Thursday, February 23, 2012

Increase Your Property Purchasing Power With Gold

Disclosure: This post should not be considered financial advice. Examples are based on predicted variables which may differ to real life outcome.

Introduction

A recent quote I read on the Bubblepedia forums “Rent is the fee you pay for the owner to take the property price risk” rings true when prices are falling. When there is such a large disparity between renting and buying and prices are falling you are saving two fold by choosing to rent.

I have been publishing a series of Gold/Silver charts for the past 18 months showing Australian houses priced in Gold and Silver ounces (here is a link to the most recent). And here is the chart for Sydney showing the current trend (a trend which is evident in all Australian cities):

CLICK CHART TO ENLARGE
Some might consider such a measurement as useless, however Gold tends to run in cycles against other assets and if one can harness the cycle there is the potential to make it work in your financial favour.

I suspect there is still room in this cycle to improve affordability of property through the use of Gold (and/or Silver) as a saving tool to increase your purchasing power. I will use some practical examples below to show how this can be done and how the numbers stack up using this methodology.

Scenarios

In the post below I will outline 3 scenarios which detail the potential results of a First Home Buyer:

    Buying in June 2012 & how they fared by mid 2014
    Buying in mid 2014 after saving in cash
    Buying in mid 2014 after saving in Gold


To put numbers to these scenarios I have to fix or predict a number of variables. Many of these variables could change or be predicted incorrectly resulting in a real life outcome that differs greatly from those I've posted below. Furthermore some variables could significantly differ between states with some states still offering increased incentives for First Home Buyers (over and above the national First Home Owners Grant). The example I will be basing the numbers on will be Adelaide (my hometown).

The example will be based on a working couple living in Adelaide who both earn $50,000 per year ($82,800 combined after tax, $1592 per week). They currently pay $300 per week in rent for a 2 bedroom unit. Normally we would probably see rents increase over a 2 year period, but for simplicity sake I will be fixing the rent at $300pw for the last two scenarios where the couple rents through to 2014. It won't make a large difference to the results and my suspicion is that as the economy deteriorates in Australia we are unlikely to see rents increase by much anyway.

The couple lives frugally resulting in living expenses (other than rent) totaling $700 per week for the two of them. This allows them to save $592 per week toward their future goal, owning their own home. As of June 2012 (when our scenarios start) they have already put away $30,000 in savings towards a future property.

Variables

Interest Rate on First Home Savers Account: 5% (Member’s Equity)
Interest on Savings Account: 5.4% (Online Account)
Interest on Mortgage: 6.5% (Variable)
Price of Gold as of June 2012: AUD$1700
Price of Gold as of July 2014: AUD$4200 ($100 per month rise)
House Prices: Down 7.2% pa over 2012/2013, down 3% first 6 months of 2014
House Price as of June 2012: $356,680
House  Price as of July 2014: $309,078

The $370,000 starting price used for Adelaide is the RP Data "dwelling price" as outlined in their January 2012 report. The word house will be used in place of dwelling (whether it's a unit, courtyard home or house they've purchased is of little consequence).

House price correction rate of 7.2% per annum over 2012/2013 based on a report by S&P based on a moderate landing for China (as reported by Macro Business):
This scenario for Australia is allied with our “medium” landing scenario for China, which features 7% growth in GDP and a one-in-four likelihood of that occurring. Under that China scenario, there is a deep weakening in prices  for Australia’s resources exports, accompanied by weak volumes of exports.

Business confidence and spending weakens below trend, and there is a deferral of capital expenditure in areas relating to economic infrastructure. Consumer sentiment weakens in line with softening employment conditions,  which see the unemployment rate rising to 6.5% in the second half of 2012. Without the support of higher  commodity prices and interest rates, the Australian dollar depreciates, allowing other export sectors (such as  education and tourism) to become more competitive.

Despite lower borrowing costs and rising affordability and household savings, the Australian housing market weakens further, with nominal house prices falling annually by 7.2% over 2012 and 2013.
Gold price based on my expectations of a strong performing Gold price over the next 2-3 years as we enter the public mania phase of the bull market.

