This is how the property bubble bursts

There are always opportunities, whatever the market. Selling up and waiting for the next market crash is not an option, especially with interest rates this low.

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“CPI data crunches banks”

So screams the Markets Live headline in The Sydney Morning Herald.

Let me translate.

Inflation is running bang in the middle of the RBA’s target range, which means interest rates are less likely to be cut in May (but only marginally so).

Banks are beneficiaries of lower interest rates, because the lower the interest rate, the higher the willingness of consumers and investors to borrow money. The more we borrow, the more banks profit.

As I write, Australia and New Zealand Banking Group (ASX: ANZ) shares are down around 1.5% on the day. Some crunching, huh? I guess when you are used to bank shares only going up, it’s a bit of a shock to the system.

Also a shock to the system is the jump in the Aussie dollar. The RBA wants a lower dollar, but with inflation running at 2.4% and Sydney house prices running red hot, Glenn Stevens hasn’t got a lot of room to move.

Lucky he gets paid the big bucks. I figure he’ll work something out. He won’t get any help from our gutless political leaders.

Out of all this, one thing is certain — interest rates are low, and staying low. The search for income carries on regardless. Dividend paying stocks, anyone?

Low interest rates are great for the mortgage belt, and the property market in general, even if they are devastating for savers and retirees.

Speaking of the property market, in Sydney and Melbourne at least, to say it’s hot would be an under-statement of epic proportions.

Auction clearance rates are through the roof. Sydney house prices are increasing by around 1% per month.

Foreign buyers are jumping into the red-hot “can’t lose” property market, adding petrol to the fire.

Local owner-occupiers are paying top dollar now, fearful that by waiting, the two bedroom brick box in Leichhardt, complete with dated kitchen and bathroom, will cost even more than $1.025 million, stamp duty on top.

Cashed up local property investors, forced out of the comfort of term deposits and into the “wild west,” are turning to investment properties. Don’t mind the net rental yields of around 1% — with property prices only going up, who worries about the yield, especially when you can borrow money at just 4.5%, interest only, of course? Throw in negative gearing for good measure.

SOLD!

I did some sums. At an 8% annualised return, in five years time a $1 million unit bought today would be worth almost $1.5 million. In ten years, over $2.1 million. In twenty years, over $4.6 million.

Do you feel lucky, property investor, that you can flip your tiny unit to an eager buyer in 2020 and walk away with a decent return on your investment?

By comparison, give me a liquid, fully franked dividend-paying stock any day.

The old saying goes there’s always a bubble somewhere.

Just today, bond king Bill Gross says 10-year German bonds are the “short of a lifetime.” The yield today on those bonds is a pitifully low 0.11%.

Bond yields can turn negative, but never for long. Eventually, they must go up, and when they do, bond prices will go down. It’s just a matter of when.

Investing is about putting the odds in your favour. Minimise the downside. Gross’ German bond bet fits the bill perfectly.

If he could, you’d fancy Gross would be interested in shorting (betting against) Sydney houses, particularly investment properties swapping hands at net rental yields of around 1%. The odds certainly favour prices falling than rising.

Yet the frenzy, and the obsession, rolls on. When it ends is the great unknown. How it ends is a little easier to answer, a question I put to our own Joe Magyer, Chief Investment Advisor of Motley Fool Pro.

Bruce Jackson: How does the house bubble end?

Joe Magyer: Hard to say. Sometimes overvaluation can be its own catalyst. For example, I can’t remember what sparked the end of the American housing bubble to pop.

Here, I’d say it is rising unemployment.

Interesting twist to keep in mind is that American property investors weren’t negatively geared like Australians are.

I read about this guy who worked at the mines. He’s badly underwater on two investment properties in WA, both of which he’s struggling to get tenants in consistently, and now he’s just lost his job.

He’s basically a forced seller. He can’t afford to not sell.

Then again, if prices keep falling, he won’t be able to afford to sell either. Ugly potential spiral.

Another wrinkle is that a lot of these guys who worked in mines bought investment properties in mining towns, so it’s like a triple-whammy. Your job is gone, you can’t find a tenant, and your property value collapsed. Meanwhile, you’re bleeding cash.

