Knowing the implications of cross-collateralisation is crucial to developing a long-term property investment portfolio.
So what is cross-collateralisation?
Cross-collateralisation occurs when more than one property is used to secure a loan or multiple loans.
For example, a person owns Property A and wants to purchase Property B without using any of their own funds.
The bank can use both properties as collateral for the new loan.
Many investors have cross-collateralised loans without knowing it.
One way to determine if loans are cross-collateralised or not (stand-alone) is by checking the detail in the loan contract.
There will be a section in the body of the contract which will note the addresses of the properties over which the lender holds or will register its mortgage.
Cross-collateralisation may often seem to be an appealing option to an investor, but it puts banks in a stronger position as it provides them with greater control over the properties.
There may be benefit initially to the investor in that he or she has not had to use their own cash to acquire the second property; however this strategy does have the potential to negatively impact future investment opportunities.
There are several important issues to consider:
1. Loss of Flexibility
If a property portfolio is cross-collateralised it can limit severely the way in which sale proceeds may be used.
For example, if a property is sold, the bank might require that the sale proceeds are used to reduce other loans in that portfolio, to keep the Loan to Valuation Ratio (LVR) within a certain level.
In that case, the loan proceeds would not be able to be used at the investor’s discretion.
2. Increased Complexity
It is often the case that every property in a cross-collateralised portfolio needs to be re-valued whenever one property is released.
There may be significant costs associated with valuing each property, especially if the portfolio is not within a loan package product.
The valuations are undertaken in order for the bank to determine its exposure with the remaining properties.
In addition, there is documentation to be executed every time a portfolio is changed.
This paperwork is known as a Variation of Security.
3. Limited Product Choice
In general, most property investors favour Interest Only loans.
As an investor’s exposure increases with any one lender, that lender can restrict future loans to only Principal and Interest.
Regardless of one’s asset position, many banks will want to control the type of loan that they will make available to an investor when his or her aggregate debt with them is high.
It can often be a better strategy for a smart investor to use multiple lenders and therefore gain access to the most suitable loan products.
4. Changing Lenders can be Difficult and Costly
When a loan(s) is secured by multiple properties, the establishment fees are usually higher as they include charges for ‘additional’ security.
This cost can be compounded when an investor wishes to move those cross-collateralised properties from one lender to another.
Exit fees can be significant, especially if any of the loans are fixed.
In addition, new valuations may be required (as explained above) where the investor wishes to release property.
5. Equity Access
If one property in the portfolio has enjoyed a capital gain and the others have dropped in value, the net effect on the total value may be zero.
The equity in the property that increased in value is inaccessible to the investor because overall the equity in the portfolio didn’t increase.
This can have serious consequences. For example, it could mean that an investor does not have ready access to cash and may miss valuable investment opportunities.
If the loans were not cross-collateralised, an application to increase the loan or credit limit against the property that increased in value would be a relatively simple process.
How can cross-collateralisation be avoided?
Whenever possible, insist on stand-alone loans and securities.
Take out separate loans for each new property with the deposit and costs coming from an established line of credit or offset account.
Cross-collateralisation can be removed by the current lender, subject to LVR and product guidelines.
While I know a bit about finance and how it relates to property, you should always seek the opinion of a proficient finance broker who can provide assistance with refinancing or restructuring loans to avoid the potential shortcomings of cross-collateralisation.