Is this sensible ? Risk management in buying a property ?

I saw this blog from a buyers agent (published in Nov 08):

 

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I am working with some clients at the moment that were initially looking to sell their current home and upgrade to a larger home to match their growing family.  They didn't have not had any luck selling their home (at the price they felt it was worth) so were feeling dismayed about not being able to move in to a larger home. 

With the drop in interest rates and taking in to account what they could rent their current home for in the current market, it turned out they are able to buy the larger new home and still hold the current home.  They are now really excited at the prospect of bing able to buy a great home that they couldn't have afforded before due to its price coming down and holding their current property to sell in a few years time when the market picks up.

They did their sums and are turning the current financial doom and gloom in to an opportunity.

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The blog is especially interesting because it brings into focus a key bull argument for the property market i.e. falling interest rate. It also brings into focus that the property market may be stalling a bit for some sellers. The blog got me thinking....Would I follow this strategy ?

The answer is NO personally but a lot depends on your risk tolerance. First, let's see why it is a good idea. The ONE reason why you would want to follow the strategy is if you strongly believe in the property market i.e. it will go up and up and up. In that case, the rent pays for your holding cost and, if you are truly astute (your property is positive yielding), your tenant will help you to pay down your mortgage as well. In short, you are strongly increasing your leverage.

However, leverage cuts both ways (up or down). It brings me to the key idea of this post. I remember in the years past when I was snoring in the lecture hall in the back row, a finance professor said again and again one of the core tenants of risk management is matching the duration of assets and liabilities. Incidentally, I suspect this is also the reason why some of the high profile investment banks got unstuck recently. 

Applying the concept to the Sydney property market, I would argue that some folks have probably taken on a lot of risks without aware of it. In the simplest term, a bank will foreclose a property if interest payment is not being made. In most cases, the interest payments are funded by the wages of the household. We also know that most people do change jobs every few years. Thus, we can probably assert that there is cash flow uncertainty (bonus may change/disappear, two income household becoming single income etc etc...) for every household. In contrast, a 30-year mortgage is a very long term liability with minimal flexibility. This is a case of pretty bad asset/liability mismatch.

So far, this mismatch has caused minimal problems for the society and households (very vibrant economy and ever increasing house prices). Still, do bear in mind that good times do not last forever. 

Now imagine if you are the home owner advised by the buyers agent. Let's say you have a comfortable 3 bedroom house worth $1.2M. And you are looking to upgrade to a $2M 4 bedroom house in Mosman. Let's say you have paid off a reasonable chunk of your mortgage and you only owe $600000 in your own home and have another $400000 saved in the bank/shares. If you could sell your home, you would only need to borrow another $400000. You can still be quite comfortable because you would have 50% capital in your new $2M mortgage. Let's say you follow the strategy of the buyers agent, you still owe $600000 in your original house and then you take on another $2M in mortgage (or $1.6M assuming you have saved another $400000 somewhere). Suddenly, you find yourself with total debts of $2.2M. Imagine one day you find out you are having another kid or maybe your tenant has lost his/her job ?

Food for thought.