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You are here: Home / CPF Are You Ready? / 4 Risks in Property Speculation

4 Risks in Property Speculation

15, November 2009 by Wilfred Ling Leave a Comment

MAS flagged two risks to property buyers and painted two scenarios:

1. If the economy growth proves weaker than expected, property buyers may face capital depreciation when market corrects;

2. If the economy recovery stays on course, interest rates will increase causing mortgage loan installments to increase. Home buyers would have to pay a larger cash outflow.

My comments:

If you look at the two scenarios you will find that these are the only two outcome of the economy. Either the economy remains weak or recovers. There appears to be no third option. Therefore, a property speculator is heading for trouble if there was no prior prudent planning.

To be more precise, there are other financial assets there face similar problems. For example, equities have run-up significantly too. If the economy growth proves weaker than market’s expectation, equity markets will also correct. However, property investment can be more dangerous than equity investment. Risks of property investment are:

1. Liquidity risk. The number of property being transacted is very small compared with the total number of properties in the country. This is basically an illiquid market. If you wish to sell, it takes a significant amount of time to find a buyer.

2. Inefficient market. The property market is inefficient despite the advance technology being offered for equity market. There is no organized exchange in which buyers and sellers bid for the price they wish to transact. Many of the property are marketed by property agents who will place advertisements on traditional print and online portals. The inefficiency is further compounded by the lack of regulation over property agents. Fortunately, regulation is coming soon.

3. Costly transaction. Each transaction is costly. Besides the necessity to offer an unfavorable price for a desperate buyer/seller, other cost such as stamp duty, commissions and renovation do add up to a sizable amount. It is quite common for people to sell and buy simultaneously. I am not surprised that the total cost for each “switching” (i.e. selling a property in order to buy another property) can be 10% or even more. If this is the case, you need to be selling at above 10% of the original price just to break even.

4. Leveraged market. One of the reasons why many people are involved in property investment is the availability of credit. You can get a high loan-to-valuation ratio. For example, if you can borrow 90% from the bank, your leverage ratio is 10 times. But this means is that if the property price drops below the 90% mark, you are in negative equity and run the risk of foreclosure. Leveraged itself is not a disadvantage. But most people cannot handle leverage due to the ready access to huge sum of money from the bank. As MAS has warned of home prices correcting if the economy growth turns out to be weaker than expectation, there is a real danger of increase number of foreclosures. Related to leverage is the mortgage installment. If you had assumed a low interest rate in your budget, you will be hard hit with the increase in the mortgage installment when interest rate increases due to a strong economy.

I know many of my clients who financed their property using a three years fixed interest rate package. They think they will be safe from interest rate risk for the next three years. My advice to them is that this safety is merely a perception due to liquidity risk, inefficient market risk and costly transactions.

I also know of a particular client who engaged in property speculation this year. Overall their net worth is a very healthy positive six figure. Unfortunately that net worth is merely on paper because large amount of that asset is in property. Due to poor planning and poor usage of leverage, they need to urgently sell one of their properties to raise cash. However because of poor liquidity, inefficient market and the need to sell 10% above original price just to breakeven, they are not able to find any buyer. If there is no miracle appearing, bankruptcy is not remote.

The use of leverage to finance investments is a subject in financial planning called “Credit Management.” This is a subject that is often neglected by property buyers. Many financial planners do not do this significantly because there is no commission to earn. Yet, it is important that before you make any leveraged purchase, you should engage a qualified financial planner to assist you in planning.

This article first appeared on CPF Board's IM$avvy website: www.cpf.gov.sg

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