Negative equity hurting McMansion owners, but most home owners needn’t worry

By Catherine Cashmore
Tuesday, 27 March 2012

Over-spending on real estate is a temptation often hard to resist. It’s not an emotion restricted to houses, however as property is often the most expensive purchase most make in a lifetime – usually with the intention of making a profit from the proceeds – it’s a serious enough “habit” to ponder the psychology behind it.

This past week, the media has widely publicised RP Data’s research revealing that the number of home owners experiencing negative equity rose to 6.11% in December 2011 compared with the previous quarter, which came in at 4.9%.  The report measures “baseline” equity – so in other words, it doesn’t take into account debt levels, which are based on individual circumstance and correctly observes most owners are covering interest payments on their home loans, as well as paying down the principal.

It simply assesses the difference between what your home was worth then and what it’s worth now. A full breakdown of how RP Data collates the information is described on the company’s website and to give the company its due, it leads the way in such technology, taking into account not only location and property type, but also basic attributes of each listing such as number of bedrooms and so forth. However, while this is valuable – especially when analysing broad market movements – it cannot accurately assess why two properties with similar attributes including land size and location may differ quite considerably in their sale price – did one owner overpay? To answer this, a physical inspection and subsequent assessment is needed.

RP Data uses an “automated valuation model”, which it has assessed through “blind tests” to be “within plus or minus 15% of the actual sale price”. However, while automated models are gaining traction as a credible tool even among time-poor (and arguably underpaid) valuers (some of whom seem to think a quick “drive by” is enough to attain an accurate assessment of “real value), they simply cannot be relied upon for an assumption of current market value when the majority of Australia’s real estate market is made up of home buyers whose individual circumstance and needs are subject to attributes that can only be assessed physically.

Last year the national capital city median dropped 5.5% (RP Data), which is a big enough drop to instigate a degree of concern. Yet RP Data reveals that in assessing the disparity between the previous sale price of a home and its current market value, it can be anywhere up to 15% “inaccurate”.  Even if we’re generous and assume properties entered into the system fall closer to the mark being just 10% or maybe even 5% out in terms of real selling price, it’s not a good enough analysis to make an assumption of the exact number of properties in negative equity – which is precisely what RP Data has done.

When valuing a home, certain aspects cannot be ascertained by an automated valuation model. These include physical condition of the property, the “feel” of space, natural light and most importantly, the “emotional appeal” unique to each home buyer. All of these you can only assess via a physical inspection and yet all bear a significant impact on the final sales price.

Our lives are ruled by automated systems that churn out statistics that affect not only commodity prices, interest rates and market sentiment, but also bear an increasingly controlling effect on our society and the decisions we make for ourselves and families.  We’ve had a year during which on paper, the economy looks remarkably OK. Market sentiment has been blamed for the housing downturn, however large numbers of small businesses are struggling – numbers that are somehow missed in various statistical models or eclipsed by the mining boom. This is not to dismiss the importance of transparent data; I’m simply drawing a line between where this data is useful and where it becomes an unnecessary and inaccurate intrusion affecting the paths we take.

Property is an emotional purchase where beauty is commonly in the eye of the beholder.  Spend enough time assessing a location, walking through open homes, attending auctions, gaining access to accurate sales data, and understanding the demographics of the area-specific buying market and what may drive one property to sell higher than another, and you’ll get easily within 5% accuracy on a property’s sales price 95% of the time – something an automated model cannot independently achieve.

This is one reason why buyers’ advocates are becoming an obvious option for the time-poor who don’t have the energy to do the necessary legwork I’ve described above.

We also need to bear in mind, in some states – such as Victoria – there’s still not open disclosure to the general public of “private” sales data aside from listing the street and suburb – further details revealing the exact house number are limited to licensed estate agents, therefore any detailed research in the public domain is limited to properties that have been auctioned (of course, assuming those prices are not listed as “undisclosed”).

