The average house price in Sydney is now over $1 million. Last weekend, the city recorded a median auction price of $1,222,500, up from $1,196,500 the weekend before. Property values in Australia’s largest capital cities have increased by as much as 50 percent in the last three years alone.

Many homeowners have felt the exhilarating rush of watching their net worth increase rapidly, and with practically no effort at all on their part. They just happened to own property in the right place at the right time, and now they’re basking in the glory of their good fortune.

But there is a problem; it’s a psychological problem. Having personally coached hundreds of investors, I’ve seen first hand that most people can intellectually differentiate between an unrealised gain and cash-money in the bank, but emotionally, they can’t.

Unrealised gains bring the emotional illusion of wealth, without the substance.

The former Chairman of the Federal Reserve, Ben Bernanke, spoke about this back in 2012. Here’s what he said:

To the extent that home prices begin to rise, consumers will feel wealthier, they'll feel more - more disposed to spend. If house prices are rising, people may be more willing to buy homes because they think that they'll, you know, make a better return on that purchase.

Yeah, uhm, you know, a better return, and all that stuff.

Bernanke says your unrealised gains will make you feel wealthier, and when you feel wealthier, you’ll buy more. What he fails to mention is that spending money you don’t yet have is a very dumb thing to do.

Here’s the top three dumbest things I've see property owners do in Australia’s crazy-hot real estate market:

1. They justify luxury purchases.

Driving around Sydney not long ago in my Hyundai rental car, I was amazed by all the new BMWs, Mercs, Land Rovers and Porsches I saw. As I pondered the reasons why money is pouring into the luxury car market, I began imagining the inner conversations many people may be having with themselves.

“I work hard and I spend an awful lot of time in my car driving to and from my damn job every day. I’m due for a bonus and a raise, and besides, my home has just appreciated by half a million dollars in the last two years. I’m such a smart investor. I should reward myself.”

This was not hard for me to imagine because I had just had a conversation with someone who had similarly justified his purchase of a $90,000 Range Rover.

During boom times, when people feel wealthy, they want to manifest those feelings. When assets have appreciated significantly, rather than going to the bank to get a car loan, they can simply draw down on the equity in one of their properties or take some saved up cash out of their mortgage offset account.

I try to remind Aussie investors often that unrealised gains do not make them wealthy. It only gives them the illusion of wealth. I try to help them not to be psychologically duped by their luck into believing that they deserve to spend some of these imaginary gains today. If and when property prices start moving against them, they will regret spending so much money on assets that go down in value.

2. They draw down on equity in their homes to speculate on ever-increasing property prices.

Low interest rates and significant capital growth in real estate has created an environment ripe for speculation. Many investors have been redrawing equity to use as deposits to buy more properties, raising their loan-to-value ratios back up to 80 percent or even higher. This can only turn out to be a profitable move if values continue rising. Of course, the more they rise, the less likely we'll see future capital gains .

One my primary responsibilities mentoring investors is to try to help them avoid this mistake. As I learned from someone who mentored me, the key is understanding the difference between focusing on the asset and focusing on the outcome.

Asset-focused investors rush out and acquire properties, assuming that all real estate perpetually goes up in value. In the end, this amounts to little more than gambling as you’re completely relying on the market gods to deliver profits.

Outcome-driven investors first determine their objectives, and then through careful planning and incremental goal setting, strategically acquire the assets that most appropriately correspond to their desired outcome. This outcome approach harnesses skill, rather than luck, to create wealth.

In the current property market, it’s becoming increasingly more difficult to find deals that will deliver a profitable outcome. Even renovations, subdivisions, and developments, typically strategies that can bring a profit in a flat market, are becoming more and more risky.

3. They fail to consider long-term borrowing costs.

Hot property markets are most often the result of easy lending policies and cheap money. With interest rates at historically low levels, many investors seem to be drunk on the euphoria of a rising market and failing to think long-term on interest rates.

It’s likely that rates will continue to fall further in the short-term. But eventually all financial variations tend to revert to a mean. Over time, whether through central bank policy, or unstoppable market forces, interest rates will tend to move back toward their historical average.

The average standard variable home loan rate in Australia from 1959 to 2016 was 8.53 percent. At that level, most investors today would see their interest costs double. Many would be under severe cash flow pressure, and some would default on their mortgages.

In the current irrational market brought on by low interest rates, I try to help investors have a long-term perspective. The temptation is to take advantage of the season and leverage up. Unfortunately, those who don’t manage around their interest rate risk may be in big trouble in the not-too-distant future.

Are you seeing any similar behaviour in the property markets where you live?

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@jasonstaggers

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Image credits: danger, Bernanke bill, Merc, debt, rates

I originally posted these thoughts in an article I wrote for PropertyInvesting.com.