Bruce Jackson: I just swapped emails with a Perth mate of mine. Works for an ASX 200 waste management business. Says Western Australia is in a pickle. Sees job losses ahead. He’s in his early 50’s and sees little prospect of re-employment should he be made redundant.

Joe Magyer: The pain there is just starting to unfold.

Bruce Jackson: How does the WA pickle translate to the rest of the country? Or does WA just go bust on their own?

Joe Magyer: Still plenty of commerce between WA and the rest of Australia. The same banks that serve NSW serve WA.

If you’re Westpac Banking Corp (ASX: WBC), you’re probably not feeling so hot about what’s happening in WA right now. Meanwhile, your share price is through the roof.

Bruce Jackson: So what does Westpac do?

Joe Magyer: Pull back on lending in WA, further adding to the pain. Depending on how bad things get in WA, they might have to tighten up elsewhere.

Bruce Jackson: That’s the unknown. Will the WA pain spread to the rest of the country.

Joe Magyer: Not to the same degree, but will at least partially.

If the implosion of housing in the US could rattle Australian shares, I would think an implosion in WA, NT, and parts of Queensland could even more easily.

It’s hard to believe you could have a major recession in WA and it not spread.

If you’d asked an American analyst what condos in Las Vegas had to do with rents in New York, they would have laughed.

Plus, you’ve got guys losing jobs in WA who own properties in the east, and the other way around.

Bruce Jackson: Meanwhile, Melbourne and Sydney house prices career up and up, with net rental yields down to 1 and 2%.

Joe Magyer: Another wild card is that 40% of new mortgages are interest only.

If housing prices pull back even just a bit, what happens when you go back to refinance? Just another potential accelerant to the downside.

All this is really, really hard to forecast.

Bruce Jackson: Could we muddle through, somehow?

Joe Magyer: I think an Australian stumble will be less severe but longer than the US because of the difficulty here of shaking off debts and starting anew.

Rather than try to predict a when and how, I think more about increased likelihoods and downside risks.

Bruce Jackson: What’s an example?

Joe Magyer: The banks.

Let’s say there’s a recession, and Commonwealth Bank of Australia (ASX: CBA) shares drop to 1.5X tangible book.

That’s a long, long way from the 3.7X valuation CBA shares are trading at today. And given the premium valuation, which is already above historical and global averages, you can’t really expect further multiple expansion.

At best, if nothing goes wrong with the economy, CBA shares will track earnings growth, say between 5 to 8% per annum.

Let’s say the odds of a recession are 1/3 sometime during the next three years, and CBA shares lose 60% of their value.

For someone considering buying CBA shares today, it’s not a good move to risk a 60% fall for a relatively modest gain.

Bruce Jackson: And what about the rest of the economy? If there’s a recession, and banks and property tank, it will get very messy for Australia.

Joe Magyer: For sure. A lot less consumer spending as consumers de-leverage. Think discretionary retailers like Myer Holdings Limited (ASX: MYR) and Harvey Norman Holdings Limited (ASX: HVN). Classified ads would drop across the board. Loan demand would fade and the number of bankruptcies would pick up.

Bruce Jackson: And what about opportunities? Should investors steer clear of the share market?

Joe Magyer: We think a company like Burson Group (ASX: BAP) would do very well, as auto parts companies did during the US Great Recession. People will put off buying a new car, but they won’t put off fixing a broken one when that is what stands between them and a pay cheque.

There are always opportunities, whatever the market. Selling up and waiting for the next market crash is not an option, especially with interest rates this low.

I wouldn’t steer clear of the share market, but I wouldn’t invest in companies with a lot of debt or that don’t have strong recurring revenue.

That doesn’t mean sacrificing upside either — we’re up 32% at Motley Fool Pro versus 12% for the ASX.

When you protect your downside, the upside tends to take care of itself.

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Of the companies mentioned above, Bruce Jackson has an interest in Commonwealth Bank, ANZ, Westpac and Burson Group. The Motley Fool owns shares in Burson Group.

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