However, for a home buyer, the assessment on how much to pay for a property is an emotional issue. What a house may be worth to one buyer is not an indication of what it’s worth to another. I’ve attended a surprisingly high number of auctions during which the next-door neighbour has been bidding for the home. Obviously a sale of land that has the potential to dramatically increase the value of the neighbouring house or apartment is worth significantly more than it would be to an average home buyer. Therefore overpaying and subsequently experiencing negative equity in such circumstances is consequential and should not be a concern considering the long-term benefit to the holder.

So are we really looking at 6.4% of homes in negative equity? Well, considering we’ve just been through a year with turnover has been at its lowest level for a decade and a drop in median value that has – in some areas and suburbs – eclipsed 10% or even 15%, there’s no doubt that those who purchased some three years ago at the peak of the market will be wondering if they didn’t over pay comparatively to today’s prices. Additionally, there are always those who didn’t research the market closely enough before jumping in, got carried away at auction and arguably overpaid. I see this often enough to genuinely believe that every home buyer should be diligent enough to get qualified independent advice prior to purchasing.

Other concerns on price paid include the number of off-the-plan sales, which are fast rising in number. Trying to value an unfinished product considering the considerable and temporary oversupply is hard at the best of times – therefore in answer to the question above, we can assume there is certainly a number of properties that are currently experiencing negative equity.

The report suggests there are some – albeit 1% – who have owned their homes for over 10 years that are looking at lower values. I would find this hard to perceive in any capital city area unless we’re assessing a location affected by floods or a regional location, therefore the exact breakdown of these results would need to be assessed further to draw conclusion. Therefore in short, yes, there are numbers who may be suffering a temporary period of negative equity, but to assess how many is quite simply impossible outside of a broad estimation (even “guess-timation”).

Aside from what I’d assess to be a report that is more of an assumption than accurate representation, there is a tendency to overpay for real estate that resides deeply in every home buyer’s psychological makeup. I’ve worked with many investors and owner-occupiers with budgets ranging from $300,000 to in excess of $4 million.  Without fail, all desire one step more than they can reasonably afford and the more money they have to play with, the more grandiose expectations become. You can somewhat understand it when dealing with a first-home buyer or a family who need a house but can only extend to a unit. Genuinely “needing” more than the budget can afford is a frustrating hazard of a rising population.

However, it’s a little harder to relate to at the other extreme and no better is it demonstrated than in those who commonly have the purchasing power to own modern man’s equivalent of the ancient castle. This is also the demographic most likely to experience negative equity when trying to sell in a downward cyclical phase.

As I’ve pointed out in previous articles, since history began, housing has been an integral part of the most valuable asset man desired, fought over, possessed and in many cases died for. Land was – and has always been – the ultimate symbol of power and wealth, and owning it often holds more significance for the vendor than can be assessed in monitory value alone. In this instance, it’s not so much about need for shelter, but desire to exhibit status, and the higher the price paid, the greater the risk involved. For example, head out to the suburbs surrounding the capital that fall into the highest median price bracket, with large land sizes complete with McMansions – suburbs such as Toorak in Melbourne and Point Piper in Sydney – and the buyer market diminishes considerably. The further away from the median price bracket you get, the more volatility experienced.

Supply verses demand is what fundamentally drives market activity, therefore the less demand you have, the less opportunity for price appreciation. In a downward cycle, multimillion-dollar real estate will be forced to drop further in price in order to sell. Therefore if you’re a bargain hunter, pick the right time, and this isn’t a bad place to start! Once the cycle turns, these areas will re capture the greatest gains in median value and make a tidy profit for the astute buyer who “timed the market”.

Meanwhile, to each and every home buyer, considering we have not experienced anything near to a 40% drop in median value as exhibited in areas of the US and strong indications suggest we’re unlikely to for some time to come, you can assume any talk of negative equity affecting your property is a consequence of what a computer has assessed, not a home buyer. Once computers get to the level demonstrated in the film I, RobotI’ll take a little more notice.

Catherine Cashmore is a market analyst with extensive experience in all aspects relating to property acquisition. 

Negative equity…

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