How to increase borrowing capacity [even if you don't have enough equity]

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As an investor, you'd want to be able to expand your portfolio take advantage of the current opportunities. But how will you obtain finance if you don't have enough equity? Bill Zheng, CEO of Investors Direct looks at the options and strategies to go about it safely.

Wouldn't it be nice if you can keep on purchasing more and more properties without being told by lenders that you can't get more finance?

The reality is that the most common problem property investors' face is that one day they will be told by lenders that they can't have more finance, usually due to insufficient income, lack of equity, or both. 

Being stopped from continuing to invest because of problems with finance is even more frustrating if you are an investor who has already mastered the skill of selecting high performing properties, or can create instant equity or income by adding value to your properties. All you have to do is to be given enough finance to acquire it.  Your profits are so near and within reach, but yet so far away at the same time! If only you could access the finance to make it a reality...

So how do you gain access to 'unlimited' finance? 
You may be in one of the following 3 scenarios when you are stopped by lenders:

1. You don't have enough equity despite the fact you have good enough income;
2. You don't have enough income despite the fact you have enough equity;
3. You have neither equity nor income.

In this article we will focus on solving your problems if you are the type of investor that falls into scenario 1: you can't get finance because you don't have enough equity, despite the fact you have a good enough income.

Equity
Equity is the difference between the market value of a property and the claims held against it.  Such claims can be your mortgage.  Most of the time, this equity value should be positive if your property value is greater than the claims held against it. Occasionally this may not be true if you experience a sharp drop in the property value.

In general, most lenders would like to see you having some positive equity in the property before they lend you any money, and the equity percentage is usually 5-20% of the property value if you have good income.

If you are thinking about buying your first property, you may see your equity in the form of cash, shares you can sell, cash gifted by parents or even the First Home Owners Grant.

If you are thinking about buying more investment properties, you may be able to use the equity from the increased value of your existing properties, and this can be achieved by releasing equity by refinancing or topping up your current loan.  More recently a number of products have emerged that allow you to even use cash in your own Self Managed Super Fund as deposit for an investment property.

It is not difficult to see that even if you have 'unlimited' income, by setting aside 5-20% equity (plus costs) in each purchase, you will eventually run out of equity to obtain more finance from any lenders. 

We call this the 'finance death sentence' due to lack of equity.

So how do we postpone this 'death sentence', hopefully forever?
 
The strategies you can use are:

• Use as little equity as possible on each purchase;
• Create more equity fast with each purchase;
• Use other people's equity;

Let's look at them one at a time.

1.  Use as little equity as possible on each purchase

Using less of your money usually means using more of other people's money and reducing your cash outlay on purchase.

Here are some of the ways you can put in less deposit for your property purchase:
• Borrow as much as you can so that you can put in less of your money.  This means that you may choose to borrow more than 80%, quite often investors would go to 90-95% gearing.  Higher gearing usually comes with a cost, either by paying mortgage insurance costs or higher interest rates.  If your income is good, you can get tax benefit from both financing cost and interest repayment on your investment properties;  
• Borrow the cost of finance instead of paying them with your own cash.  Most lenders would charge Lenders Mortgage Insurance (LMI) or a risk fee if you borrow more than 80%. Some lenders actually  allow you to add these additional cost on top of the loan, so that it can reduce your cash outlay initially;
• There are some lenders that would offer 100-105% borrowing, that means you can put in very little of your own money.  They do however charge more to lend you more money, so you need to weigh up the cost and benefit before you make a decision;
• You may want to pay less on stamp duty.  This can be achieved by purchasing off-the-plan properties, vacant land to construct a property on, or low value properties which incur very little stamp duty.

2.  Create more equity fast with each purchase

The most common approach to create equity is to wait for your surplus income to accumulate or your property value to go up over time.  To make the 'waiting' approach work, you need to select good growth properties, or high yield properties to pay down debt, meanwhile maximizing your tax benefit along the way.

If you don't want to or can't wait, here are some of the activities you can do to create instant equity:
• Improve the value to your property.  This can be done through renovation or redevelopment; It is not uncommon to increase your property value by 10-20% after all costs. This could mean most or all the equity you put in to the purchase can be released back to you through refinance;
• Create a subdivision of larger blocks.  It is very common to see investors subdivide larger blocks in established suburbs into multiple town houses. The demand for these type of properties can see investors gaining instant equity on completion.
• Create strata titles from a single title building.  There are many single titled buildings that may have 4-16 units, some of these buildings can be turned into strata titles which can then be potentially sold individually. The increase in liquidity usually leads to increase of equity in each of the units in the building.
• Negotiate longer settlement to buy growth.  On a rising market, a long settlement (6 to 12 months) could mean instant equity when you settle the property.
• Purchase properties with an option.  It is possible to purchase a property with an option. An option is the right to pay a certain price in a future day.   This can either allow you to add some value to the property before you have to settle on it, or give you time to find another purchaser to pay a higher price.
• Combine property improvement with purchasing techniques.  For example, you may choose to do a renovation before you have to settle the property, or apply for a town planning permit before you have to exercise your option;
• Change zoning or usage of the property.  This is not for everyone as it is not easy and can be risky.   Some properties can be rezoned or reshaped for different use.  A typical example can be a large rural block being divided into smaller residential blocks. This can greatly increase the value of the property.

3.  Use other people's equity

You probably all heard of the expression 'you need money to make money', but it doesn't say it has to be your money. 

