"When" to buy - The tipping point hypothesis

All,

I've decided to start putting my thoughts on paper and try and pull it together into a bit of a body of work. Who knows, one day someone might be silly enough to publish it for me...

I thought I'd start with my favourite topic at the moment which is the "When" to buy. Ultimately, I plan on fleshing out the whole "Why, what, where and how" as well. And I'll share the whole lot with the good ship Somersoft as I go along. I know there's a lot more experienced investors than myself here so it should help to refine my thinking.

OK, to the "When"...

I've been thinking about a hypothesis related to what I consider to be the Tipping Point Rate. I define this rate as the premium to buy over rent, i.e. the difference between home loan interest rates and rental yields.

I am hypothesising, and substantiating with worked examples, that the property market follows a distinct cyle with booms commencing when the premium rate reaches the tipping point premium rate which is zero. i.e. When home loan interest rates are equal to or less than rental yields. When this occurs, owner occupiers move into the market, feed demand and bring about booms in property prices as investors follow them in on the back of potential short term capital gain.

I've written a couple of detailed pages and attached them here for your consideration.

I know there are some out there that genuinely believe "Booms just happen"; or "Its a seven year cycle". For those people, can I politely suggest that this thinking is not for you. I base the likelihood of asset price growth on hard financial fundamentals. I consider that the booms are a by-product of a bull herd following short term gain when certain financial criteria are met.

This is why you will often see me post here that "the financial fundamentals aren't right to support another boom". I don't just tick off years and say, yep, time for another one...

BTW, I differentiate this from Rental Reality in that I consider yields in the context of current prevailing home loan rates. Rental Reality only considers yields in the context of historic yields from that postcode.

Hope this is of interest to some.

Regards,
Michael.

OMG, Micheal, you make my head spin. I'm a simple girl & will buy when it stacks up for me. Easy! However, I know there are a lot out there that will really enjoy your mammoth essay, probably even my own Hubby.

Awesome

Hey dude - thats awesome - I love it.. Nice to see some analysis and deeper thinking!

I was wondering - can you attempt to quantify the 'emotional premium' accompanying people who buy homes to live in? I would assume some people would buy despite a difference of 0.5% (Im guessing, but you get the idea).

Along the same lines is the 'exposure' to the market factor - people would also (if they are in the position to) like to maybe pay a little more rather than 'wasting' their money on rent to waste it on interest and therefore gain exposure to future price rises.

And on the flip side there are the usual holding costs of property and the 'emotional' side of inflexibility which home ownership may bring (as some would see it).

thanks for the effort michael - i have printed it out and will read when the house quietens down later tonight.

Great article Michael!

I suspect that the 'tipping point' would vary with region, with areas that (a) have a more transient population, (b) are small towns and (c) have lower population growth showing tipping rates closer to zero. You'd expect that anyway as these areas have typically higher yields.

Though it may seem rational to buy, personal circumstances (such as an intention not to stay in town for long, have kids, etc) can mean that people who could afford to buy will rent instead, despite the economics.

I don't regard it as a given that tipping rates should necessarily be positive in all areas (despite the benefits of ownership).

Mining towns are a prime example of areas that have had negative tipping rates (between -1 and -3%) for years. Even in 2005 some properties in some towns are dearer to rent than to pay the interest on.

There could even be several tipping points.

For example, a figure of around -3% could be significant, as it's around this point that rent starts to exceed total holding costs for the purchaser (ie CF+ for the investor).

So even if the buyer doesn't value future appreciation, they're not taking much of a gamble (or compromising their living standard) by buying such a home.

However though they're not spending any more, they're not saving any more either. Thus the only financial benefits are capital gain, which is long-term. As this could be less significant than short-term plans, the decision to buy is not necessarily compelling enough yet. Thus the tipping point can be slightly negative, but many aren't yet driven to buy.

