This article was originally published in 2019 in the Australian Financial Review

According to the RBA, apartments accounted for roughly one-third of all new dwellings approved for construction in Australia from 2014 to 2018, so with such an oversupply of apartments in a suffering market, it’s interesting that negative equity has been going largely unnoticed.

apartments in Sydney reflecting negative equity issues with oversupply
Buyers could make a profit if they are clever about their purchases. Peter Braig

With the peak of apartment completions occurring in 2018, data from the RBA and ABS below show several of Australia’s capital cities still have a large number of apartments scheduled for completion in 2019 and 2020.

This could lead to a potential oversupply and reduction in high density apartment values.

Financial institutions report increasing negative equity

Recent reports by major financial institutions show substantial increases in problem loans, and a rise in the number of properties currently in a state of negative equity. However, the physical loss from falling property values is often felt hardest by those who buy off the plan.

Macroeconomic analysis in the five-year corporate plan from the Australian Prudential Regulation Authority (APRA)suggests loans in negative equity could be a factor that affects its operations, and those of other large financial institutions.

“Loans in negative equity, where loan value is greater than the encumbered asset value are increasing, although widespread loan losses are not evident and presently unlikely,” the plan states.

The Commonwealth Bank followed suit, releasing its annual ASX statement for the full year ending June 2019 that mirrored APRA’s concerns.

Recent house price softening has resulted in a moderate increase in portfolio loan-to-value ratios, including an uptick in accounts in negative equity,” it states. “Based on June 2019 valuations, approximately 3.5 per cent of Australian home loan accounts and 4.5 per cent of balances are in negative equity. Seventy two per cent of negative equity relates to Western Australia and Queensland.”

Negative equity, the two valuations

Negative equity occurs when the market value of a property falls below the outstanding amount of a mortgage secured on it. This predominantly occurs when properties are bought off the plan, as the initial valuation could vary greatly from the valuation after build.

The complexities of negative equity exist in calculations of deposits, as the amount you owe based on your Loan to Value Ratio (LVR) can change if the property drops in value.

The reason for this is that you essentially get two valuations when you buy a property off the plan. The first is from the initial developer before build, and the final valuation is by your home loan lender, who values the property after completion.

What is key to understand, is that even if your bank values your property as less than the developer’s purchase price, you still owe the developer the purchase price.

Let’s say, for example, you bought an apartment off the plan for the purchase price of $550,000. This is the developer’s valuation of the property and is an estimate based on what they believe the property is worth when you purchased it. This is based on artist renderings, furnishings, and the state of the property market at the time of purchase.

Now, as there is often a year or two between the plan stage and the final development stage, elements outside of both the buyer and the developer’s control can affect the final bank valuation.

How can you owe more money if the property falls in value?

When you buy a property off the plan, you enter into a contract with the developer that binds you to paying the agreed purchase price. Let’s take the previous example of your apartment you bought for $550,000.

To get the deposit for this property, you might get a home loan with a lender offering an 80 per cent Loan-to-Value Ratio (LVR), meaning you need to provide a 20 per cent deposit.

On a $550,000 loan, the 20 per cent deposit is $110,000, so you get pre-approved for a loan with the lender for $440,000.

A year or two later, when your apartment is built, it’s time for your lender to complete their valuation, but they decide that in the current property market, the apartment is only worth $490,000.

This is where it gets tricky.

Although your property is now worth only $490,000 you still owe your developer the full purchase price. As your lender will lend you only the amount they believe the property is worth — to mitigate their risk — a shortfall occurs.

As your loan is only 80 per cent LVR, your bank will now loan you only 80 per cent of the $490,000, which is $392,000.

Your $110,000 deposit, plus the $392,000 that your bank will loan you amounts to only $502,000. You owe the developer $550,000, and this is $48,000 less than that. As such, you need to come up with the rest, as per your contract with the developer.

For many Australians, $48,000 is nothing to sneeze at, so what can you do to avoid this situation when buying off the plan? Some options may include:

  • If you’re dealing with a mortgage broker, make sure they consider multiple lenders and their subsequent valuations, as different lenders may have different valuations
  • If you’re working directly with the lender, see if you can organise other valuations with different lenders, as property valuations can vary depending on the lender
  • Regardless of who you are dealing with, make sure you seek professional advice as to whether any other assets you have can be used to cross-secure the shortfall

Interest rates are at a record low, is it time to buy?

Talk of negative equity on the increase can potentially scare off prospective homebuyers – but it shouldn’t. With interest rates at record lows, and CoreLogic showing a slight uplift in property prices in August, buyers can make a profit if they are clever about their purchases.

Understanding the risk of a drop in value and researching the areas in detail before you begin your property search should allow you to buy with more purpose and less risk.

RateCity research director Sally Tindall believes owner-occupier home loan rates starting with “2” could become the new norm, especially if the RBA decides to cut the cash rate twice more as predicted.

“From here on in, lenders are going to be hard pressed to pass RBA cuts on in full, but rivalry in the home loan market will keep pushing rates down, even if it’s not by as much as the RBA would like,” said Tindall.

“This pressure will force more banks to offer owner occupier rates under 3 per cent, especially for people with a decent amount of equity in their property.”

The upside to buying off the plan

Corelogic research has shown an increase in house values over the month of August, reporting a 1.5 per cent rise in Sydney and 1.3 per cent rise in Melbourne.

This could suggest historically low mortgage rates are encouraging the purchase of new property, and that demand is in fact picking up.

Although negative equity can be dangerous when buying off the plan, there are some instances when buyers can make thousands in profit when property values increase, when essentially all they owned was a piece of paper.

Let’s say for instance you buy a property off the plan for $800,000. You get a home loan with a 90 per cent LVR, meaning you put up an $80,000 deposit, and need to borrow $720,000. Once the apartment is built, the bank values the property at $1,000,000. This adds an extra $200,000 in equity to your loan, as you still owe the developer only $800,000 as stipulated in your contract.

This means you can then sell this property for $1,000,000 and come out $200,000 richer, minus transaction and holding costs, and associated fees and charges. As highlighted above, buying off the plan in a booming market can create positive windfalls. However, a lot can change in the time between when you sign the contract and when the building is completed.

Buying off the plan has its advantages and disadvantages, but as with all financial decisions, it’s important to speak with a trusted financial advisor or broker before you sign anything.