Guest Post: The property crash is coming

A guest post by a reader:

There is a story regarding the 1929 sharemarket crash involving Patrick Kennedy (the father of assassinated US President John F Kennedy).  At that time, Mr Kennedy was a leading stock market investor and entrepreneur (this was the original source of his personal wealth, which after the crash he then allegedly applied even more successfully to bootlegging during the prohibition error of the great depression that was to follow). 

But the story explains why, unlike virtually all of his fellow investors in the over-heated US stock market in 1929, Mr Kennedy still had any wealth left to invest in illicit alcohol after the spectacular Black Monday crash in October 1929.  In fact, Mr Kennedy was one of the very few investors who shrewdly foresaw the impending crash and sold his shares for a handsome profit.

The storey explaining why Mr Kennedy knew to sell his over-priced shares in mid-1929 may be apocryphal but it is still relevant.  At that time, the movement and developments on the US stock market were followed closely and widely discussed by both investors and watchers alike.  It was the historic equivalent of the current New Zealand public and media’s fixation on property prices and everyone joined in.

And at its peak in mid-1929 Mr Kennedy is reported to have fallen into conversation with one of the many shoe-shine boys who worked around the New York Stock Exchange.  To Mr Kennedy’s surprise the shoe shine boy started swapping stock tips with the million investor.  Intrigued, Mr Kennedy enquired as to the boy’s stock positions and predictions for the market. 

Afterwards Mr Kennedy pondered how a nearly impoverished child could possibly have invested all he had in the stock market – and what this meant for the market over-all.  He quickly realised that, once the shoe shine boys were investing, there was literally no one left to sell too and the market had become saturated – so he then liquidated all his positions and sold his holdings, mere weeks before his predication proved true.

Mr Kennedy’s decision to sell his shares was an instinctive example of what economists call “the greater fool” theory.   That theory goes that, when a market is “hot” and everyone is participating, investors stop properly weighing the risk of future losses but instead focus upon the fear-of-missing-out (FOMO) on future price rises. 

Each new sale provides evidence of price rises and so draw in even the most cautious investors.  Soon prices become detached from the inherent value of the asset (its actual financial return from normal ownership or use).  Instead, the focus is now upon the profit from a future on-sale of that asset and not from its financial return in the interim.  

An investor may be prepared to take a short-term loss while it owns the asset provided s/he thinks that asset can soon be on-sold at a profit.  But this strategy is based on the assumption that there will be someone willing to buy that asset at an even higher price – a “greater fool”! 

But eventually the music must stop and someone will be left holding the asset – and s/he will be the greatest fool of all, who suffers both an ongoing loss while they continue to hold that asset and also a loss if they try to sell it.

Applied to the New Zealand property market, for nearly 40 years the tax system effectively guaranteed the profit of each greater fool.  Ongoing losses could be offset against other sources of current income (thereby providing a cushion against poor rental investments) and the proceeds of any future sale to another fool were tax exempt.  So any fool who could wait out market corrections was largely protected until the music started again and a greater fool could be found.

But in the past 5 years those tax protections have been stripped away.  Ongoing rental losses are now “ring fenced” and cannot be offset against other income – the cushion has been removed.  And under the Brightline rule, tax is now routinely imposed on most on-sales of rental properties (and may soon be imposed on repeated sales of the investor’s own home). 

These tax changes leave the fools exposed – yet fools continue to flock to the over-heated New Zealand property market.

In my professional capacity I advise many career property investors.  For almost 20 years I have had a ring-side seat to the activities of these professionals.  These are hard-bitten men and women who have spent years to learn and understand the market, know how to weigh the risks and crunch the numbers, and have nerves of steel.  The skill and courage necessary to succeed in “the property game” is beyond me – and it is not for the faint hearted.   But win or lose, they know what they are doing.

Unfortunately in the past year I have noticed a different calibre of clients.  These are mum-and-dad investors with no previous experience in property development or trading.  Accordingly, their understanding of the market is lower and correspondingly their risks are greater.  They are risking it all to enter the property market, driven by FOMO and the hope of a greater fool. 

This cannot end well.  With the New Zealand economy shut in its bubble, Covid-19 ravaging all our international trading partners, local business suffering and unemployment rising, the market is propped up solely by the historically low interest rates upon which all profit projections are based.  But even a small change to those interest rates could prove devastating to many of my new clients.  There may be no greater fools left.  Because in 2021 all the shoe shine boys have become property developers …

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