But when it gets to around -5% (rental yields approx 12% at current interest rates), so buying is unambiguously cheaper than renting, even on a cashflow basis. Assuming zero future capital gain, then even more people may (eventually) sit up and take notice. That is if there is a substantial potential pool of employed and willing new homebuyers, which may not necessarily be the case, eg small mining/agricultural towns (eg Norseman or Kambalda?).

Peter

Peter,

Excellent points mate! And some of these I'd been thinking about myself. In my hypothesis I proposed a tipping point of zero, but as I was driving home I considered the differences between regional and city markets. So, to develop it a bit futher, I think I need to introduce a "beta" by region and probably by city. i.e. some way of weighting individual sub-market tendancies to swap from renting to buying at a certain price point equilibrium.

For those that think this might all be hypothetical, I personally am hoping it is not. I am contemplating buying the series of historical yields across a series of postcodes from RP Data, then doing a statistical correlation with historic home loan mortgage rates to try and determine the true correlation and tipping point nationally if it exists, as well as specific postcode tipping points.

If it turns out that there is a statistically significant correlation then it could well prove the holy grail of timing the market. However, I'd suggest that it is more likely that Sydney leads the market, so finding the Sydney tipping point or the Melbourne tipping point would be a good start. Then just expect the ripple effect to take hold and the rest of the other sub-markets to follow regardless of their own correlations between yields and mortgage rates.

Thanks for taking the time to read my brief paper and come up with an insightful, thought out response.

Much appreciated!

Trogdor,

Yep, I definately plan on trying to map out some of the other aspects that might impact the beta for specific situations. Individual circumstance and mindset can play a key factor, but I think the tipping point is really a measure of the collective willingness of the market to buy over rent at a certain price premium so is the "mean of the group". Once the market starts booming when the tipping point is exceeded then the herd mentality takes over, so in a way the individual characteristics are less important. It would still be interesting to understand what can constitute the price premium though. i.e. What "benefits" from buying are substantial enough to increase the tipping point premium above zero. i.e. Make people buy whilst it is still more expensive than renting. And vice versa too as Peter pointed out. Some people would rather rent even though it is more expensive than buying.

Thanks for your input too!

PS Looking forward to Lizzie and Bargain Hunter's input as well...

Cheers,
Michael.

I have printed it to read it later.

Looks interesting though. Well done!

Cheers,

Up there for thinking!

Gotta be honest though Michael, I'm not sure that it's how people think when it comes to their PPOR - well, at least not the way I thought. Most people I know haven't tried to justify PPOR vs Rent costs - for most it's an unwritten rule that the PPOR will cost more than rent. Typically it comes down to a matter of how much deposit do I need to live in the area I want, can I save it? Then save, save, save, spend - oops, save some more. Ahh - I have the bucks - lets go! From then on, very few look back to renting again unless a big move (geographically) occurs or financial troubles strike.

I guess I'm trying to say, I don't know that we can look too much to PPOR buyers for the analysis - people were buying PPOR's the whole time through the boom and continue through the bust. Investing in IP's - now that's a different ball game, but isn't really a choice between renting / buying for the investor. Unless there was a correlation between tipping points and rentals / vacancies rates .....

Hi Michael,

Interesting approach.

Here are some of my thoughts as I work through it:

1) There are always people who prefer to rent than buy, even when R is greater than HL. This can be a lifestyle choice, or due to ignorance about the market, fear, lack of entry funds (deposit) or transience (defense/students).

This doesn't invalidate your theory - but it does mean that there is always rental demand even when models may indicate that everyone will be buying their own home.

Equally there are always people who prefer to buy than rent, as covered in the last post. This indicates that there is always some demand for purchasing property regardless of pricing or timing.

2) The theorum only indirectly takes into account the supply of property. If there's a shortage of supply this would push up the R side - but doesn't necessarily increase the number of people looking to buy as some might decide it's simply too hard at the time and withdraw from the market - just as when unemployment rates are high more people decide not to seek work.

