Business Cycles

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.

 

Locations

There is no simple answer!

 

Smart property investment involves identifying assets that offer growth potential coupled with a sustainable level of rental return.

This combination is the basis for long term wealth building.

Australia is a vast country and opportunities exist in different states and different locations within those states. Even within the same suburbs, various types or styles of property present different opportunities.

The best place is the place that meets the investor’s specific situation and strategy.

One thing is for sure, the best place is not necessarily, the place you live in now! Many novice investors make the mistake of assuming that the ‘devil you know’ is the best way to go.

Looking over the back fence of an investment property is not only unnecessary but ill-advised. The investment property is an investment vehicle and should be chosen devoid of emotional attachment.

Concentrating on your work and income earning potential and leaving the management of your asset to a carefully chosen property management professional is the wiser approach. ( the benefit of specialisation is higher productivity)

This is particularly appropriate when you build a property portfolio. The logistics of managing multiple properties is beyond the scope of most people unless it becomes your full-time job!

Choosing a location to invest in ought to be a well-considered decision, based on your situation, budget, goals and time frames as well as an analysis of the demand side drivers and the supply side constraints prevailing in different places at different times.

The factors influencing demand and supply in any location are multi-layered and don’t always conform to textbook models.

Perfect competition requires perfect knowledge. To get the lowest price for bananas, you need to know who is selling them, where and at what cost at any time point in time.

Likewise, perfect knowledge and mobility in the housing market do not exist.

It is unrealistic to expect that the price of accommodation, either house prices or rents will be met with a ‘perfectly elastic’ responses on both sides of the equation.

For example, despite rising rents, families may not be easily mobile across locations in search of lower prices. Access to employment, transport options or the lack thereof, family ties and established links to schools, sporting and friendship groups make moving home tricky. It can also be prohibitively expensive.

Likewise, the timeframes involved in new supply limits the ability of the market mechanism to work as efficiently as it might otherwise.

 

It’s important to understand that Monetary Policy is what’s known as a ‘blunt instrument’, that is, it affects all sectors of the economy generically and it’s not possible to selectively target just the ones you want to dial down or the ones you want to stimulate.

The effect of macro drivers for demand, such as interest rates is not location-specific. For example, the RBA was not able to increase interest rates in Sydney and Melbourne alone to slow house prices during the past expansion phase without collateral and unintended damage to other property markets. So, while record-low interest rates now are designed to provide a stimulus to the economy and to ‘soften the landing’ of slowing activity, they do so generically.

You can’t assume all markets will grow as a result of increased consumer optimism and confidence – it’s crucial to look at the specifics and to match a location to your particular needs before arriving at a decision.

 

 

Knowing your risk profile, assessed borrowing capacity and importantly, your comfort range will be the starting point for establishing your property investment strategy:

Influences on the choice of location include:

 

 

 

 

 

 

 

 

 

 

 

 

Investor Mindset

“Life rewards action, not inaction.”

 

Be careful what you wish for! The media is full of stories about people who have won money in the lottery and have not only lost it all but ended up in a more unfortunate situation than they were in before the windfall. Without the right mindset, it can be a house of cards!

 

 

 

https://www.news.com.au/lifestyle/real-life/the-lotto-curse

 

 

 

What these people were missing was education and obviously any ability to postpone gratification!

Told you it was necessary!

A sensible decision would be to eliminate any debt and satisfy some basic needs – perhaps the car needs replacing or a home? But none of these so-called  ‘winners’ seems to have any inkling that they could invest the winnings and live off the interest or rent earned and retain their capital.

What they lack is the investor mindset – immediate gratification is driving them, not financial discipline or long term goals. They could make the winnings work for them for a long, long time with just a little restraint and planning.

Opportunity doesn’t necessarily equal success, but it can.

According to Steven Covey, author of The 7 Habits of Effective People, the number one habit is Be Proactive – make decisions to improve your life through the things you can change.
Abundance isn’t finite, there are opportunities for ordinary Australians to create wealth, but you need to know about them and be prepared to act on them!

It comes down to knowledge and attitude.

That attitude is an INVESTOR MINDSET

1. The decisions you make need to be of the head and not the heart!  They need to be made after due diligence and based on the balance of evidence.

2. When it comes to property investing, too many focus on their ‘own backyard’.

Australia is a big place, and as we will see later, there is no one property market as such. There are a collection of markets, some growing, some stalling, and even within those, and there is varying demand for different types of property.

These variations are a result of the fact that supply and demand for housing is a function of a wide variety of economic and demographic drivers that can vary from one state to another, one town to another and one house type to another. The best location and type of property is the one that stacks up dispassionately, based on the figures that suit your circumstances and goals.

3. You don’t need to be looking over the back fence either. Expert property management is crucial, particularly as your portfolio grows. Managing the property is the property manager’s job, you do your job, and they do theirs. Property management fees are tax-deductible – just another cost of ownership.

4. Similarly, the investor should not be overly concerned with the design and decor of an investment property. Too many people imagine themselves living in the property. While it’s essential to have plans that meet demographic changes, investment product is built with the tenant in mind. What appeals to the tenant market is what counts and also what maximises the market on resale.

The same goes for the inclusions in a property. Is it worth spending thousands on upgrading a property’s interior for rental? Some things are commonplace and expected, such as air conditioning, window coverings and hard floors in high traffic areas, etc.. But any quality offering will include those things – complete turnkey means that the tenant just needs to move in with their furniture and start living – the investment is basically  ‘remote control’.

Going beyond that is something that can be done as part of an exit strategy, many years down the track if necessary. Don’t pay extra interest on an upgraded inclusions list for twenty years, instead, spend the dollars when it’s needed.

5. The property is an investment vehicle – an opportunity to generate income, build wealth for the future and reduce your tax burden now.

6. Time in the market is more important than timing. Some people wait so long for the right time that they never make a decision – suffering ‘paralysis by analysis’. No activity in life is risk-free or opportunity cost-free, but it is a matter of prioritising your goals and then making a plan to achieve them and sticking to it.

7. Understand that psychology plays a significant part in most people’s decision making. The ‘herd mentality’ (FOMO) can lead investors to come in and out of the market because that’s what others are doing. Instinct is what makes us run at the sight of a lion; it’s logic that should override impulse and make investment decisions.

“Be fearful when others are greedy.
Be greedy when others are fearful.” Warren Buffett

8. The media too is responsible for a great deal of fear and confusion. Bad news sells, drama sells. Investors need to ignore the doomsayers; they come and go. Lack of consumer confidence, fueled by the media, the crowd and sometimes their own family and friends (often those who have ever invested in anything) can often bring to fruition what the fear peddlers predict.

9. Successful investors gather a talent bank of support around them – Investment Property Advisor, Accountant, Broker, Financial Planner, Insurance Broker, Property Manager – all experts, trained and qualified in their specialty.

10. Understand that market corrections are inevitable – panic is not an option, nor is it a strategy! Business cycles are to be expected. Sometimes they are a result of macroeconomic policy by the policymakers via Fiscal Policy (the Budget) or Monetary Policy (interest rate manipulation by RBA), or even exogenous factors, outside of our control, such as a decline in commodity prices paid by our Asian trading partners or the current pandemic.

Property markets go through cycles and periods of correction too. Rapid appreciation in prices is often followed by a tightening of credit conditions and a softening in demand. It is essential to be prepared for these and to stay the course. Remember, it is the trend that is important.

11. Patience is a virtue! Property is not a get rich quick scheme.

12. Most importantly, Investors have the mindset that life rewards action, not inaction.

 

 

 

Property Cycles

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: