UNLIMITED FINANCE FOR UNLIMITED PROPERTIES – wouldn’t that be nice!
Many of us have been to the seminars, seen the websites and read the newspaper adverts. They say – ‘Use a company or trust structure’. Only buy high yielding commercial or industrial properties. Use vendor-financing or wrap techniques they spruik.
So, is there such a thing as unlimited finance for unlimited properties? If so, how is it achieved?
I’m going to try and explain what factors cause investors to hit ‘borrowing limits’ that temporarily or permanently prevent people from accessing further finance to acquire more and more properties.
YOUR BORROWING CAPACITY –
To understand if unlimited finance is possible, we first need to understand what factors can affect our borrowing capacity. Borrowing capacity is impacted by three key factors:
1. Income and expenses (known as your serviceability).
2. Assets and liabilities (known as security).
3. Your borrowing history (referred to as your credit worthiness).
To borrow money, you need to be able to demonstrate to a lender that you earn a stable and sufficient income to comfortably repay the loan. You don’t need to earn a six – figure salary to be able to afford an investment property; you just need enough money to cover your personal financial commitments, the investment property loan plus a small buffer. Your personal financial commitments include living expenses for you and your family, rent or existing home loan repayments, credit cards, etc. The ‘buffer’ will provide the lender with comfort that if one of your investment properties becomes vacant or if interest rates increase then you have the surplus capacity to still meet the loan repayments.
When banks assess a loan application, they calculate the dollar value of the principal and interest repayments using a benchmark interest rate regardless of how you elect to repay the loan (which is a fixed margin above the standard variable rate) and they compare this amount to the assessed rental income.
Assessed rental income is based on a percentage of the gross estimated rental income (normally in the range of 75% to 100%). The average gross rental income allowed for and included in their assessment is usually 80%. The rental income is reduced to this amount to take account of the expenses associated with the investment property (e.g. property management, maintenance, etc.) plus an allowance for any vacancy risk.
The average interest rate margin (added to the standard variable rate) is usually around 1.5%. Therefore, the average benchmark interest rate at the moment is approximately 6%. As an example – Assume a property is valued at $100,000 with a rental yield of 6.5%. The investor contributed $20,000 (plus costs) in cash towards the purchase of the property. The remaining value is financed by a mortgage (i.e. $80,000). Therefore, the assessed rental income would be equal to 80% of the estimated gross rental = ($100,000 x 6.5% x 80%), which equals an income of $5,200 per annum. This would be compared to the assessed loan repayments on $80,000 at the benchmark rate of 6%, which equals to a loan payment of $4,800 per annum. Therefore, this application has an assessed surplus of $400 per annum ($5,200 -$4,800).
In this case the property is supporting the loan without requiring any income support from the borrower. In fact, in this case, the property would actually have the effect of marginally increasing the owner’s borrowing capacity, because it adds an extra $400 of net income to the borrower’s annual financial position.
So what rental yield is required to ensure that the investment property is not ‘draining’ your borrowing capacity?
So in this scenario if your investment portfolio’s yield is much less than 6%, then I am sorry to say that you will not be able to achieve unlimited finance… eventually you’ll hit a serviceability limit. One thing to consider is that there are lenders that will take into account up to 100% of estimated investment property rental income. There are also other lenders that currently use a benchmark interest rate of less than 6% when assessing loan applications. Investors who have weaker average gross rental yields might consider searching for these lenders. Ask your Broker. These lenders may not have the most competitive products, but they may allow borrowers to continue building their investment portfolios. After all, as an investor, which would you prefer? Saving 0.30% in interest or buying unlimited properties? So, is it possible to have a property portfolio with an average rental yield of over 6%? Too right – Dual Income Properties offer exactly that.
One property with 2 incomes.
However, don’t throw in your job just yet. A lender will generally prefer that borrowers have two sources of income so that a borrower is not too – as they would say – “rent reliant.”
Now we know now what our average rental yield needs to be in order to generate unlimited borrowing capacity. How does security (the equity in another property or deposit) affect us?
It comes as no surprise that a lender would like adequate security to cover the loan in case you default on your mortgage and cause the lender to take possession and sell the property. If they do sell the property, they need to be able to realise sufficient money to pay out the remaining debt. So, what does this mean? Well, you need to have enough money or equity in your property to be able to contribute to the investment. A lot of investors choose not to borrow any more than 80% of the total value (LVR) of their property. One reason for this is to try and avoid having to pay for Lenders Mortgage Insurance (“LMI”). LMI is a one-off cost that a borrower must pay at the beginning of the loan which insurers the lender’s risk (not the borrower’s) if a shortfall arises between the sales proceeds and the loan amount (that is, if the lender ever has to take possession and sell your property). Lenders Mortgage Insurance companies are underwriters where the company is liable for insured losses in return for a fee (premium). Mortgage insurance can cost in the range of 1% to 3% or even more of the loan amount, which is substantial if you’re borrowing a large amount of money. One of the other advantages of avoiding LMI is that a mortgage insurer does not have to approve your application. Mortgage Insurers’ credit policies are often much tighter and stricter than a lenders’ because they are accepting a higher risk by lending at a higher loan-to-value ratio (LVR).
Investors must therefore weigh up the pros and cons of purchasing now and borrowing over 80% LVR compared with purchasing later and saving more deposit. The cost of mortgage insurance can easily be offset by capital appreciation in a fast-moving market… assuming the property delivers the capital gains you expect.
Most people think it’s their income that will limit them buying more property… the ‘serviceability barrier.’ But this is not usually correct because as we’ve learned, investors can increase, or at least maintain their borrowing capacity by purchasing high yielding properties. Therefore, generally it’s the security or deposit issue that poses the biggest hurdle to ongoing property purchases.
3.BORROWING HISTORY –
Having a good borrowing history is as simple as paying your bills and loan repayments on time and not having any defaults recorded on your credit file. Be careful… telecommunication and utility companies are sometimes very quick to record a “default” if you don’t pay your bill on time.
Also, every time you apply for credit (loan, credit card, etc.) the credit providers may undertake a credit check, or as it’s often referred to, a credit enquiry. Credit enquiries are recorded on your credit record. Some lenders may decline to lend to you if you have too many credit enquiries on your credit file. So, if you apply for a pre-approval for your next investment property, you might consider asking the lender not to do a credit check until you’re absolutely sure that you will go through with the finance. Good reason to use a Broker.
UNLIMITED FINANCE… FACT OR FICTION
We know that serviceability and security have the greatest impact on our borrowing capacity. We also know that at the moment it looks like we need to attain an average rental yield of at least 6% to ensure unlimited finance. We also need unlimited equity to be able to secure this debt. It’s very important for investors to be able to understand what impacts borrowing capacity. Investors may need to consider these factors when planning their property investment strategy, as their investment strategy will have an impact on their borrowing capacity.
You need to ask yourself how your strategy will affect your borrowing capacity. For example, most knowledgeable investors would like to be involved in commercial or industrial property investment knowing that they offer high yields. However, these also come at higher risks and most times a lender will require a lot larger deposit, usually in the range of 30% – 50%. This puts these types of properties out of the reach of most investors.
Also, if you plan to buy a number of low yielding residential properties (perhaps in the expectation of high capital gains down the track), then it’s very likely that you’ll quickly limit your borrowing capacity. Eventually you’ll reach the limits of your ability to service the debt.
It makes far more sense to buy positively geared residential properties that will put money in your pocket each week and not limit your purchasing ability than have to wait for the capital gain that may or may not come.
Mark M Bone.