How Property is Co-Dependent on Debt

Acumen Finance offers a closer look at the dependency between debt and property to show you how they work together to create a strong, healthy economy

Nathan Daly
October 16, 2020

How Property is Co-Dependent on Debt

Have you ever wondered why a key indicator of the economy’s health is measured in housing starts? To answer that question, we here at Acumen Finance are going to take a closer look at the dependency between debt and property and show you how they work together to create a robust and healthy economy. As you will see, property debt is a primary artery for creating money and keeping the cash-flow pumping like blood.

The Debt Economy

In our Money Matters article, we talked about how money is created by banks. Simply put, once a deposit of hard cash is made to a bank, the bank (as the legal owner) retains a fractional reserve, typically 10%, for security purposes, and is then able to loan out the balance at an interest rate that generates income while fueling consumer spending.

Each time a loan is transferred/deposited to the borrower’s account/balance sheet, it is considered “new” money - like a magician pulling a rabbit from a hat. And the banks can repeat this process as often as they like, turning a $100,000 deposit into $1 million dollars, backed by $900,000 worth of debt. And since you’re not actually given that loan in a briefcase filled with $100 notes, the loan is not real, or fiat, money, it’s just numbers in a ledger.

Rather than just sitting idly in a vault, your deposited cash is used to help others in the community. From this simple precept, two other significant ideas can also be validated: 1) a strong economy is dependent on generation of debt as it creates money for circulation, and 2) if we were to pay off all our debt, we “un-create” money, meaning that once the $900,000 worth of debt (from the example above) is paid off, all that remains is the original hard cash deposit of $100,000 - definitely not in the best interest of the community.

So, when you go to a bank and get a mortgage loan, the bank is lending you money that doesn’t really exist - it only “becomes” money when you sign the contract to repay the loan. When a bank makes a loan, it creates an asset that earns a lot of interest and a liability that costs them almost nothing because banks barter in IOUs, meaning most of their debt never needs to be repaid - as long as the system keeps working.

When the system is working properly, the property market goes up - everyone is getting good financing deals, and more loans generate more circulating cash. In the housing market, this cycle is particularly obvious when considering large development projects that start from raw land and end with multi-family residential buildings, for example. In a good and free-flowing economy, traditional banks are confident; and therefore, are writing higher LVR loans with looser covenants (fewer restrictions on the borrower and fewer protections for the lender). Developers are taking loans to buy raw land with the plan to generate housing while creating jobs and feeding the local economy. Meanwhile, the banks are salivating at the prospect of hundreds of new home buyers who will need more loans. It’s a self-perpetuating cycle.

The Strangulation of Debt

If, however, debt dries up, as it did in the wake of the GFC of 2007/08, the entire system collapses. While the effects were wide-reaching, impacting all types of property asset classes, this was particularly evident in the property development market - the most nascent and vulnerable stage of the property/debt cycle. Also gravely affected, were the high-end markets, where up-scale luxury communities such as Sovereign Island, Byron Bay, and Noosa found themselves suffering huge losses in perceived equity.

As the first wave of GFC trouble crested the horizon, banks retreated from their standard, if not somewhat aggressive, lending activities, and assumed an offensive approach - “using an umbrella on a sunny day” - in essence, constricting the creation of debt like a hungry python.

Gone were the days when a bank would take a bet on a developer looking at raw land - even with a proposed zoning change that would potentially increase land value by double, treble, or even ten-fold upon subdivision. When debt dried up, so too did reliable market evaluations.

Prestige properties were likewise brutally affected. Appraisers were reluctant to put their names on high-end valuations in these turbulent times because the market couldn’t differentiate between a $10 or $20 million property in this niche market. So properties that were “one-day” valued at $20 million or more, suddenly found themselves at $12 million or less the next. This put the squeeze back on the banks because, if the borrower had an 80% LVR on that $20 million property ($16 million), the bank is suddenly over-exposed, holding a note for $4 million more than the property’s post-fallout evaluation. And yes, this also occurred in the more-moderate markets as well.

The Band-Aid Effect

In this time of drying debt, many banks exacerbated the situation by turning to some of their more favourable, low-risk clients, instigating “safe deals”, encouraging them to buy up assets that were suddenly “cheap” due to the fallout in the market. This strategy was nothing short of a market manipulation designed to protect the banks. While the slightly higher interest rates helped the banks cover some bad debts, it did not generate enough cash or momentum to infuse money back into the weakened economy and stop the slippage. Still, they did not come to the rescue.

Economic Resuscitation

Just a bit more than a decade later and these valuable lessons seem nestled in the annals of history. Today, 70% of all homes are backed by a mortgage, up 10% from just two decades ago. With an increase of debt through commercial property investments, project development finance, and commercial mortgages, the Australian economy has emerged from the python’s squeeze. Possibly the most important lesson, albeit only implicit in the footnotes, is that Big Banks can always be counted on to look out for their coffers first - they do not necessarily have the best interest of the “market as a whole” high on their agenda. It is, after all, a bank’s world.

Luckily, there are alternatives to a development application, prestige properties, and commercial mortgage financing. Tier 2 (non-bank) and Tier 3, Private lenders are viable options when it comes time to make your property investment dreams a reality. See our article on Understanding the Differences for an in-depth look at these lending solution providers. Alternatively, contact the experts at Acumen Finance to talk with a specialist about your investment goals and let us help you develop a plan to make it happen without supplicating to the tyrants of the banking world. We use the latest in mortgage calculators and financial modelling tools to help you plan your investment strategy. We understand who’s who in the Tier 2 lending world and know where assistance can be found. And we have access to a pool of private lenders who have the ultimate in flexibility and will judge a financing proposal based on the merits of the deal. With our knowledge and extensive contact list, we can match you to the financing operative to start your empire today.