I have had a number of people contact me recently about wanting to establish property investment portfolios.
One such person referenced Steve McKnight’s book “From 0 to 260+ properties in 7 years” (published in 2012) and asked me what’s necessary to embark on this kind of journey.
I’m the last person to get in the way of anyone’s ambition, however I think the two key points I made to this client are worth sharing to my broader audience…
You may be familiar with the National Consumer Credit Protection Act 2009, or “NCCP”.
NCCP is legislation designed to protect consumers in the finance industry.
All lenders and mortgage brokers are required to adhere to the rules, but they are relatively new rules – they never existed prior to the Global Financial Crisis in 2008.
The following example is a good illustration of how NCCP has changed the property investing landscape in Australia, with the banks now assessing borrowing capacities far more conservatively…
Example – the ‘cash flow neutral’ investment property
Take an investment property which generates $500/wk rent, and pretend there’s debt against this same property which costs the borrower $500/wk in (Interest Only) interest repayments.
In the good old days (pre NCCP), when assessing a clients’ borrowing capacity for a new loan, many banks would look at the above scenario and ultimately ignore it from their calculations.
The thinking was that the investment property was ‘cash flow neutral’, it was washing it’s own face so to speak, and therefore it wasn’t jeopardising the ability to take on a new commitment.
You can see how this thinking would enable borrowers to amass a large number of investment properties, as did Steve McKnight…
So long as each property was at least paying for itself, then the banks would happily keep on lending.
Nowadays, under NCCP, lenders look at the same scenario very differently.
On the income side:
- Most banks now shade rental income by 70-80% (accounting for the possibility that the property may not be rented out for the full 52 weeks of the year, amongst other things…)
- The $500/wk rental income may now only equate to $375/wk from the banks’ perspective (a reduction of 25%), when performing their borrowing capacity calculations
On the cost side:
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- Most banks add the costs associated with running investment properties into their calculations now (e.g. the costs of a property manager, repairs and maintenance, insurance, water/ sewer charges, council rates and land tax)
- Most banks also now ‘buffer up’ the interest rate used in their calculation (in the current market they tend to add 2.5% to the actual interest rate, or use a minimum interest rate of 5.4%, whichever is higher)
- Most banks also now work off notional ‘Principal & Interest’ repayments, even if the borrower only has an Interest Only commitment. Principal & Interest repayments are substantially higher than Interest Only, and they are even higher when assessed over the shorter/ remaining term of the loan, after the Interest Only period expires (the longer the Interest Only period, the shorter the remaining loan term, and hence the higher the assumed repayments for the borrowing capacity calculation)
- The $500/wk actual interest expense could easily now inflate to something like $1,200/wk in total assumed costs
So whereas the investment property under the old borrowing capacity calculations may have had no impact on new borrowing capacity, you can see how under the new rules it could deteriorate borrowing capacity substantially, by creating an $825/wk commitment in the above example (e.g. $375/wk sensitised income – $1,200/wk buffered up costs = $825/wk cash outflow)… even although in practical / real life terms the investment property may not actually be costing the borrower any money whatsoever.
It follows that the prospects of owning vast numbers of neutral or positively geared investment properties is more difficult now.
Don’t you wish you (or maybe your parents) started a bit earlier?!
Sure there are banks who will perform their borrowing calculations slightly differently, and this is where we can add a lot of value to clients as a mortgage broker... providing more options to clients (e.g. beyond just the big banks), helping them increase their borrowing capacities where that is their stated objective.
But the key point is that every borrower has a ‘debt ceiling’ now.
The second point I raised to this client was more of a question... “Do you own your own home yet, or is that something which might be on the radar soon?”
This is an important consideration in light of my above points on borrowing capacity.
If every borrower now has a debt ceiling, there is essentially an opportunity cost associated with taking on any new debt.
That is, taking on investment debt may prevent you from borrowing more money for another purpose, like a home to live in.
The risk is therefore with the person who starts buying investment properties at the outset of their property journey, only to then want to buy their home to live in soon afterwards (perhaps when they have children), and realising they have either run out of borrowing capacity or the investment properties they took on now prohibit them from being able to buy the Principal Place of Residence they really want to.
In this scenario the client could sell some or all of their investment properties to either unlock capital and/ or to get their borrowing capacity back up, however property tends to work better as a longer term investment… therefore selling prematurely may not be ideal from a financial perspective.
In conclusion, the way lending works now is very different to how it did pre-NCCP when the banks were more lenient in their assessment methods.
With borrowers reaching their lending limits much sooner now, the importance of mapping out a longer term property journey before simply diving in has never been greater.
Borrowers are encouraged to build relationships with strategic long term advisers as they can add a lot of value in this regard.
Any bankers or brokers or property experts who are just transaction focussed are unlikely to help clients plan ahead, and this can prove to be very costly.