The interest rates will almost definitely fluctuate in real life over the term of the scenario, but having seen the dismal performance of most economists & commentators on predicting rate changes more than a month or two in advance I will refrain from guessing and leave them where they are now.

Buy in June 2012 (Scenario 1)

Based on prices falling 7.2% over the year (down 3.6% from $370,000), the purchase price of their property is $356,680. Stamp duty and transfer fees on the property total $16,681. LMI would vary slightly between lenders, but likely to be at least $8000 which is the amount we’ll use for the example. Deposit $30,000 + $7,000 FHOG.

$356,680 + $16,681 + $8000 = $381,361 (total purchase cost)
- $37,000 deposit = $344,361 (mortgage amount)

Resulting LVR is approximately 96.5%, which should be fine as I believe some lenders will still allow the borrower to cap the LMI on top of a 95% lend.

We are going to assume that the couple live frugally and put any extra money that would have been saved into extra repayments on the mortgage. However they will have some extra costs associated with owning rather than renting (for this example we are going to use a very conservative .5% maintenance rate equaling $1,780, and $1,500 per year for Council Rates, Water and Levies).

$1592 per week (combined income after tax) - $700pw living expenses - $63pw (maintenance/rates) = $829 per week they can pump into the mortgage ($3592pm). The speed at which these extra repayments will pay down the home loan will benefit them hugely over the long term (it would cut a 30 year mortgage to around 11.5 years), but how are they faring by July 2014?

By the 26th month of the mortgage they have paid down the loan to $296,274, reducing their loan by $48,087 over around 2 years, impressive!

However, with house prices falling their property is now only worth $309,078 (with prices having fallen 7.2% over 2012 and 2013 and another 3% over the first 6 months of 2014). The resulting LVR is still 96%, even they’ve paid a substantial amount off the loan, they have gone no where when it comes to building equity and this will really limit their choices in the case they need to upgrade to a larger house or something affects their ability to repay the mortgage.

If at the end of the 2 years they decided they wanted to sell the resulting sale costs would leave them no more than a few thousand dollars change, even after tipping in a $37,000 deposit and having paid $48,087 off the principle. Not a good place to be financially.

Save in Cash, buy July 2014 (Scenario 2)

The First Home Savers Account (FHSA) is probably one of the most underrated and poorly utilised measures that the Government has implemented for First Home Buyers. I prefer it over a cash boost from a sustainability perspective as it provides incentive to save over a long term period (rather putting a lump sum into the hands of inexperienced buyers).

The low uptake on the account probably stems from savers looking at the 4 year term and cringing, but the reality is that deposits for full government contribution only have to be made over 4 financial years, so as per this example someone could make the maximum beneficial deposit in June of one year (in this example 2012) and a final full payment in July of the 4th financial year (in this example 2014) and then shortly after be able to withdraw the lot, resulting in a savings period of just over 2 years.

As well as a reduced taxation rate (15%) the FHSA also sees Government contribute a 17% bonus payment (up to $935, $5,500 deposit per financial year required). Some financial institutions are offering an attractive interest rate as well, not quite as high as the dedicated online savings accounts, but not far off.

For the example used the savers put $5,500 from their initial deposit into their FHSA account (earning 5%) and put the rest ($24,500) and ongoing deposits into a higher interest bearing online account (5.4%). Their ongoing savings amount is $592 per week as they continue renting their $300pw unit.

Come July 2014 they have $27,163 in their FHSA account ($22,000 of their own contribution) after Government contributions, interest and minus 15% tax. A good return for just over 2 years.

Their $24,500 put into the online savings account along with regular contributions of $2108 per month (which is a reduced amount to account for FHSA $5500 deposited each year) amounts to $79,308. The interest earned at 5.4% is $6329 + roughly $230 earned on the amounts being saved for the FHSA annual $5500 deposit = $6559, but tax of around 30% will be payable resulting in $4591 net interest to add to their deposit.

The total from the FHSA account ($27,163) and online account ($83,899) results in a total deposit they’ve saved of $111,383. Wow!

