dothesums blog

There are five new essential lessons for house buyers :

Lesson 1 - We can no longer trust financial institutions to assess risk on our behalf.

Lesson 2 - The financial responsibility of buying a house lies with buyers themselves.

Lesson 3 - Buyers should budget for cash.

Lesson 4 - Buyers should budget for capital.

Lesson 5 - Do the sums.

We have previously described how the property market has changed in the last two or three years.

Most people have not yet adjusted to the fact that property buying has changed radically.

The thing that has changed is how we perceive 'risk'.

In the past it has been generally assumed, at least in the UK, that the value of all residential property will increase year upon year.  There may be a period when prices fall, but it has been accepted by most people, that this correction will be relatively short-lived and that prices will then begin to rise again.

But buyers cannot assume any more that mistakes in the choice of property will be corrected by a general increase in the value of all properties, or that the adverse effect of taking out too large a loan will be righted by erosion of that loan by inflation.

The world recession and the collapse of Lehman Bros Bank in September, 2008 have changed all that.

For many of us 'of a certain age', our bank or building society in granting us a mortgage/loan was, in effect, approving our decision to invest our savings, and part of our future earnings, in property.  The old idea was get a mortgage, buy a house and eventually in the fullness of time, in twenty or twenty five years, we would have ownership of that house, live rent free and retire on our pension.

In addition, the local branch manager was often expert in assessing, not just the credit worthiness of the applicants for a loan, but also the present and likely future values of local property.

Taking the long view, this approval suggested that the risk involved in buying all residential property was low.

The banks have changed all of that now; probably forever.

The near collapse of the banking system has shown that not only have the banks been unable to run their own businesses, but worse, coming from a bank, they have not been able to assess the risk of lending their capital. If they cannot judge risk in their own businesses, how can we trust them to advise us about risk in our finances?

Lesson 1 - We can no longer trust these financial institutions to assess risk on our behalf.

The casualties of this recklessness include taxpayers, shareholders, business owners, the unemployed and property owners, everybody really. Very few of us have escaped the effects of this recession, apart apparently from the bankers themselves.

It just seems so unjust. Well there is no such thing as justice in investing, only winners and losers.

In terms of property, what can we learn so that we may avoid being a loser?

The buyers, not the bankers, not the solicitor, not the surveyor and especially not the estate agent, who acts on behalf of the seller, have the authority to do something about it. The buyers are accountable to themselves, if financial problems arise in the future.  The buyers will have to bear the outcomes of those bad decisions, if things go wrong.

(In short, the old saying 'caveat emptor', 'buyer beware' applies.)

Lesson 2 - The financial responsibility of buying a house lies with buyers themselves.

What are the dangers?

There are two main financial hazards, just like any business, inadequate cash flow and the loss of capital.

Cash

When the fear of depression recedes, 'Quantitative Easing' will end and the Bank of England will raise their base rate, which will cause increases in mortgage repayments.

So homebuyers will be paying more and more per month, for the privilege of buying their homes.

It is principally a matter of cash-flow and making provision for increased outflows, either by reducing other spending, or by increased inflows, if possible.  Latest figures suggest that many people are reducing debt and therefore saving on costs, credit card balances is a good example, in preparation for the time when more realistic interest rates return.

Capital

Many property owners have coped with lower values and consequent reduced equity, by concentrating on the long term.  And so they should.  Property should be viewed as a fixed asset with long term potential.  We generally think of three to five years minimum, which enables annual variations in value to be absorbed into a long term appreciating trend.

Cash and Capital Combined

However, there is one nightmare which even we are worried about.  And that is the horror of higher interest rates and simultaneous falling values.

Most of us can probably deal with one or the other, but the prospect of paying more and more, for an asset which is worth less and less is scary, especially if this situation holds for some time.  The horror of these two combining and consuming all of the owners' equity and trapping them in a property because of negative equity is almost too awful to think about.  But it has happened and it will happen again.

House Owning Dangers

Cash

• Rising mortgage repayments.
• Repossession, if payments not maintained.
• Reduced cash flow for other expenditure.
• Owners trapped because it is more difficult to sell.
• Increased maintenance costs compared to renting.

Capital

• Loss of capital.
• Reducing equity.
• Negative equity.
• Difficulty in selling; there will be more sellers in a negative growth area.
• Difficulty in obtaining loans, either for new property or re-mortgage.
• Higher loan to value means fewer available loans, which means it is more difficult to move.
• Reduced mobility (e.g. job change), because of poor saleability.
• Probable decline of neighbourhood.

Is there anything we can do to protect ourselves?

Fortunately there is, and it is a tool familiar to most buyers and is used in business every day.

We need to look forward and anticipate the likely costs and values involved and formulate a plan for the future.  Or more accurately a budget, which is just a plan expressed in financial terms.

As is suggested above, especially at the time of purchase, but for any house, two simple budgets can be prepared, one for cash and one for capital.

We would suggest a period of three to five years.  Use a spreadsheet to forecast the probable monthly inflows and outflows of cash, using realistic estimates.  For example if we suspect that interest rates are going to rise, as seems likely later this year, we can build this into the budget.

Rather than letting things happening to us if we plan ahead we can detect problems early and seek a solution before the problem occurs.  We can also detect when having a large mortgage is too risky.

Lesson 3 - Budget for cash.

Similarly property values can be estimated, the more specific the better.  But if local value forecasts are not available use national or regional stats. The long term average of house price values in the UK is approximately +6.5%, or +2.9% above inflation. The current falls in value are a return to that long term average, following a sustained period of much higher increases.

It goes almost without saying, that our house should be primarily our home and should be chosen on that basis. Why be unhappy living in a property you have chosen for investment purposes only? We choose our own houses to enjoy, but we also recognise that we are investing a considerable amount of capital in it. Capital that we have worked for, and as such we need to protect it and if possible, get it to grow over the longer term. If you don't want to do this consider renting, it is much simpler and you don't have the maintenance costs.

So preferably choose a property with your heart, but of a type and in a location, where your heads tells you, it is financially safe to do so.

Lesson 4 - Budget for capital.

Dothesums.co.uk

Dothesums combines the client's property details with forecast statistical data to produce a report on the cash and capital budgets for a specific property for a period of five years ahead.

Lesson 5 - Do the sums.

In summary the five new essential lessons for house buyers are:

Lesson 1 - We can no longer trust financial institutions to assess risk on our behalf.

Lesson 2 - The financial responsibility of buying a house lies with buyers themselves.

Lesson 3 - Buyers should budget for cash.

Lesson 4 - Buyers should budget for capital.

Lesson 5 - Do the sums.