA and government incentives and exogenous shocks to the economy.
Influences on the demand side include:
The business cycle – if the economy is growing, unemployment is low, and consumer confidence is high, as incomes rise more people buy their own homes and more people are in a position to invest. If the economy is slowing and unemployment or underemployment is growing, and consumers are pessimistic about the future they will hold off and wait for conditions to improve, leading to a decline in demand.
Government incentives through fiscal measures encourage owner-occupiers and investors via grants and stamp duty concessions, negative gearing allowances and capital gains tax discounts. Removal of the same inducements will have a reverse effect. Political uncertainty and imminent elections also inhibit consumer confidence.
The RBA’s manipulation of the cash rate influences the cost and availability of credit in the economy, and more people are likely to borrow and purchase property either for owner occupier or investment purposes when rates are eased and less so when the policy is tightened.
Prudential regulators such as the Australian Prudential Regulation Authority (APRA) can encourage or discourage borrowing by relaxing or toughening the guidelines for financial institution’s lending criteria.
Demographic trends such as population growth and the divorce rate will increase or decrease the demand for housing (and the type of housing)
Media coverage intensifies consumer perceptions and fear of missing out (FOMO) and it can also drive ‘doom and gloom’. Consumer confidence and emotion govern many decisions.
Influences on the supply side include:
The availability and cost of development sites and materials: vendors will assess the profitability of entering the market as a supplier and calculate the risk and return potential. If they expect costs to increase, they will seek a higher margin as insurance against future erosion of profits.
Bureaucratic red tape and compliance costs influence the profitability of ventures, including the approval process and mandatory infrastructure co-contributions
The cost and availability of finance for developers. If credit is limited and difficult to obtain, a smaller number of projects will get off the ground, typically by more substantial, corporate developers.
Builder expectations, confidence and perceptions of buyer demand influence their willingness to take risks and enter the market.
The property cycle is divided into 4 phases: