Property Investor | The downside of leverage

Hammer, nail, spanner

A few clients have rediscovered recently that it isn’t always easy to release equity when selling property. I had a client sell an investment property just before Christmas. He intended to repay the existing mortgage on it and retain the equity. The "cash out" was needed to cover the cost of a resource consent for another property he wanted to develop into town houses. Needless to say the bank was uncomfortable with his overall level of borrowing and took all of the sale proceeds. My client wasn’t in a position to talk about his development. Even if he was ready, banks are conservative on development, so regardless it would have been a hard conservation. I’ve written about this a number of times, but it really needs to be emphasised again and again. Leverage, combined with lack of cash flow, are the biggest risk for investors and it materialises quickly.

When an owner sells a property the bank can review your overall financial situation and can unilaterally decide to take the full sales proceeds.

You can have $millions tied up in property that can easily disappear if you are forced to sell down in a soft market. The trigger for the bank to take total control is when you run out of cash. I saw that firsthand in 2009 when investors heavily exposed to provincial cities like Rotorua started to suffer cash flow issues from tenants missing rent payments (due to high unemployment.)

There are Spruikers out there who suggest that property has at least two or three years of growth ahead. Most of them have something to gain and will highlight facts that suit their argument – shortage of housing, unitary plan, immigration, and cash out of China. Its an easy story to sell. Maybe it has a few years to run, but I’d suggest that is an increasingly speculative assertion and reliant on what happens in China. Most of us only have a superficial view of China. It goes something like this - China has one billion people who need food which we have plenty of. To add some balance to this perspective lets look at the Chinese property market which is in a massive bubble. Property prices are 30 times income compared to about 9 times here. And everyone says we are overvalued! When (not if) the Chinese property market bursts we will feel the impact here.

Iron ore prices have already fallen from USD$130 per ton to USD$66 per ton in the past 18 months. Iron ore makes up roughly 25% of all Australian exports and that has wiped $16 billion of income out of the Australian economy. The party has to end at some point and when it does you need to make sure you are on the right side of it. As an Investor now is not the time to get drunk on highly leveraged purchases. You should hopefully have your overall loan-to-value ratio below 70% at this point in the cycle. I'd focus on improving cash flow rather than be preoccupied with buying. Increase your rents. Review your portfolio and consider selling your worst performing properties. That might also free you up to buy a better property without taking unnecessary risk.

I’m surprised the number of people who don’t sell under-performing properties and still want to leverage up in this market. Cash is critical; so make sure you have access to a decent cash reserve. Also try and keep your revolving credit away from the bank you have most of your rentals with. It is a 1-year renewing facility that can trigger a review at any time. Be particularly careful if you are Business managed, as your Manager has to conduct an annual review regardless. Have at least two banks in the mix and possibly a third for your home. If you can’t get your home debt-free consider having one property at a minnow lender (SBS, TSB, Cooperative, Sovereign) so you are guaranteed access to the equity should you sell it. 2015 is the right time to spring clean your portfolio and get everything in order. You can continue to look at opportunities, but assess them carefully and make sure you have your downside risks properly covered just in case.