People are now buying Auckland houses for speculation rather than investment.

The Greater Fool fallacy

The problem with this is that it is based on the "greater fool" fallacy: buyers think "It doesn't matter what I pay because prices will keep going up and someone else will come along and take it off my hands for a profit."

You can see this happening at any auction. You look at a do-up which will be worth $950,000 after you spend $50,000 modernising it. So you need to buy it for $850,000 or less to make a worthwhile profit.

But you get outbid by someone who pays $900,000 thinking that prices will go up by $50,000 in the time it takes to do it up.

This happy little scenario works for a while, but at some stage it ALWAYS comes to a grinding halt.

I'll see it coming and get out fallacy

People always agree with you when you point out that it can't go on forever.

But they always assure you that it will go on for at least another year, because reasons.

But the lessons from the past tell us that you get no warning at all.

One day everything is going along fine, the next, something (usually an overseas crash) pulls the rug out.

This Time It's Different

In past recessions house prices have stabilised, rather than collapsed. 

Some were forced into mortgagee sales, but most owners simply sat on their loss-making places until prices recovered.

That was feasible because rents weren't too far out of kilter with outgoings.

This time, they are.

Typically, people are taking on $1 mill of debt to buy a $950,000 house, plus the $50,000 they need to do it up. They borrow 80% against the purchase, and fund the rest against their equity in their main home.

They are paying about $60,000 a year in interest, while the house is worth about $25,000 a year in nett rents ($500 a week after rates, insurance and repairs). The deficit is about $35,000 a year, or $700 a week.

And that's if mortgage rates stay the same. 

Most people can't afford that.

So either the bank, or reality, forces them to dump the house.

But everyone else can do the sums as well, and they can see that the house, as a renter, is worth maybe $6-700,000, and so that's all they'll pay. The speculator has lost all of his investment, and still owes the bank an extra $100 -200,000.

So all of a sudden, two houses are on the market - the spec one plus the first home that got over-leveraged to buy the speccie.

That's an extreme case, but there will be plenty of similar examples when the music stops.

How To Deal With That

An investor has two choices

Stay on the escalator - keep buying and developing, and hope that can survive a downturn.

Get off the escalator - cash in now and pick up bargains later.