Sell your leisure property and get out of debt

As I write, Wall Street has been falling away and there is fear that the light at the end of the tunnel is an express train. If you see the Dow Jones index of US shares fall sharply – say to 11,500 compared to about 12,000 now – then make this report a call to urgent action; because if that happens it will be a signal from Wall Street that the financial system’s rescue bid has fallen off the rails.

On the other hand, a Wall Street rally will mean there is no urgency to act and the crunch coming to Australian property will be manageable. But irrespective of whether Wall Street continues falling, there are signs under the surface that show that all is not well.

I think most Eureka Report subscribers have their share portfolios to a point where they are comfortable with their level of cash and long-term share investments. Last week, Alan Kohler said his level of comfort was about 50% cash and 50% equity. I have a similar view. It is perfectly legitimate to have a long-term equity position that is higher or lower –as long as you have considered the issue and are comfortable with your stance.

And for those with a higher level of equity there is good news: The lesson from our previous difficult times is that those who held good shares and property came out of the hard times with a substantial surge in profits.

Those who sold out often did not get back into the market until much later. That is why financial planners advise continued equity investment in both good times and bad. But these alternatives do not apply to those that are over exposed with debt. In previous troubled times, those with large share-related debt did not have the option of holding equity through the crunch so that they could benefit from the upturn. I hope there are very few readers now in that situation.

Even if you are comfortable with your long-term share exposure, investors often do not realise that property carries big risks in tough times and they can be bowled over.

If we have a further substantial fall in Wall Street, it will be accompanied by a similar Australian sharemarket fall and that no conventional areas of equity will escape a pummelling.

The main possible exceptions will be gold and silver, which are offsets against the falling American dollar. A Dow index of US shares below 11,500 will signal that the American banking system is going to suffer a loss substantially greater than the $US400 billion estimate that was promoted recently by the G7.

I know that at least one large Australian bank fears that the loss may be more than twice that level. If that happens, the amount of money available to lend to Australian banks will be substantially contracted and the interest rates they will have to pay for the 50% of their funding that they obtain with overseas borrowing will rise sharply.

So, in the event of a deepening US crisis, we will face the likelihood of a combination of a credit squeeze and higher interest rates, which will savage those who have highly leveraged exposures to property. Those who have investments in leisure areas such as the Gold Coast and Port Douglas may see any Wall Street warning but feel it is too late to sell because property values have already fallen, say, 15%. But leisure property is the most vulnerable area in any credit crunch, so move quickly to reduce debt.

An early warning of the Queensland property dangers has emerged via the difficulties encountered by City Pacific, which is a major funder of Queensland property development. Once the economy starts to pick up, leisure property can rise faster than any other property group. There is no sin in deciding to hold your leisure property through any storms that may be ahead, but it is extremely dangerous to make that decision if the leverage on your leisure property is high and will jeopardise your base financing.

However, I fear a convergence of two events on the leisure market. First, a lot of professionals in stockbroking, merchant banking and advertising are earning less and some will lose their jobs. They will be sellers of leisure property. Second, many borrowed heavily – using leisure property as collateral – to fund substantial once-off superannuation contributions before the deadline of 30 June last year. They are now thinking of selling.

This 2007 superannuation borrowing is also about to hit small commercial properties. If you are over-exposed in either leisure or small commercial properties it would be safer to act now rather than wait for Wall Street.

Rents in most capital cities are rising because of a shortage of residential housing. And in some areas that is translating to higher dwelling prices, particularly in better-quality houses. But the level of dwelling prices is determined by how much banks will lend and at what interest rate. Our general housing market will not be totally insulated now that we have restrictions on overseas funding for banks, which are altering their lending criteria.

Many people have businesses that have enjoyed the unlimited bank credit that has been available over the past decade. Now is the time to secure current levels of funding so that if times get tougher you will be protected. If you can’t secure long-term funding then now is the time to make the decisions necessary to protect your business. Those decisions may involve a sale or some other substantial reorganisation.

It is a clear option to wait until Wall Street takes another dive (so locking in the certainty of much tougher times) before making unpleasant decisions. But for those who are exposed right now, a safer course might be to secure your position because even if the US banking system is rescued, the lower leverage will enable you to concentrate on the business.

The important lesson of every other economic downturn is that whether you are invested in shares, property or a business, do not go into the downturn with high levels of debt. The sharemarket has discounted our banks by more than 33% – there could be no more stark a warning of the dangers of gearing ahead.

I am an admirer of ABC Learning Centres chief executive Eddy Groves. Eddy did not arrange his finances well and never anticipated the bear raid that Australian superannuation funds and index funds would sponsor via lending their script to hedge funds. But he moved swiftly to secure his business by selling assets. He recognised that the game had changed.

Groves has shown that there are still substantial sums in the US available for attractive equity positions. But if the US experiences a further contraction, then the world’s available capital will be required to rescue the American banking system and deals like the Morgan Stanley/ABC Learning exercise – in which ABC sold 60% of its US centres in a $US775 million deal – will be much harder to secure.

Right now Australia is surfing on a flood of commodity revenue. The universal view is that whatever might happen in the US that commodities, and therefore Australia, will not be affected because demand in China and other parts of Asia exceeds supply.

The stockmarket is not marking commodity shares down substantially. I hope the market is right, but the view will be tested if the US crisis becomes too deep. I don’t plan to write about commodities in this article except to say that IF we have a substantial US decline and a significant fall in parts of Europe and/or China continues with its high inflationary problems, then it will be very difficult for even a robust economy like China to pay for the current commodity prices.

That is an argument that will be opposed in many quarters. We are attacking our economy on five fronts: higher interest rates, a credit crunch, lower government spending, lower equity and property values. We haven’t experienced such a squeeze since 1960.

This story first appeared in EurekaReport.com.au