The very first article that I wrote for a magazine was published 19 years ago! No wonder I feel old. The article was called ‘Unlimited finance…’. My thesis was that investing in high yield properties, doesn’t magically extend ones borrowing capacity allowing them to invest a lot more.
Some investors believe targeting high rental yielding investment properties will allow them to borrow a lot more and therefore buy more properties. And the more property they hold, the more wealth they accumulate, or so their theory goes. However, the truth is that borrowing capacity isn’t that sensitive to rental yields.
How much does rental yield affect borrowing capacity
I wrote a blog last week highlighting that borrowing capacity is probably the tightest that it’s been in 20 years. The reason is that lenders must add a benchmark interest rate of 3% on top of the actual rate you will pay to ensure you can afford a loan, should interest rates rise further.
Banks will also base their affordability on principal and interest repayments over a 25-year loan term. As such, the benchmark repayments for a $1 million investment loan will be $93,000. Consequently, for an investment property to be borrowing capacity neutral, it must generate a gross rental yield of over 13%, as most lenders shave off 20-30% of rental income to allow for expenses.
Obviously, there aren’t a lot of residential properties yielding more than 13%. As such, even higher yielding investments (e.g., 4-6% p.a.) eat into an investors borrowing capacity.
Lower yielding properties reduce your borrowing capacity by 25%
I spoke to an investor recently that had invested in 3 properties. The aggregate value of these properties was $1.2 million, and the portfolio had $1 million of debt. The gross rental yield across the portfolio was around 5.2% p.a. This investor thought targeting high yielding properties would allow him to borrow more and buy more properties.
It is true that higher yielding properties do increase your borrowing capacity. Let’s look at an example. I assumed each spouse earns $100k p.a. gross, an outstanding home loan of $350k, spend $5,500 per month on living expenses and have a credit card with a $5k limit. Based on these assumptions, I calculated their borrowing capacity as follows:
- If they achieve a gross rental yield of 5.5%, they can invest $1 million in property.
- If they achieve a gross rental yield of 3%, they can invest $815k, a reduction of 18.5%.
- If they achieve a gross rental yield of 2%, they can invest $750, a reduction of 25%.
It’s all about the amount and quality of land
Generally, a property’s accommodation size and quality will determine how much rental income it will attract. Therefore, to achieve a higher rental yield, you must spend proportionally more on building value, and less on land value. But doing so will mean that you will probably accumulate less wealth, as discussed here.
Using the same assumptions that I used in this blog, I have calculated the amount of wealth an investor would accumulate if they invested in a property and sold it after 30 years, repaid the loan and paid any tax liability (CGT). The cash flow holding costs were also included in this calculation.
As the chart below demonstrates, even though the investor that targeted a 2% rental yield and invested 25% less (i.e., $750k versus $1m), they accumulated almost twice as much wealth after 30 years in today’s dollars (compared to the investor that targeted 5.5% yield and invested $1m).
Why is there such a big difference
The main reason for the difference is that I have assumed that over a 30-year period, both investors generated a total return of 10% p.a. This means the high-yield investor attracted a much lower capital growth rate of 4.5% (being 10% less rental yield of 5.5%) versus 8% for the low-yield investor.
It is also worth noting that the low yield investor, invested in slightly more land. I assumed that a high yield investor would have to spend 55% of his $1m budget on building value to achieve a 5.5% rental yield – so $450,000 of land value. Whereas the low yield investor only spent one-third of this budget on building value – so $500,000 of land.
The higher growth rate more than makes up for the lower borrowing capacity
This analysis demonstrates that more is not better. Making investment decisions based on borrowing capacity outcomes will invite you to make mistakes by investing in the wrong type of property. Instead, you should invest in the highest quality assets that your borrowing capacity will allow.
Of course, actual cash flow must be considered
The problem with lower yielding investment properties is that they cost more to hold from a cash flow perspective. Therefore, if you are going to invest in a low-yielding property, you must consider whether you can afford to fund the monthly shortfall i.e., difference between the net rent received and loan repayments.
Alternatively, consider a structure such as the one discussed here.
The only way high-yielding properties are better investments…
This analysis assumes that the total return of any investment property will not exceed 10% p.a. over the long run i.e., over a 30-year period. Of course, it is possible that returns could exceed 10% but I don’t think it’s wise to assume this. Therefore, the only way a high-yielding property can generate more wealth is if its total return exceeds 10%. Whilst its possible some properties might do that for short periods, such out-performance is unlikely to persist over the long-term.
Use this theory to allocate your investment budget
When determining your investment strategy, this analysis highlights 3 actionable considerations:
- The number of properties you own doesn’t matter. Some people think buying several properties is better. But I’d rather own one investment grade property than 3 average ones. Quality is the most important factor.
- Don’t manipulate your investment strategy to suit your borrowing capacity. Instead, determine your borrowing capacity to ascertain your investment budget and then allocate that budget accordingly. If it means you can only afford to buy one great asset, so be it.
- Target a property as close to investment grade as your budget and cash flow position will allow. A $1.5 million budget will allow you to purchase an investment-grade house with a high land value component in an established capital city. However, not everyone can afford to invest this much. If that’s the case, target the highest quality asset your budget will allow i.e., an asset with a strong land value component in the best quality location.