If there's a supply surplus rentals come down and per your model the propensity to buy would reduce. However this instead might be seen as a great time to enter the market by people who have previously experienced rental crises. Thus the equilibrium point may be above 0% as even with a high HL Rate people are emotionally concerned about being locked out of the market in future, as they were in the past, with high rentals.

3) Can you chart the tipping point month on month from 2000-2005 in a city and track it against price movements. This would give two indications - how closely your theorum matches reality and how much lag there is in the market. I'd anticipate at least 3-6 months lag as many people keep buying after the peak of the boom as both data is not available in real time, it's several months delayed and also many people do not investigate markets sufficiently and buy post-boom expecting further gains.

The book Extraordinary Popular Delusions and the Madness of Crowds illustrates this last point.


What I do like about your model is three-fold, firstly it's simplicity, second it's testability (as long as it does get tested) and thirdly that it provides a way, if it works, to assist in buying decisions TODAY rather than waiting months for data or pursuing a gut-feel headcount/bid count approach (are there less people at auctions and open houses, are there less bidders and offers)

On the other hand, the model might be too simple to use as an effective planning tool or simply may not match the market reality. We need more than 4 data points to judge.

BTW, I agree that there are likely to be local situational variances in the Tipping value. This is due to cultural, social and economic variations amongst others.

Cheers,

Aceyducey

Hi Micheal

A interesting theory but ......

The set of figures where that the theory doesn't seem to work is late '80s interest rate 14% up to 17% and if you were involved in a bad rate 24%.

Yields on rental were at about 7% with the initial interest rate 14% but we still had a boom and it was a biggy.

I suspect you have applied the current set of figures and invented a formulea to suit you need to back test it across several booms to really determine its viability.

I look forward to further refinements.

Cheers

Hi all,

Good theory Michael, but does it stand up to the scrutiny as stated by Handyandy??

I was about to bring up the 80's boom myself. You may find that there are different tipping points for different booms, depending on a whole host of factors. This in itself would make it difficult to predict when the next boom should start.

Maybe you could refine it, and we would all be eternally gratefull.

bye

handyandy said:

Hi Micheal

A interesting theory but ......

The set of figures where that the theory doesn't seem to work is late '80s interest rate 14% up to 17% and if you were involved in a bad rate 24%.

Yields on rental were at about 7% with the initial interest rate 14% but we still had a boom and it was a biggy.

I suspect you have applied the current set of figures and invented a formulea to suit you need to back test it across several booms to really determine its viability.

I look forward to further refinements.

Cheers

Click to expand...

What the hell happened in the late eightees?

I think I remember term deposits were paying 14%! But maybe I'm dreaming. I was paying 23% interest rates on my farm loan! Farms are considered high risk so interest rates are higher. I very nearly didn't make it out. Wasn't home loan interest rates capped at 14%? I've always suspected business and farmers were subsidising home owners.

Then there was the big share boom and bust. Shares tripled from 84 to 87. 2% dividend yields in Oct 87 when cash was paying double figures! The big property boom after the share bust. crazy times. What was everyone thinking?

Handy andy, your 7% rental yields, are you sure that wasn't at the end of the property boom in 89/90? Therefore they would have been double figure yields at the start of the boom in 87 before property doubled? I remember better returns than 7%.

Any stories from investors at the time? Things were really crazy!

Then of course, Japan went even sillier than Oz. They been paying for it ever since, but that's another story.



To expand further, What happened in the late eightees is why I suspect property got so cheap in the mid 90's. Quality property being able to be positively geared is maybe something that will never happen again. It only happened because investors could still remember their near death experience just a few years earlier. As interest rates plunged, average investors were too slow to see the bargains. The smart investors who saw what was happening can now retire.

Some on this forum [myself included] are waiting till ratios get back to 1996 levels. Probably we will miss the next property train altogether if we expect those levels to ever happen again.

See ya's.

Hi Topcropper

Talking Sydney western subs here. The returns were up to 10% (easy) in about '85 interest rate 13%, towards '87 the returns had generally fallen to 7%.