Given they’ve waited until mid 2014 and house prices have fallen substantially they are now in a great position to buy. Their large deposit means they will not have to pay LMI (an $8000 saving) and the reduced purchase price means almost $3,000 less in stamp duty and transfer costs.

$309,078 + $13,956 = $323,034 (total purchase cost)
- $118,383 deposit (inc FHOG) = $204,651 (mortgage amount)

They are almost $92,000 better off having rented and saved rather than bought, with only $48,000 of that resulting from the price fall and the rest from the extra amount saved by renting, interest earned and avoiding LMI/reduced purchase costs.

Save in Gold, buy July 2014 (Scenario 3)

Rather than the savers putting their money into a savings account, this example will see them purchasing Gold with all their savings. Their initial deposit will be used to purchase a lump amount and then they will dollar cost average by buying Gold every month.

The starting price used for Gold is AUD$1700 (as I write this it’s AUD$1670), it may be higher or lower come June 2012, but for the sake of the example we will predict a $1700 price and it will rise by $100 every month between June 2012 and July 2014. Of course it’s extremely unlikely that such a balanced rise occurs, more likely the move higher will be much more volatile.

As Gold increases in price it reduces the number of ounces they are able to purchase with their monthly savings, so while they start being able to purchase 1.5 ounces per month, by July 2014 their savings are only buying .6 ounces with the Gold price at AUD$4200.

They start off with 17.64 ounces having purchased this with the $30,000 deposit they have saved and over the course of the next 26 months they are able to purchase an additional 24.28 ounces of Gold resulting in a total of 41.93 ounces. They’ve paid $96,733 accumulating the ounces and final value of the Gold at new spot price is $176,097, resulting in a capital gain of $79,364. They will be eligible for the 50% CGT discount on some of the Gold purchased as they’ve held it for over 12 months. My rough estimate puts tax on the capital gains at around $18,000, so following the sale of the Gold they have $158,097 to put toward their deposit.

Ounces of Gold Accumulated Over 26 Months
In this example they will also enjoy the reduced costs to purchase and no LMI.

$309,078 + $13,956 = $323,034 (total purchase cost)
- $165,097 deposit (inc FHOG) = $157,937 (mortgage amount)

They are over $138,000 better off than if they’d purchased in June 2012 and almost $47,000 better off having put their savings into an appreciating hard asset (Gold) instead of saving in an interest and government bonus paying accounts.

Something worth noting is that a $4200 Gold price and $310,000 median Adelaide house price would result in a ratio of 74oz Gold per median house, this is pretty close to the monthly average peak we saw in this ratio in January 1980. For example in my latest charts and data you can see that Brisbane houses fell to a low of 62oz Gold and Melbourne to 67oz Gold. To catch a ratio around this level you only had around a 2-3 month window to scale out. That said given some of the key differences in the current bull market versus the last one we may see Gold outperform expectations.

A recent article written by FOFOA pointed out some past quotes of his which ring very true:
“Gold would not be valuable if one person owned all of it. It is most valuable in its widest distribution possible, the wealth reserve, which requires a much higher valuation than it has right now. A higher valuation denominated in hard assets, not just fiat currencies!”

“Just look at the BIS’ own gold actions. Their owned gold hoard has shrunk from 194 tonnes to 120 tonnes over the last 6 years, as has the entire Eurosystem’s hoard over the last decade (from 12,576 tonnes down to 10,833 tonnes). Most gold movements in Europe have either been lateral reshuffling or dishoarding and encouraging citizens and other entities to start hoarding physical gold themselves.

I have written this before… if you were King of the World with 35,000 tonnes of gold in a world of 160,000 tonnes, you would gladly – happily – reduce your “stash” to 10,000 tonnes if that reduction came with a 50x revaluation. Trying to get ALL the gold into your hoard is a fool’s strategy. FOFOA
Heavy demand from the east is a very positive development in the market as they have the (population) numbers to send Gold/Silver to astronomical heights.

