Would you hedge right now?

[Sunder]

A quick question with a VERY long background. I hope people have the time to read this.

My wife and I bought an apartment at the end of last year and live in it as a PPOR. We're wanting to upgrade to a house in about 5 years time. We currently have about 200k of equity in the apartment (Assuming the price hasn't shifted since last year - we had 100k deposit and have since saved another 100k - about half of which came from cash wedding gifts. Unfortunately, we can't keep saving that fast. We can realistically put away about $50k a year on top of mortgage repayments)

We have been approved for, and can easily service another $500k loan.

You've all probably noticed the bipolar media the last few months - 30% growth over 3 years. 62% overvalued. Normal 8% growth returning. 40% crash coming. I give up.

My options is this:

1. Buy the house now. We'd look at about 500-550k. Rent it out for $480-$520 and claim about $9k of negative gearing for the next 5 years. Depreciation will probably add another 5k to that.

Basically a hedge against the possibility of price growth that will cost us about $100/week after tax.

2. Buy a $450k falling down ruin now. Lease it out for $320-$350. Demolish in 4 years, and build a home on the block of land.

Tax wise, it's almost the same.

3. Pay down our existing mortgage as much as possible, hope for a easing of prices (or at least no rises) and buy in 5 years?

Questions are these:

a) Are there other options I've missed?

b) Which would you choose if you were in our position?

Thanks for any opinions or advice that you can give.

 

[tess85]

Do you want to keep your current house as a future investment property? If so, stop paying down the loan immediately - take out an offset account instead and change the loan to interest-only.

I'll let other more experienced SS'ers comment on the other aspects!

By the way, welcome to somersoft

 

[Sunder]

Hi Tess, thanks for your answer. I've been here a while with 227 oops, 228 posts! I asked a LOT of questions when purchasing the apartment we're living in now!

The apartment will never become a negatively geared investment property because it's in my wife's name and when we move we want to give my wife at least 5-10 years off to be a mum and housewife. So no income to reduce it off. It may become a positively geared though.

I should also add that I figured at 5k after tax loss on the property would be a $25,000 hedge - which on a 500k property is hedging against a 5% gain. (i.e if the house appreciates in price by $25k over 5 years, I'm break even. If it goes above that, I win, if it doesn't move or falls, I lose).

If property hasn't moved up 5% in 5 years, I'd be somewhat surprised - though many here and on Credit Crunch seem to think 60% drops are inevitable.

 

[Propertunity]

You've all probably noticed the bipolar media the last few months - 30% growth over 3 years. 62% overvalued. Normal 8% growth returning. 40% crash coming. I give up.

You gave up. I just gave up listening to the bipolar media and do my own research.

1. Buy the house now. We'd look at about 500-550k. Rent it out for $480-$520 and claim about $9k of negative gearing for the next 5 years. Depreciation will probably add another 5k to that.

This would be my first preference. It is a known quantity. I do not believe prices will fall (depends on the area/s you select though).

2. Buy a $450k falling down ruin now. Lease it out for $320-$350. Demolish in 4 years, and build a home on the block of land.

This would be my second preference. I am risk averse and you don't know what building costs will be in 4 years time - except to say, that they will be more than they are now.

3. Pay down our existing mortgage as much as possible, hope for a easing of prices (or at least no rises) and buy in 5 years?

My least preferred option. Boring, no leverage involved, equity not being used...........yawn.....zzzzzzzzzzzz.
Hoping for easing of prices...as I've said before, "hope is not a strategy". What if you're wrong and prices continue to climb? I think you missed the walk to Mt Kosciusko

 

[tess85]

Oops!! Sorry! baby brain at work.... you have been around SS longer than I have, lol it's you who should be welcoming me!

OK, sounds like you have thought about it re: offset and IO loan vs P&I account..... it's just that the offset/IO path allows you more options later. But if you are confident that things won't change down the track, then so be it!

So you're in Sydney.... funnily enough I am having this same dilemma too, as we will one day have to upgrade our current PPOR as soon as we have 2 kids or more. I may be completely wrong but given what's happened in Sydney for the past 18 months, and our own personal circumstances (stretched budget due to upcoming baby), I'm not convinced that it's a great time to buy..... I want to wait and see what's going to happen to the market with rising IR rates etc. I realise that this strategy of not buying our future PPOR now could cost us quite a bit of money if prices do end up rising...... but I wouldn't be too fussed as we will have exposure to the Sydney market via our current PPOR.