The interesting thing about the returns is that have just deteriorated further and further, with the recovery not exceeding the previous rate. I am not including special areas where there was some negative aspect that help restore the % return.

You also had government inteverance in the form of removal and reintroduction of negative gearing. Personally going out on a limb I suspect every boom is in some way fuelled by govermnent policy (meddling).

Even the most recent boom was for me influenced by the intro of GST and was absolutely influenced by the doubling of the first home buyer grant.

Cheers

ps you could get 17% on your money if you were with Pyramid, but only if you were quick and got your money out in time.

Hi all,

Topcropper, Handyandy is correct. In the 80's the highest yield on property that we had was around 8-8.5% and this was just before the boom when interest rates were ~14%.

Interest rates for existing(PPOR) loans were capped at 13.5%, but new loans were allowed to go higher. Investors paid at least 1% higher. We fixed a loan at 14.5% and thought we were clever!

bye

MW

You've probably got me on ignore, but....

As has been alluded to by other posters, imho your tipping point analysis will never be able to take account of arguably the most important factor behind the house purchase decision - emotion.

But don't feel too bad - the best econometricians in the world are yet to devise a rigorous way of taking account of it either.

I pretty much agree with all the comments made on this thread thus far


MW, if you truly are open to new ideas, consider this one......buying IPs is not rocket science.

Mark

Michael

Nice to see you putting some thought into it.

It's obviously a complex subject , and not one I've attempted to assess from a fundamental view point. The only person who has done that to a degree of effect is Kieran Trass, and obviously he discounts interest rates, which is something that supprised most observers.

I'm still looking at it from a TA view point , and a while ago came to the conclusion that attempts to pick the highs and lows was not necessary . Sure it would be nice , but not required from the practical view point of making money.

At some stage I'm going to get around and start looking at and tracking the factors that Kieran nominates but too busy with other things.

See Change

Pitt St said:

MW, if you truly are open to new ideas, consider this one......buying IPs is not rocket science.

Click to expand...

Yes, that's right, it isn't rocket science - in fact few things in life are (in fact I read somewhere once that rocket science, isn't even rocket science).


For all our technological advances and doo-dads, humans remain simple creatures.

Though our behaviour is quite complicated, our underlying motivations are quite basic (Shakespeare was right). Indeed several recurring themes emerge, they include (but are not limited to):

- Love

- Power

- Money

- Success (and it's flipside - the fear of failure)


MW, I think this last one is your achilles heel.


You want to buy an IP, but you are afraid of failure (aren't we all?).


And how do you minimise the risk of failure?

In your case you appear to be waiting for a person and some otherwise meaningless numbers to tell you when you are ready.

MW, no investment is 100% safe and if you're willing to take the success that investment may bring, you also have to be willing to accept the risk that it may turn to custard.

You cannot have it all one-way.


Mark

Guys,

All excellent input, thank you! I agree that it needs to be back tested through the 80s, and I even alluded to the need to do this by buying historic data from RP Data and looking for correlations.

I still think the theory is fundamentally sound though even if the previous tipping points were at a premium of greater than 0. This just means that certain other criteria served to broaden that tipping point in those instances. We all know its fear and greed that drives buyer behaviour. I don't know enough about the 80s to comment on the implications of these through that period though. I mentioned briefly some of these criteria, but it could be things like government interventions (FHOG, NG etc. Thanks HandyAndy), scarcity of supply etc etc.

Aceyducey said:

Can you chart the tipping point month on month from 2000-2005 in a city and track it against price movements. This would give two indications - how closely your theorum matches reality and how much lag there is in the market.

Click to expand...

This is precisely the sort of work I am contemplating undertaking. I believe that in a "benign interest rate environment" there will be a statistically significant correlation. But that's the basis of my hypothesis. I think the RBA has a handle on rates now and we are unlikely to see a repeat of the 80s rates. I could be wrong, but I hope that I'm not. Therefore, the current benign interest rate environment provides a steady basis on which to analyse boom tipping points.

