Podcast: What Happens If I Buy a Property For More than It's Worth? | Ep. 205

Posted by Ed McKnight on 21/04/20
What Happens If I Buy a Property For More than Its Worth 001
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Show Notes

What's Covered in the Show?

In this episode, we discuss what happens if you come to settle a property, and it is worth less than the purchase price?

This is most important for investors who have signed an unconditional contract to purchase a brand new property that is currently under construction.

If we do go through a period of economic downturn due to the Coronavirus, then there may be a situation where some investors come to settle a property (12 months after going unconditional), and the property is now worth less than the purchase price.

In this instance, you would still need to pay the agreed price, but the bank will only lend you 80% of the valuation of the property, which means you need to come up with a larger deposit, whether in cash or by leveraging off your own home.

Let’s look in the numbers:

Let’s say you sign an unconditional agreement to purchase a property for $500,000 But, the property has decreased in value by 5%, down to $475,000. In the first instance, the bank would lend you $400,000 against the new property, and you might leverage your own home to make up the $100,000 deposit to make it $500K. In the second instance, now that the value of the property has decreased to $475,000, at 80%, the bank will only lend $380,000 against the new property, so you’ll need to make up the extra $120,000. That will typically be leveraged against your own home if you have enough equity.


Transcript of the Podcast

Ed McKnight: Hello and welcome along to the Property Academy podcast. I'm your host Ed McKnight and I'm Andrew Nicol, and today on the show, we're going to be talking about what happens if you come to settle a property and the valuations lower than the purchase price. Now, this is a really interesting topic because, investors who have bought properties off the plans are going to be thinking about this.

Why is that? Because if you've bought a property 12 months ago and you've signed up, you've gone unconditional on it, but it's taken 12 months to build, if we enter into a period of economic downturn like we, we are likely going to be entering into one, then there may be a small dip in the value of that property that you've signed up to buy, but you still have to settle it at what have you paid for it, so that might've been $500,000 but the value of it might be, say 475,000 if it's taken a 5% dip.

Now, why is that important? It's most important for the banks because you're going to be borrowing perhaps say 100% of the value of this property, but you've got a pay 500 K, but the banks only going to lend to you 475 K for that property. Have I got that right Andrew?

Andrew Nicol: Yeah, so basically Ed the way it works is if you if you purchase a property, the bank always goes off the lower of the purchase price or valuation. So say for example, you buy a house for 500,000 but the valuation says 475, the bank works on 475 being the maximum value that they'll lend on, and then they'll, they'll scale that depending on what you're buying, either 70 or 80% depending on if it's new or existing.

If on the other hand, you buy a property and because it's gone up in value because now it's complete, it's ready to go, and it's worth more to more people, if it says 525 but you're only paying 500, they go off 500,000, so they're always going to go from the most conservative number of the two. And if you listen to our old podcast on valuations, there's a bit more detail on this, but for today, let's just talk about the scenario if someone signs up for a property, lets imagine that the media is completely accurate and there is a 5% reduction and prices, which. I don't think is going to be the case and those main centres, but let's just say it was true.

So if you've got a property that you come to settlement and, your valuations says 475 the bank will treat that as the value and they'll, they'll lend you up to 80% of that. Now that's 380,000 against that asset. If you are using existing properties or your own house as your deposit, like most of our clients, where you using leverage against your own house, rather than having to put 100,000 in because 20% of 500,000 you'll need to put in the difference between the purchase price 500,000 and 475 at 80% which is 380 so your deposit goes up from a hundred to 120 so it goes up by $20,000.

Now if you've got a house that you've paid off 50% and it's worth 600,000 you'll probably find it's probably going to make no difference really, there's a little bit of an extra security held against your house, but it's not the end of the world. Where it could be the end of the world is, well a bit more of a challenge um not the end of the world. Is if you've got a situation where you're using cash or, or, um, you don't necessarily have that extra equity in your property.

Now, if that's the case, then maybe what you'd want to do is you'd look at it, you'd investigate something like a, a second tier lender that might lend 85 or 90% against the rental property, and that's still available. And actually at very, very good interest rates, very compelling interest rates, but despite the fact that they're second tier lenders, so that is, that is still a possibility for a lot of people.

The other thing that you could do with, with all of our clients, we tell them keep a buffer account, always have a buffer account of, say, $20,000. So in this example, you could eliminate your revolving credit buffer account, whilst it's not ideal, it could be a very good band-aid to allow you to still settle so you don't fall into a situation where you're being charged penalties from the developer from late settlement or something like that.

So just remember that your problem, if you do get in that situation, you're going to, you're going to need to come up with some extra equity or cash. If you don't have that, you'd need to look at a second tier, lender,or you maybe could negotiate with the developer. That's always a possibility. I know that there are developers out there at the moment that would rather, you settle, 95% of the property take possession and owe them another 5% when the market corrects, if you got onto that situation.

Now, the great thing about dealing with a company like us is that you've got some grunt when you go to make those negotiations. None of our clients would ever be in a situation where they'd be left on their own to deal with something like that. Just thinking about some of the other strategies that you might do if you did need a bit more deposit and, and you couldn't come up with it yourself and you couldn't get another loan, maybe that's when you bring in another investor.

If you need 120 you've only got a hundred maybe you get a friend or a relative to lead you the other $20,000 and you pay that off and or you include them as a, as a percentage share of the investment. That could be a way of getting around that as well.