We have also considered buying a dilapidated house too for the land content but am having trouble finding any in the Sydney area that we want to stay in (inner west)...

In short.... we are waiting to buy as we would be seriously stretching our repayment capacity otherwise... but this is a thread i am interested in hearing more responses to!

EDIT: just noticed that Propertunity got in before me, he makes a lot of good points which may be worth considering seeing that you ARE in a capacity to buy your future PPOR now, unlike us!

 

[Sunder]

You gave up. I just gave up listening to the bipolar media and do my own research.

This would be my first preference.

This would be my second preference.


My least preferred option. Boring, no leverage involved, equity not being used...........yawn.....zzzzzzzzzzzz.
Hoping for easing of prices...as I've said before, "hope is not a strategy". What if you're wrong and prices continue to climb? I think you missed the walk to Mt Kosciusko

Those are my order of preference as well, (hence why I listed in that order). But as Tess said below, after the last 18 months, I'm cautious about a pullback. Interest rates were at 50 year lows. Surely that's gotta bring forward some demand. Govt stimulus was at record highs - especially for first home buyers. Surely that's gotta bring forward demand as well.

If it brought forward say, 2 years of demand, does that mean in 2 years prices will still be flat, and I would have wasted $10,000 or so on 2 years of hedging?

Worse still, if house prices retract 10%? They've done that in 5 year periods before. In which case I'd be 50k + my $25k hedge out of pocket. I think it's the less likely scenario, but not an unlikely one, if that makes sense.

Also... You're a buyer's agent, I work in IT There's only so much research I can do, I have to rely on other people to do the analysis and present me their findings!

I may be completely wrong but given what's happened in Sydney for the past 18 months, and our own personal circumstances (stretched budget due to upcoming baby), I'm not convinced that it's a great time to buy.....

We're thinking kids soon too. We want to start trying some time next year

I also think that because of 20% gains in the last 12 months, we need to be careful as well. I am thinking watch for the 2010-2011 Alt-A resets in the US - whether that dries up credit and drives up credit spreads. Also, the Euozone credit crisis.

If both those get resolved without a hitch, I doubt anything realistic on the horizon would hamper continued house price growth and we'll be in the all clear.

 

[HiEquity]

Questions are these:

a) Are there other options I've missed?

b) Which would you choose if you were in our position?

Thanks for any opinions or advice that you can give.

a) Yes.

b) My preferred option would be to find a cheap rental somewhere to live, move out and rent your current PPOR. This way all your interest bill will be tax deductible, giving you an extra chunk of cashflow straight up, on top of any rental differential you can make up in the move into cheaper accomodation.

Then use your equity, cash, incomes and aforementioned extra cashflow to leverage into as many IPs as possible with excellent yields and growth profiles in diverse locations while keeping good serviceability and buffers in hand. By the time your planned kids are in primary school and you actually need some certainty of tenure in a PPOR (7 years?), you will be much wealthier courtesy of the tax effect, CGs, cashflow (rent) growth and enforced savings in the IPs and will be able to actually afford a nice place to live and bring up the kids.

Wish someone mentioned all this to me ten years ago!

Good luck!

 

[Propertunity]

Interest rates were at 50 year lows. Surely that's gotta bring forward some demand. Govt stimulus was at record highs - especially for first home buyers. Surely that's gotta bring forward demand as well

Yes, I agree, all that brought forward demand. The only comment I'd make about demand is that I see it first hand, everyday, at ground level. Most Saturdays I'm at auctions & Opens and I can see more demand than supply in the better higher growth suburbs I buy in. Seeing it, beats reading about it or researching it on the internet or forums any day of the week IMO.

Also... You're a buyer's agent, I work in IT There's only so much research I can do, I have to rely on other people to do the analysis and present me their findings!

Sounds like you are a candidate to use a buyers agent then
I spent 15 years in IT as well. It made me a lot of money which I was able to invest in property and shares.

I also think that because of 20% gains in the last 12 months, we need to be careful as well.

A lot of people think that as well. The only thing I'd say, is that it is not uncommon for property to go up 40-50% per year in some years of a full cycle. So 20% in one year after being flat for 6 years is nothing special to my way of thinking.

As for hedging, that is more terminology reserved for shares IMO. Yes I am into buying put options for a hedge on my portfolio if I am buying $100K+ of shares with a fair bit of a margin loan......but I don't know that I'd do the same in a property related scenario.