Here are a few ways you can use other people's equity in purchasing properties:
• You may get the first home owner grant if this is your first home;
• You may use your parents' equity.  This can be done by way of a gift from your parents, or some lenders would allow your parents to use the equity in their property to provide a limited guarantee for your purchase, so that you can borrow the lot with your purchase including fees;
• You may use the vendor's equity.  This is commonly referred to as 'vendor finance'.  Instead of putting in the deposit, you pay the vendor only a percentage of the property value now (usually 70%-80%), and pay the remaining over a period of time.  You can then refinance your property to release the cash to pay the vendor back once your property has gone up in value.
• You may use the rent-to-buy method.  You set up a contract with the landlord, pay them a higher than market rent in exchange of a substantial discount of the purchase price in the future.  This way, you don't need any of your equity to acquire the property. If income is not your problem; this is a good way to get into property sooner.
• You may use investor's money as your equity.  There are investors who are not interested in taking on debt, but mainly interested in a fixed income or future profit share.  You can use their money to put in as deposit, in return you offer them a fixed return on their money, or future profit share, or the mix of both.
• Finally, do not forget the equity in your own properties.  This equity has been given to you by the market, that's why we have included it here as "other people's equity".  It is quite common that equity can be accumulated through the increase of your property value, or reduction of your existing mortgages.  You may choose to release the "trapped" equity through refinancing your existing properties into a higher gearing ratio. The equity you can release from refinancing is usually more cost effective than selling because you don't need to pay capital gains tax, real estate agent fees or most importantly forgo on the future capital growth your property will receive!

Risk Management

Let's say you have managed to come up with equity required to put into your next purchase using one or a few of the strategies we have described above. What do you need to be careful of?

First of all, you will soon run into the situation where your income won't be high enough to service your debt if the investment properties are not producing positive cash flow.  This is quite common with investors who are focusing on mainly high growth properties.

There are only two ways to service debt:
1. Income servicing debt.  This is to use money from ongoing income such as rent, personal and business income;
2. Cash servicing debt.  This is to use a lump sum of money large enough to cover the repayment for a period of time, this lump sum of money can be cash, stocks you can liquidate, or credit available in a debt facility such as a Line of Credit.  When you draw money from a debt facility to service other debt, we call this 'debt servicing debt'; you are paying interest on both debt accounts.

The risk management of these two methods is quite different.  So how do you manage you risk here?

Income Servicing Debt
If the income you have available to service debt is large enough to cover your debt repayment, then the only risk you need to worry about is how quickly you can find that income again if you have lost it? 

For example, it may take you no more than 3 months to find a job with a similar income. So it is prudent then to put aside enough money to cover at least 3 months of not having that income.  While rental income for residential properties is relatively stable and vacancy rates are quite low across the country, it is usually sufficient if you have up to 3 months of vacancy covered.

As an investor you should also seriously consider income protection insurance and landlord insurance can also be considered to reduce your risk.

Cash Servicing Debt
If you are an investor who has mastered the art of creating equity, you may soon run out of income and have to rely on the second method of servicing debt.

In the residential property market, it is a lot easier to control income than capital growth.  In other words, there is no guarantee that capital growth will happen all the time to provide you more equity to service debt. Hence this method of servicing debt is considered a higher risk approach; however some sophisticated investors do this as it can also lead to higher return.

If the income you have available to service debt is not large enough to cover debt repayment, most conventional lenders won't lend you the money.  But if you have a reasonable property portfolio and treat your property activities as a business instead of a passive investment, there are lenders that would lend you money purely based on your equity position or the money you make from your property business, even when you might still have a PAYG job or run other kinds of businesses.

Before you consider using 'debt servicing debt' instead of the traditional 'income servicing debt', you need to know that you have chosen to become an active property business owner instead of being a passive property investor.  Business owners take business risk, you now assume not only investment risk but business risk as well Business risk is more aggressive than investment risk as it is beyond any investment advisor's advisory mandate. You need to be extra careful in making this decision.

When you use the 'debt servicing debt' strategy, you must have a clear exit strategy. It is usually a sale or refinance in the future, say 3-5 years from now.  This type of exit strategy is usually not available for home owner, as selling their home is not a viable option for most home owners, but selling an investment property can be for an investor.

The main risk of using 'debt servicing debt' even with a clear exit strategy is that interest rates may go up faster than you have anticipated, and the property value may not go up  enough to give you the future equity you require to continue servicing debt.

The main risk management measures you need to put in place are:
• You need to put aside enough credit buffer in your current facility to cover a period of time long enough to allow equity increase before a sale or a refinance;
• You need to make sure that your properties can have sustainable growth during good times, and have limited drop in values during bad times;
• You need to make sure that you do not put all the loans with lenders who might recall your loans during bad times;
• You need to properly manage your other money activities (such as personal expenses and other business expenditure) so that it won't affect the debt servicing strategy you have put in place.


Food for thought
Most small businesses in Australia can be purchased within a few hundred thousand dollars if you want to get into a business yourself.  The issues just about every business faces are always how to raise capital and debt, mange debt repayment and share holder interest, control cash flow, increase revenue and reduce expenses, find the right people for the work, etc.

We see a lot of similarity in having investment properties to having a business.  In other words, it may be a good idea to treat your property investment as a business, so that you can reap the greatest financial rewards of having them.  

Leaving your business to chances or others can be the biggest risk of all, maybe that is why the business world seem to believe that 'the more you appreciate your business, the more your business appreciates'.


This article was written by Bill Zheng (founder and CEO) and Tim Riley of Investors Direct™ (with contributions from Vincent Power (VIC), Doug Bannister (QLD), Regina Looi (VIC), Rhoda Downie (WA), Lynda Heise (NSW) and Michelle Coleman (VIC)). Investors Direct is a property finance company that provides financial solutions exclusively for property investors and understands that your mortgage is an asset, not a liability. Like this article? For more finance insights subscribe to our FREE monthly e-newsletter on investment property finance visit www.investorsdirect.com.au

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