China has been encouraging its own citizens to buy Gold/Silver, a market which as I understand it was untapped during the 1970s bull market with private ownership of physical Gold banned (until 2003).

We’ve seen what the Chinese can do with a property market when speculation pushes prices higher… can’t wait to see what they can do with the Gold and Silver markets…

Ultimately while I think $4000 Gold is a reasonable target, there is definitely the potential for it to move a lot higher in a parabolic blow off. As I've pointed out previously, in the last 2 years of the last Gold bull market the price Quintupled ($169 to $850, doubling from $400 in last 2 months) and I suspect this bull market will end with a similarly impressive move.

As an alternative to Gold the couple could have split some of their savings into Silver as well. If Silver performs similarly to the last parabolic move into the January 1980 peak then it could perform 3x better than Gold (e.g. Gold at $4200 with the Gold:Silver Ratio at 1:15 would give a Silver price of $280, an 8x rise in price where Gold from $1700 to $4200 is only a 2.5x rise).

Final Term & Interest Reductions

As well as reducing the obvious purchase costs, saving the larger deposit and having a smaller mortgage will also result in a reduced loan term. If the couple are able to continue repaying at the $3592 calculated per month in the first scenario this is the length of time to payout the loan and interest paid (from July 2014):

Scenario 1: 9 Years, 2 Months - $97,757 Interest Paid
Scenario 2: 5 Years, 8 Months - $40,546 Interest Paid
Scenario 3: 4 Years, 2 Months - $22,776 Interest Paid

So as you can see there are less obvious benefits to reducing the size of the mortgage if you keep your repayments at the fixed higher amount (as opposed to sticking with minimum repayments.

Charts

LVR that results from 3 scenarios
Mortgage that results from 3 scenarios
Final Word

I have no doubt that the actual outcome over the next couple of years will be noticeably different from the scenarios I’ve laid out above, but I do think the major themes will be evident, namely:

- House prices will continue to fall
- Gold and Silver will continue to rise in price

This will result in an environment where First Home Buyers (or any other buyer for that matter) will likely be better off renting, saving (in cash or metals) and buying in the future rather than now (from a financial perspective, as I've pointed out in the past for some buyers the stability that owning offers is priceless). 

As pointed out in the scenarios they are better off not only due to buying the house cheaper, but they also avoid LMI (due to increasing their deposit above 20%), pay a lower amount of stamp duty/transfer fees and reduce the term and interest they pay on the remaining mortgage.

This extra deposit saved could translate into a smaller mortgage on the property purchased or the buyer could decide to make the move to a larger and more expensive home saving the costs of churning their first home to buy their second.

In May last year I wrote a short piece detailing 5 reasons that First Home Buyers should reconsider buying now. The 5 reasons were:

1. Renting is around half the cost of buying
2. Falling prices will continue
3. You may quickly outgrow your first home
4. Ownership isn't all it's cracked up to be
5. Living at home/renting = Freedom

As it stands right now all these reasons still stand for putting off the purchase of your first home. While interest rates falling have reduced the gap we had between renting and buying it’s still significantly more expensive to buy. Falling prices which we saw in 2011 will in my opinion continue through 2012. Saving a larger deposit now means you may be able to skip the first step on the property ladder and buy a larger home in a couple of years instead of buying the smaller one now and churning later (which saves on selling/buying costs).

It was shortly after the “Don’t Buy Now” campaign was kicked off by Prosper that I wrote the "5 Reasons" post and today their message is still as strong and important as it was 12 months ago. Their latest article suggests price falls in 2012 could be as large as 15-20%:
“We expect property prices to wilt under these combined pressures, with prices at end December 2012 between 15 and 20 per cent less than today. We renew and repeat our warning to potential home buyers to stay out of the property market. Falling prices erase equity while buyers’ mortgage liabilities remain payable in full.

