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McGrath’s failed IPO is a warning for investors

Ding, dong, down: John McGrath ringing the bell. Real estate agent McGrath listed on the ASX and closed almost 13 per cent down from the IPO price. That may seem strange, given shares were not overly expensive – according to conventional metrics – and given there was plenty of demand in the IPO.

But weak demand for McGrath shares might be telling us something about the broader n economy. You see, since the mining boom went bust, the strongest part of our economy has been residential real estate. And with more than half its offices located in Sydney, McGrath has a strong presence in ‘s strongest property market. For believers in the house price boom, McGrath must look attractive.

So could it be that house price bulls are getting thin on the ground?

There’s little doubt that the housing boom is over in the resource-focused regions such as Western . But the larger markets of Sydney and Melbourne are still going strong. And since high prices mean high commissions, McGrath is well positioned to profit. But how long can it last?

House prices in our major cities are already at the level where it has become commonplace for first-home buyers to buy only with the assistance of their parents. Even those who spring for the entire deposit themselves have often received help from their parents, even into their early thirties. In fact, the n Bureau of Statistics reports that 17 per cent of ns aged 25-34 still live with their parents. Often, this cohabitation is required to allow children to save a deposit on a first home, or increasingly, an investment property. This shows that the next generation is already at the limits of their capacity to pay.

Sydney house prices were 1.4 per cent lower in November, as foreign demand softens, banks tighten lending, and buyers baulk at high prices. Indeed, auction clearance rates in Sydney and Melbourne are trending lower, and McGrath itself says that “house and unit prices are expected to peak in FY2016 before declining in FY2017 and FY2018.” Others argue the peak has already passed.

Some might see McGrath Real Estate as a bargain at less than 14 times 2016 earnings, but it seems that is not the view of the market. Indeed, the fundamentals suggest it probably isn’t the best time to buy a real estate business, given that the company’s profits will be profoundly influenced by residential property prices (agencies make money on commissions, after all). Making it up on volume?

McGrath may be quick to argue that even if lower prices lead to lower commissions, increasing volumes can make up the difference. While that may be true in theory, the company’s own data shows that volume didn’t grow in during the GFC, even though it only had a minimal impact on house prices. Over in the USA, where price falls were much more significant, the volume of existing homes sold roughly halved from peak to trough. There’s little doubt that falling house prices would mean falling profits for McGrath.

With interest rates in at historical lows, many younger investors and first home buyers would struggle to conceptualise a high-interest rate environment. In the face of the end of the mining boom, rates are likely to stay lower for longer than many suggest, but anything can happen over the course of a 30-year mortgage. The Reserve Bank of can’t continue cutting rates forever, and if rates eventually rise, it will put pressure on the property market. Foolish takeaway

Gen Y and the Millennials after them may baulk at signing up for 30 years of debt for a house on the outskirts that they can barely afford without mum and dad. In that case, new McGrath shareholders might find that they’ve made a leveraged bet into the property market at precisely the wrong time. It won’t take much to see n property prices cool significantly, and few would cheer that outcome. But it pays not to forget that prices can go down as well as up.

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Claude Walker is a Motley Fool investment analyst. You can follow Claude on Twitter @claudedwalker. The Motley Fool’s purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).

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