Property Investment Planning - New Risks on the Horizon

Financial planning Written by John Bolton, Mar 18 2019

For a while now we’ve grappled with investors coming off interest-only mortgages and for the most part we’ve managed to extend them, with the odd argument here and there. But these arguments and the reticence of banks to extend interest-only terms is increasing no matter how sound the logic. As it stands, investors can get up to five years of interest-only but more than that is getting harder.

It’s banking by numbers and often shows scant regard for the investor’s circumstances and their plan on what debt to repay and when. It feels similar to 2009-2010 when the credit rope was last tightened.

The most glaring observation is that for many banks, servicing is not only tested at a high rate of around 8.00%, and on principal and interest repayments. But the repayments are based on the remaining term of the loan. In the past we could assume a 25 or 30 year term on everything. Not anymore. For example, an investor with an interest-only mortgage on a remaining term of ten years will be assessed on their ability to repay that mortgage in ten years.

The difference is stark:

A $1,000,000 property borrowed at 50% LVR with rent of $700 per week.

  1. Typically the bank will allow 75% of rental income to allow for costs, so $2,275 per month.
  2. On interest-only actual repayments would be $1,708 per month so the property would be cashflow positive up to a rate of around 5.50%.
  3. A mortgage of $500,000 at 8% assuming 25 term = $3,860 per month so negative servicing of $1,585 per month.
  4. $500,000 at 8% with 10 year remaining term interest-only = $6,066 per month and negative servicing of $3,791 per month.

For investors who have been on interest-only for a long time, this can destroy how the banks view their servicing, and consequently limit their ability to borrow. Or even extract cash when selling a property, as banks also look at your servicing when you sell.

As a result, investors may need to consider refinancing simply to reset their interest-only clock and push out their mortgage terms to improve servicing calculations.

Pricing

The next issue that investors are having to come to grips with is pricing. In the past, investors were priced the same as owner-occupied borrowers. That was as long as you managed to stay in the retail bank.

Increasingly, larger investors are finding themselves in Commercial with more business-like pricing and terms. It’s not uncommon to see more expensive pricing, no cash contributions, lender fees, and bankers trying to put GSA’s (general security agreements) over entities. If you’ve borrowed for commercial property this is all fairly normal, but it’s now slowly drifting over to property investors.

The driver for this has been the Reserve Bank’s requirement for banks to hold more capital against investment property. That is about to get worse if the banks are required to increase their tier-1 capital from around 10% to 16%.

With banks required to hold more capital, it’s almost certain that investment property will formally move into its own lending class with differentiated policy and pricing, and I’d expect to see the pricing difference increase.

So, what does this all mean?

Firstly, if you rely on interest-only for cash flow then make sure you keep track of your interest-only terms and make sure you have a plan well in advance of them expiring.

Secondly, it is important to not have all of your eggs in one basket. Split your portfolio across multiple lenders to make sure no one lender has too much control over your portfolio. Banks will have typically cross-collateralised your properties so when you sell one they will reassess your servicing and can take all of the proceeds. Splitting your portfolio won’t be as good for getting low rates, but it’s good for risk management.

I was dealing with an investor the other day who has $4m of lending on $7m of property.  They want to sell two properties to extract some cash as well as pay down debt. The challenge they have is they simply don’t pass servicing calculations by a country mile. The high risk for them is that the bank is going to take all proceeds from both sales and cancel their revolving credit.

Thirdly, accept that to have your portfolio properly structured it’s no longer about simply the rate or cash backs. That can be short sighted and potentially risky. You need to make sure you have options when you need them. Nowadays you may even end up paying fees to get your portfolio into the right place. It’s taken me a bit to get my head around this. For commercial sized clients the hot rates aren’t there anymore and it’s harder to even get these portfolios servicing due to how they are tested.

Be careful who you go with and make sure you properly disclose everything. This should be obvious, but banks will rightly have no tolerance for being misled. The investor I referred to above, moved all of their lending to one bank via a mobile mortgage manager. They got an approval we could not have gotten, but that Mobile Manager has since left the bank and they are now stuck.

Lastly, if you are a business owner be doubly careful. It’s very easy with businesses to assume nothing changes but it does. You’re only one bad year away from not being able to borrow, or even extract equity from your home.

If you want to make a plan or bounce around some ideas, contact Squirrel today.

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