“Don’t Buy Now!” Collyer concluded.
While I think such a large fall this year is unlikely, there is definitely a risk of it happening if we were to see a shock to the market (e.g. another 2008 credit event, hard landing in China, etc)

Right now we are seeing a lot of talk in the media about a bottom being in for property, but there are no substantial trends in place to suggest that the tables have turned. As Prosper pointed out in their article (and the Macro Business bloggers have covered countless times recently):

First Home Buyers are wary of commitment
Volume of housing stock still elevated (but lower than 2011 peak)
Consumers are dis-leveraging
Banks are not lending like they have in the past

Make your own mind up, but having sold my house to rent in late 2009 it’s not something I regret doing. Prices in the suburb are slightly lower than when I sold and I have increased my property buying power by renting and placing the released equity/capital into better performing assets (Gold and Silver). I suspect my property buying power will only increase over the medium term as I continue to stack metals and pay a small amount of rent while my landlord takes the property price risk.


BB.

 Buy bullion online - quickly, safely and at low prices

12 comments:

  1. a well laid out article. Especially given the depth of subject matter and the requirement for keeping it short.

    I'll be pointing people at it

    ReplyDelete
  2. How about a Scenario #4.

    In this one you keep your gold (at your proposed price it is probably not at it's peak), and take out a loan against it. This is difficult now, but may be much more possible in 2014, particularly if you only ask for say a 50% loan rather than 90+% that houses WERE going for.

    This way you keep the upside of gold, avoid taxed, but leverage the increased price to get into the housing market.

    Comments on the viability of this Scenario working in Australia?

    ReplyDelete
  3. Thanks obakesan. I was surprised at how easily the article flowed out once I'd run all the numbers.

    @Anon, I doubt we will see loans against physical Gold in the near future, however in 2014 if you were in the position of having the 42 ounces of Gold you could perhaps sell only half of the stash to fund an $88,000 deposit - $9,000 CGT + $7,000 FHOG - $13,956 = $72,044. This is more than a 20% deposit so you are still avoiding LMI and you still have half the Gold and then you could perhaps stagger sales of the rest up to your expectations of a peak price.

    ReplyDelete
  4. I see what you are saying. You are saying:
    1. Assume investment asset X will treble in price over the next 2 years.
    2. Assume investment asset Y will fall 20% over the next 2 years.
    3. With these two assumptions it would be better to invest in asset X.

    I believe the whole content of your blog is contained in those 3 sentences.

    ReplyDelete
    Replies
    1. I've read entire books that could be summed up in less :)

      Personally I found running through the numbers quite interesting including the results from saving in cash.

      Delete
  5. Another great article BB, interesting food for thought

    ReplyDelete
  6. Nicely written, fair detail to!
    Worked out this scenario and was walking this path since 2010.
    I would agree that there is still some potential left in the gamble, BUT it's starting to enter the risk zone if you to enter the game in the next 12 months.

    Good work BB, keep it up.

    ReplyDelete
  7. Thanks Dr1fta and Val.

    I agree Val that there is probably not much time left in the trade and it will become increasingly risky to put a high percentage of net wealth/savings into Gold/Silver.

    ReplyDelete
  8. surely a new round of stimulus combined with reduced interest rates (even more so with CFGII one would expect) and easy credit plus some further government propping up will bring in another boom, they are already talking about cutting rates with the incredibly low inflation (lol)

    don't get me wrong, i think you will ultimately be right but i think our master class of politicians will do everything they can to prop up the market and i think there is massive chance they will succeed at least one more time

    ReplyDelete
  9. mind you.. i'll still looking to offload 200k worth of debt ;)

    ReplyDelete
  10. I won't completely discount the possibility of another short term push higher in prices if the government was to pull out all the stops and try to prop up the market (and rates continue falling). However focus seems to be on return to a budget surplus, what would the public reaction be to throwing money at the housing market (again!)?

    In some cities (such as Brisbane) prices are already back below the early 2009 levels when the stimulus and low rates started to affect the property market.

    Any further 'can kicking' would only do similar, push the problem a little more down the road and extend the length of the housing bust (in my opinion).

    ReplyDelete
  11. good idea man ,i doing this since 2006,there is nothing better then renting and saving gold and silver for later ,then i will buy a nice place,we spare cash

    ReplyDelete