What would be the effect of a property crash on your investment, and how might you understand the effects on its value?

It’s almost certainly easier than it sounds. And the results are probably scarier than you anticipate.

Residential property investors dwarf the number of shareholders in Australia’s property trusts, or A-REITS. And yet the experiences of investors in the latter have much to teach them.

Because investment property purchases are typically financed with debt, the effects of small falls in rental income, or yield, can have huge implications for property values.

Let’s explain that with an example, using a concept from the world of commercial property investment called capitalisation rates, or cap rates for short.

Cap rates are used to calculate the value of an asset or liability assuming an ongoing income or cost, and are nothing more than an assumed rental yield.

If you have an income of $10 a year and you decide to estimate its capital value based on a capitalisation rate of 10 per cent, you would have a value of $100 ($10 divided by 10 per cent, or 0.10).

If you used a cap rate of 5 per cent you would get a total value of $200 ($10 divided by 0.05). And if you used 20 per cent, you would get $50 ($10 divided by 0.2).

So cap rates are like the dividend yield on shares or the rental yield on property, but looked at from the other direction, trying to ascertain a value given an assumed yield as opposed to calculating a yield by assuming a price.

The problem is that small changes to the rate can have a huge impact on valuation, as we saw during the worst of the global financial crisis.

The table shows the impact of a simple but typical boom-bust cycle. As commercial property markets boomed between 2005 and 2007, income increased due to higher demand and this had the effect of reducing cap rates.

Tiny fall, big impact

2005 2007 2009
Income $6.00 $6.30 $5.35
Cap rate 7.5% 6% 9%
Property value (income/cap rate) $80 $105 $59
Debt $60 $60 $60
Net asset value $20 $45 $-1

This helps boost valuation by more than the rise in income. Even though income rose only 5 per cent, the property value increases by more than 30 per cent between 2005 and 2007.

Lenders, seeing property values rise, make access to credit easier. Again, this is exactly what happened before the GFC.

But what happens when the music stops, as it did in 2009?

First, income falls as vacancies increase. Cap rates then rise as investors become wary of paying too much for falling income. This crunches the property’s valuation.

In this simplified example, a 15 per cent fall in income between 2007 and 2009 and a 3 percentage point rise in cap rates leads to a 44 per cent fall in the property’s value. To make matters worse, banks do the opposite of what they did in the boom years. Stricter lending standards are applied as euphoria turns to fear.

In our example we assume $60 of debt was used to purchase the property in 2005. In 2007 it seemed the banks had little to worry about. Higher valuations had reduced gearing from 75 per cent to 57 per cent.

But in 2009 your capital would have been wiped out. To avoid this happening, property investors were, in effect, asked to fill the ‘gap’ by stumping up fresh capital to bail out the businesses that borrowed too much and invested it poorly.

So after a 15 per cent fall in rent and 3 per cent increase in cap rates, that’s a wipeout. Even a 5 per cent fall in rents would have taken two-thirds off the value of your original investment.

This has been the experience of US residential property investors. Everyone came to believe that property prices could only rise, so they borrowed more and more. The boom ended, rents fell, people lost their jobs and many investors lost everything.

In Australia, where residential investment property loans tend to be covenant free, it doesn’t matter so much if the loan is worth more than the property, as long as you keep paying the interest. That provides a bit of a cushion that’s not usually available to investors in A-REITS.

Either way, the lesson is this: even if the underlying property performs OK, you can get wiped out if cap rates increase, values fall and debt is called in.

Due to high levels of debt, residential and commercial property investing is a game where small changes can have big impacts. If you’re going to invest in A-REITS, it’s imperative you understand these dynamics.

If you own negatively geared properties, much the same thing applies. Avoid too much leverage and focus on the sustainability of the underlying rent rather than just the current yield or tax advantages.

This article contains general investment advice only (under AFSL 282288).

Nathan Bell is research director at Intelligent Investor Share Advisor.

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Posted by Nathan Bell – The Age on 18th March, 2013