Leverage can mean a ton of gain or a world of pain for homebuyers
One of the primary attractions of property as an asset class is the ability to use leverage. By putting a downpayment on a property and getting a mortgage from the bank to make up the rest of the purchase price, you're getting an opportunity that an individual investor would rarely get with other asset classes. Banks are willing to take the risk because they know borrowers will do almost anything to avoid losing their home.
The beauty is that the borrower gets 100 per cent of any profits, having typically only put down 30 per cent of the purchase price in Hong Kong. That's leverage of more than 200 pr cent - you've borrowed more than two-thirds and put down just less than a third - something only institutional investors can achieve in assets such as stocks. Perhaps only futures trading - notoriously difficult to pull off but also much loved in Hong Kong - offers retail investors similar leverage.
But over-borrowing by homebuyers who couldn't really afford the properties they were acquiring was also at the root of the financial crisis in the US. A similar situation occurred in Hong Kong during the property bubble in 1997, which produced a disastrous 60 per cent correction in prices through 2003 after it popped.
The leverage becomes supremely painful in the other direction.
When prices move in the wrong direction, you're also open to 100 per cent of the losses in a property. Your downpayment is wiped out with a 30 per cent downward move. It's easy to fall into 'negative equity' in such situations, oweing more on the home than the home is worth. Banks and borrowers have generally been more restrained this time around in Hong Kong - partly by design of the banks, partly by law. No one institution is allowed to loan more than 70 per cent of a property's purchase price in Hong Kong. And as of November 19 last year, the minimum downpayment is 40 per cent on homes worth more than HK$8 million, and 50 per cent on homes worth more than HK$12 million.
The larger your downpayment, the more room for error if prices move against you. There aren't many signs of over-borrowing at the moment. Mortgage delinquencies are currently at an all-time low in Hong Kong - they stood at 0.01% of all home loans at the start of this year.
But any over-borrowing may be masked by current mortgage rates, which are also at record lows, with the effective mortgage rate paid running at just 0.89% in January, according to the mortgage brokerage mReferral. That's a far cry from the 12.25 per cent they hit in 1990, or the 11.25 per cent at the start of 1998, when the last bubble popped.
Some pain may become clear from borrowers who can't afford their monthly instalments as interest rates start to rise. In March, banks began raising their best offer for HIBOR-based loans - used by 92 per cent of new borrowers.
How much mortgage can you afford? Elsewhere in the world, investment advisers typically suggest that mortgage payments or rental costs shouldn't rise above one-third of your monthly income - with another one-third allocated to expenses and savings, and one-third allowed for tax. Thanks to Hong Kong's low levels of tax, there's a little more flexibility here. Sharmaine Lau Yuen-yuen, mReferral's chief economic analyst, recommends that home owners perform their own stress tests in case interest rates rise by two or three percentage points. Under that scenario, she feels anyone spending less than half their monthly income to service mortgage debt should be fine. But anything higher than that starts to ring alarm bells.
Some financial planners, like Martin Hennecke at the Tyche Group, don't like the use of leverage at all when buying a home. 'If I said you should put all your money in gold and leverage it three times people are going to say, 'You're crazy,' right?' he says. 'I would suggest ideally don't have a mortgage, and just buy something small.'
But of course most people can't afford to take the first step on the property ladder without borrowing. Even the downpayment is a serious challenge for most buyers in Hong Kong.
As long as you're able to avoid any forced sale in a major downturn, property owners can simply sit and hold on to properties, even if they're in negative equity. There are almost no cases now in Hong Kong, with average prices approaching - but not quite at - their 1997 highs. 'If you're going to be in it for the long term, time will erase almost all the mistakes you're going to make,' property author Chris Dillon says.