Aceyducey said:

What I do like about your model is three-fold, firstly it's simplicity, second it's testability (as long as it does get tested) and thirdly that it provides a way, if it works, to assist in buying decisions TODAY

Click to expand...

Ditto! This is precisely why I formulated the theory. Just got to do that testing to see if it is statistically valid.

barracuda2 said:

Gotta be honest though Michael, I'm not sure that it's how people think when it comes to their PPOR - well, at least not the way I thought.

Click to expand...

The first point to make here is that you're not normal! Statistically speaking of course... The mere fact that you're on this forum indicates that you're not your usual cash strapped battler trying to keep food on their kids table. Its the "middle Australia" that I consider make up the statistically significant portion of the buying population. I infer that this group would consider the relative affordability to buy over rent and as such can "start the boom rolling" by their decision to buy instead of rent when the tipping point is reached.

I'll see if I can find more information on rental yields and correlate these to mortgage interest rates so we can see if there really is some form of correlation. I might "differentiate" the 80s due to the lack of a benign interest rate environment and rampant inflation. However, it is possible I'll spot some sort of lag effect at play back then too. i.e. Were yields higher than rates a year earlier? Such that buyers figured rates might come back but were caught out by rates that kept rising?

Pitt St said:

You've probably got me on ignore, but....

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Mark, not sure why you'd think I had you on ignore. You've never come across as a flamer or a defamer. Sure, you keep telling me to get off my backside and get in the game, but if you read my other post recently on my strategy then you'd know why I'm being patient at the moment. Not all strategies fit all people. I'm happy with what I've got planned out and am "actively" reviewing my local market daily. I'll act when I find the right opportunity in that market. In the meantime I'll just keep refining my thinking on IPs and keep profiting on the ASX.

Cheers all,
Michael.

MW, whilst I tend to prescribe to Pitt St's view, I do love getting invloved in the nitty gritty of analysis (I enjoy using numbers to back up my gut feel)!

Anyway, my question - is there merit in overlaying your analysis with some supporting measures? For instance, you have written about fundamental measures in previous threads and one that comes to mind is 'affordability'. Is there correlation between your tipping point and house price affordability? Whilst it may seem 'obvious' that there is, like any analysis it is worth doing the numbers; Could we have a situation where your TP is zero yet median house prices are still upwards of 6 to 8 times median income?

It's early in the morning and I haven't had a coffee yet!

BTW, great paper!

Pitt St said:

In your case you appear to be waiting for a person and some otherwise meaningless numbers to tell you when you are ready.

MW, no investment is 100% safe and if you're willing to take the success that investment may bring, you also have to be willing to accept the risk that it may turn to custard.
rk

Click to expand...

Mark,

Thanks for the gentle shove, but rest assured that I am on top of things mate. I have my LOC of $100K deposit sitting there ready to spend. I have pre-approval to $550K in place with my bank. And, I have a specific strategy in place for the next IP. I am looking for a house and land in my local area with the potential for some cosmetic value add. I am checking my local rags and re.com.au daily. I've even spent some time meeting the local RE agents. I spent 2 hours with a particular agent a couple of weeks back after I picked her as a good one. She understands my strategy and checks in regularly if anything comes up in my prace range.

Fear of failure used to hold me back, but not anymore. I used to always find excuses why not to do things, but came to the realisation that I was doing this. I'm talking 5 years ago too, and not anything you would have observed in my short time on SS. Since then I've had a personal mantra of "You're only ever as good as you allow yourself to be", which has served me well in some key decision points in my life since. That's why I'm now a senior executive on a decent salary who's happily married with a kid who virtually owns outright his PPOR on the northern beaches. None of this would have been possible if I had any residual inherant fear of failure.

So, rest assured, I'm "in" the IP game, even if I haven't secured that next elusive IP just yet. But the signs are aligning and its looking good for a purchase some time in the next 6-12 months. Could be sooner, but time will tell...

Cheers,
Michael.