Ed McKnight: And Andrew as well, I suppose what this all comes down to is when you get the valuation and the need to have a registered valuation before you go ahead and get you lending before you settle now, just just correct me or confirm for us all as well I should rather say, is that, how far before you settle in advance do you need to get that valuation done so you can go and get the lending?

Andrew Nicol: Valuations technically only lasts for a few months, but there is a bit of a trick that you can do. If you get a valuation at the start when you're first looking at buying a property, if it's off plans, often a bank will accept just a completion certificate at the end. So the valuer will go and look at it now, they will say, okay, based on today's market, it's worth 500,000, then in six months time, nine months time, all they will do is give at letter to the bank to say it's complete.

They don't have to re-evaluate, and most banks will accept that and so that would be, if you wanted it to be really safe when we come out of isolation, if you've got a completion coming up in the next 12 months, maybe you get that valuation now, if you haven't done that already and the same if you've got a house that you're using as equity to leverage you into this and your, your equity level or usable equity is tight, get that done straight away before the valuations change because of course, remember it takes sales to occur before valuation gets affected, so it could very well be that you can go out two weeks after isolation, get a valuation on the current values, and if the values did drop over the next two months, you've still got an valuation that's usable based on today's values or when we come out of isolation.

Ed McKnight: And Andrew, this is where I need to talk as well about the difference between house prices and house values. Now this is really interesting and you might think that the difference almost is trivial. "Ed, what's the difference between the price and the value?"

Often on this podcast we've, we've previously said that there's no such thing as buying a property below value because the price is the value. Well, I just need to correct that a little bit as it pertains to the actual economic data and let me explain this.

So house prices or median house prices is often what you will see quoted in media headlines, uh, and, and, and in the, in the newspapers. And what that is, is it's based on whatever has actually sold at the actual prices over the last month. So between January, 2020 and February, 2020, the median house price in New Zealand jumped $35,000 I think it was, or it might've been $25,000 actually, now that I come to think that, so did every house in New Zealand automatically or, or somehow over February's, 28 days jump in price or value, I should say by $25,000? Not necessarily. It's just that a different set of houses were sold. And the median happened to pay $25,000 higher.

Now, of course, prices impact values, but what I'm trying to say is just because house prices in terms of what's actually being sold on the market jump up or down, it doesn't have an automatic impact on the value of your own properties. So let me get, actually break this down into some data. During the last GFC, the last economic downturn, property prices in Auckland, the median property price fell by about 9%, but the median value only dropped by about 4%. Similarly, I was looking at Hastings for some reason the other day, and I saw that the median price over that period as well, dropped by 16% but the median value only dropped by 8% and what is that caused by.

I guess it's caused by things like if somebody is forced to sell the property because they need cash flow in their business, or they need to downsize, that there's been a redundancy and they've had to sell at a lower price, and they've just being had to take whatever the market would give, that would be one of the reasons why a price would be lower than a value.

And so what I, my key message for you is, is that values move much more slowly and gradually than prices. So, when you see predictions by an economist saying, look, I think that property prices are going to drop by 7% that doesn't necessarily mean that the value of your personal home or your personal investment properties are going to drop in value by 7% it's just that the market prices of, or the average price that's on the market at a, at a particular time drops because market prices tend to jump around all the time, and that's why you can see a $25,000 gain, uh, in the space of 25 days, just because of how this data is actually calculated.

Andrew Nicol: And the last piece of advice I would give people as if you are doing this by yourself and you are in a situation where you find that the valuation is less than what the purchase price is, or your own house is not going to allow you to unlock the equity that you expected, remember of course if you can get a valuation when we come outside of isolation, you set up that deposit facility immediately so that that's there, because the bank won't take it away and ask you for another valuation later. you could do that right away if you are using split banking.

If you do find yourself in a situation where you're unable to settle, have a conversation with the developer straight away, or the vendor straight away because the sooner you have that conversation, the sooner you can start looking at alternatives. Nothing annoys developers more than when you get to settlement and then tell them that you can't do it because at that stage, bit of a panic and if you, if you are late with settling, it could cost you 15% per day, so 15% per annum, charged daily. So you need to think about that so that you can find a way out sooner rather than later.

Ed McKnight: Fantastic. Well, let's wrap it up there, but please don't forget to rate, review and subscribe to the podcast. It really does help us get the message out to more people and, hey, if you're interested in finding out what does coronavirus actually mean for the property market, why not join our live webinar, which is coming up this Tuesday at 5:00 PM the 7th of April, or if you're listening to this after the 7th of April, there will be a recording available on our website, Opespartners.co.nz, so just go over to our website to register for this webinar, or I'm going to link it into the show notes.

And what we're going to do is we're going to open up our analysis of over 165,000 different data points of all of the median values of suburbs over the last 20 years that we have, because we're going to be opening up and identifying which areas of New Zealand tend to have the biggest dips in property values during an economic downturn and also which areas of New Zealand have the speediest recoveries as well. It's going to be a really interesting talk.

Thanks for listening to the Property Academy podcast. I'm your host Ed McKnight, and I'm Andrew Nicol, and we're going to be back again tomorrow with even more daily strategies, tactics, and insights to help you get the most out of the New Zealand property market.

Until next time.