 

[Ridin-High]

Can someone explain in basic terms what hedging is

Regards,

RH

 

[wobbycarly]

Can someone explain in basic terms what hedging is

Regards,

RH

Does this do it for you?

http://en.wikipedia.org/wiki/Hedge_(finance)

To my simple way of thinking it's like a financial insurance, by assuming a known position to cover a potential risk. Like you want to go to the USA for a holiday. You can buy enough US dollars as you leave the country at a known, assumedly* fair price to offset (hedge) the risk of short term fluctuations during your trip.


*did I just make that word up? I guess you can work out the meaning by the context.

 

[Amadio]

Here you go:
http://www.investopedia.com/terms/h/hedge.asp

I like the bit that says a perfect hedge reduces your risk to nothing.

 

[brendio]

Here you go:
http://www.investopedia.com/terms/h/hedge.asp

I like the bit that says a perfect hedge reduces your risk to nothing.

Except that perfect hedges are rare. The best they usually do is trade one risk for another (more acceptable?) risk.

I've just finished reading "Traders, Guns and Money"—a book all about derivatives and featuring a lot of case studies of where they blew up in people's faces, usually because of imperfect hedging.

 

[Propertunity]

I like the bit that says a perfect hedge reduces your risk to nothing.

Yes, hedging is a beautiful thing but remember the bit you left out too

(except for the cost of the hedge).

 

[Sunder]

Can someone explain in basic terms what hedging is

Regards,

RH

All the answers above are consistent with my understanding and the way I use the word.

Most the time for me, I use it as a short term insurance against a long term position. For example, I have funds in an Index fund that have very low management fees, but a pretty large entry and exit fee, to discourage people from trading them. When the market is going well, I hold no hedges - the more common direction of the market is up. But if I think the market is going down, it can be expensive to get out, then get back in when the market improves.

Say the amount was 100k.

When the market dips below the 200 day EMA, I consider the risk of a large bear market, and I use CFDs - which are cheap to enter and exit, but expensive to hold, and I SHORT a 150k against the same index that I'm invested in.

If the market keeps falling, then I actually make money as my hedge is bigger than my long term position. If it starts to rise again, I close out the short position losing some money, but my long term position profits.

In other words, by paying for the CFD short, I reduce the risk that I'm going to lose a lot of money if the sharemarket crashes.

In the case of property, I figure that by buying a house now rather than in 5 years, I am effectively hedging my "short" position on a house (I.e. I want a house in the future, but I don't have one, hence I'm short a house ) So if I buy one now, and lease it out, I am paying a 1% hedge (my holding costs) against 5 years of growth. Considering growth is typically 8%PA, and inflation 3% you would consider this a very cheap hedge.

If on the other hand, the market goes counter trend, and falls by 8%PA, this would be a hedge in the wrong direction.

 

[Graemsay]

I think that you're really looking to hedge against two risks:

• Prices keep on rising (in excess of wages).
• Prices fall sharply.

If house prices continue to rise at 7% per annum (i.e. doubling every ten years) then you'd be looking at about a 40% rise, or circa $200,000 on the sort of properties you mention. If they tracked wages, the rise would be around half that.

Either way, your "hedge" of buying a house now seems a pretty good buy at $25,000 over five years.

But if things go a bit Steve Keen then you could see your $200,000 equity wiped out, and I can't think of any straightforward ways to hedge against that risk. The only simple way to go short on housing is to rent rather than buy.

A few years back one of the mortgage brokers in the UK sold a negative equity protection mortgage. Or you might be able to create a hedge yourself by shorting banks and house building companies, as any downturn would hit those hard.

The other option might be to look at option (2), developing a property. The rise in value would give you an equity buffer against a downturn.

 

[Amadio]

Yes, hedging is a beautiful thing but remember the bit you left out too

Sometimes it's quite cheap - like the very long dated put options before the GFC.

 

[Neophyte]

Simple thought.

Over a reasonable horizon housing should rise at a minimum inline with inflation. Its pretty tricky to see the ups and downs whilst in the middle of them. 3% a year price rise is about $15K a year. Even if things got flat for 2-3 years, on your 5 year timescale it seems like a reasonable bet to buy now rather than later.

The only drawback is the opportunity cost of having your cash, borrowing ability, emotions, time and energy tied up.