How do I afford to buy a home

What will sink the housing market and drown property investors?

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Liquidity risk as the market turns

The latest Tax Office figures show 60 per cent of investment properties are making a loss - costs (including interest) exceed rent.

For the owners of these properties, the strategy is clear: offset the losses through negative gearing and hope to book a capital gain with a 50 per cent tax discount.

It's been a winning strategy for many years, but it stops working once home prices stagnate. When that happens, the investor is just left with losses (even if they are reduced through effective taxpayer subsidy).

If this stagnation lasts long enough, many investors will want to sell out - probably around the same time.

This is where liquidity risk kicks in.

While it can magnify gains on the way up, the lack of liquidity in housing markets can also magnify falls when it is due to a lack of buyers rather than sellers.

This is especially the case if rising unemployment - perhaps due to a household consumption slump and/or the end of the apartment building boom - generates a large number of forced sellers.

In an environment of stagnating or falling home prices, banks are also likely to further tighten their lending criteria, seeking bigger deposits and borrowers with stable incomes who can comfortably service their repayments.

The virtuous cycle (for some) of rising home prices suddenly goes into reverse.

Listings jump, but potential buyers are either unwilling to catch a falling knife or unable to get finance to buy, so properties sit on the market for months unsold, while asking prices are slashed.

Banks' bad debts rise as defaults increase and more of them are in negative equity - they owe the bank more than their home is now worth.

We saw it happen in the US, Ireland and Spain during the financial crisis. We've also seen it happen in Australia, in mining towns from Queensland's Moranbah to WA's Port Hedland.

To a lesser extent, we're seeing it happen right now in Perth.

It's possible the Government could step in to prevent or break such a cycle, with some new tax breaks, grants or guarantees.

The Rudd government did this with its first home buyer grant boost at the height of the GFC, and it worked a treat.

But the Commonwealth is itself treading a fine line before it loses its AAA credit rating.

Standard & Poor's has already said a housing bust would be the final straw, potentially reducing the Government's capacity to react.

If the Government gets downgraded, the major banks' credit ratings will follow, pushing up their funding costs and potentially driving interest rates higher and putting even more home borrowers into trouble.

Economic cycles are great on the way up, but the spiral back down can be very painful, especially in markets with low liquidity where the adjustment can take years, not days or months.

(Source: Australian Broadcasting Corporation )