As you are probably aware we have held a negative view on Australian property for number of years. Indeed, we have received our fair share of criticism for it, not only from parties with vested interests in the property market but also from those who simply didn’t share our bearish view. A difference of opinion of course is what makes a market, providing both buyers and sellers.

Our thesis has been relatively simple; a glut of new apartments would force developers to discount their inventory in order to move it and recycle their capital (if any). The transmission mechanism for older apartments was equally simple. Owners of the oversupplied newer apartments would be forced to lower rents, which would cause tenants to migrate to the cheaper apartments and force landlords or older apartments to lower their rents. The lower yields from weaker rental income would then put financial pressure on highly-geared landlords (remember Australia’s mortgage debt to income level is at a record) and trigger additional forced selling beyond developers.

In the September quarter the thesis began to play out. Brisbane apartment prices plunged $81,000 amid an acknowledged oversupply in the Queensland capital, and ahead of another release of new units that will flood the market in 2018. In a report, prepared quarterly by property consultants Urbis, the average Brisbane unit price was reported to be $644,667, down from $745,563 in the July quarter. With another 7100 apartments planned for release in 2018, continued pressure on landlords and developers is likely.

Back in May last year Australia’s financial systems experienced an important change that went largely unreported. As one part of APRA’s preparations for Basel 4, banks increased interest rates on interest-only loans by 70 basis points – the largest credit tightening in more than three decades.

Academic research based on the experiences in the UK, Ireland and the United States reveals that there are two drivers of mortgage defaults. Those two drivers are Ability-to-Pay and Willingness-to-Pay. Ability-to-Pay can be measured by the Debt-Service-to-Income-Ratio, which in turn is driven by interest rates and mortgage contract changes. Willingness-to-Pay is driven by the equity held in a property and can be measured by the Loan-to-Value Ratio. A final factor is unemployment. Income loss affects both the ability and the willingness to pay but it appears that debt-service-to-income is a more important contributor to mortgage arrears than unemployment.

In the late 1980’s and early 1990’s in the United Kingdom, mortgage arrears rose significantly as higher interest rates caused the debt-service-to-income ratio to increase, despite unemployment declining between 1985 and 1991.

During the United States subprime crisis, investors with high loan-to-value ratios defaulted at two-to-four times the rate of owner-occupiers. And in Ireland the experience was similar with arrears rising as a function of debt-service-to-income and loan-to-value ratios, and at twice the rate for investors as owner occupiers.

In Australia, since 1986, variable mortgage interest rates have fallen from near 17% to just above 5% today. During that time, household debt to disposable income has increased from just over 20% to more than 100%.

A debt service to income ratio of more than 40% is considered non-prime, and the Household, Income and Labour Dynamics in Australia (HILDA) Survey – a household-based panel study that collects valuable information about economic and personal well-being, labour market dynamics and family life – reported that 38% of all mortgages have a debt-service-to-income-ratio of more than 36%.

Drilling into the ATO data by occupation, Endeavour Equities analyst Douglas Orr has discovered that aggressive negative gearing – comparing total dollar deductions to post deduction income – has been undertaken by flight attendants, ambulance staff, police officers, finance brokers and real estate agents. And for many, post deduction annual income is less than $37,000.

You would normally expect a chart of deductions to rise along with salaries. The more someone earns the greater the capacity to buy an investment property and claim deductions. And while there is most certainly an increase in deductions as incomes rise above $80,000, the much bigger deductions are being claimed by people earning post-deduction incomes of less than $37,000. It simply means lower income earnings, in an effort to ‘get ahead’ have geared themselves heavily into the hope of an apartment boom that is now unwinding.

Returning to the Brisbane property price declines, it turns out Queensland and Victorian residents account for almost all of the net negative gearing that has been undertaken in Australia in the latest round of credit expansion. That means many of those declining Brisbane apartments are owned by Victorians.

If declining property prices in Brisbane produce negative equity for Queensland and Victorian investors, who have little post deduction income, the resultant financial stress could spread to Victoria. More importantly, any spike in arrears among loans considered non-prime by the banks, might be packaged and sold to more aggressive debt collectors, causing an increased level of forced sales and further declines in property prices.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.