Expert Advice with Michael Yardney. 28/11/2016Unless you’ve come into a financial windfall of some kind, building an investment property portfolio capable of one day funding your retirement will require borrowed funds.
The question is rarely (if ever), ‘Will I need finance to purchase investment grade residential real estate?’ But more like, ‘How much should I borrow at this particular stage of my investment journey?’ As well as, ‘How much do I feel comfortable borrowing and what loan can I realistically afford?’
And this is particularly true in today’s changing lending landscape, where industry regulators have influenced banks to rethink the amount of investment related capital they’ve been throwing around. Their serviceability requirements have become a lot tougher of late and property investors are being asked to provide written evidence when trying to redraw existing equity, even below an 80% loan to value ratio.
Gearing your way up the property ladder
There are two major strategic approaches to property investment:
Those who invest for Cash Flow hope that after paying their mortgage and all property expenses there will be some money left over as profit. This can sometimes be achieved by buying properties in the lower price brackets often in regional Australia which tend to achieve poorer capital growth.
Of course you can achieve positive cash flow from a high growth property by borrowing less – lowering your Loan to Value Ratio (LVR) – but this requires more of your equity.
Then there are those investors who invest for Capital Growth (my preferred strategy) but their properties are generally negatively geared as the outgoings exceed the rent received.
Just to make things clear…negative or positive gearing are not property investment strategies - though many think they are! They are the result of the amount finance you borrow and your gearing levels.
Which leads to the question: ‘What's the right loan to value ratio?’ The simple answer is – it depends.
The first few steps
When investors begin their ascent up the property ladder they usually require a very high loan to value ratio, as many start with as little as 10% deposit, because the property markets are generally moving faster than they can save for a larger deposit.
While these higher LVRs attract the extra expense of Lender’s Mortgage Insurance, it usually makes sense to take this on in order to get a foothold on that important first rung of the property ladder.
Often when staring out you’ll be earning a good wage and have the capacity to be more highly geared. Of course with such high leverage correct asset selection is critical, as you’ll need strong capital growth to make up for the negative cash flow shortfall.
More established property investors who are still actively growing their asset base should probably aim for a loan to value ratio of around 80%. This level of gearing provides a comfortable equity buffer for when the market eventually slows, but still offers the benefit of leveraging.
The view from the top
As you approach the lofty heights of top of the property ladder and consider transitioning into retirement, the question becomes more about deriving an income from your property assets than continuing to grow your asset base.
At this stage of your life you obviously don’t want to be negatively geared. Instead, it’s about funding your lifestyle with sufficient cash flow.
While you’ll still have loans against your property portfolio, the position you want to get to is that all holding costs related to your investments should easily be sustained purely on the net returns your properties generate. At this stage it’s likely that you’ll be geared at an LVR of 50% or less.
The importance of gearing into appropriate assets
To develop financial freedom through property you need a substantial asset base. While cash flow keeps you in the property game, it’s the size of your asset base (achieved through capital growth) that gets you out of the rat race.
Successful investors first go through the asset growth stage of their property journey and then lower their LVR’s as they transition to the cash flow stage using their asset base (property portfolio) as a cash machine,
In contrast, most investors don’t achieve the financial freedom they deserve because they don’t build a big enough asset base. Sometimes this is because they don’t give their portfolio enough time to grow (starting their investment journey to late in life), but often it’s because they own the wrong assets. They don’t own “invest grade” properties that exhibit strong capital growth.
Regardless of your gearing ratios, in order to grow your asset base, it’s important to steer clear of speculative investments and stick with what’s been tried and tested…established properties situated in good locations where:
• Capital values are stable.
• The location is underpinned by multiple growth drivers including a diverse economic base,
• The local demographic has strong employment prospects, sufficient disposable income and is keen to keep upgrading their homes supporting local property values. These are often areas of gentrification.
• Good infrastructure and amenity meaning demand for accommodation is likely to outstrip supply.
Of course maintaining a financial buffer also helps to protect highly geared investors, buying them time to ride out any market fluctuations or cover unforeseen expenses that might crop up.
Then, like driving a car, finding the right gear to suit your property circumstances will make for a smoother journey.
Michael Yardney is a director of Metropole Property Strategists, which creates wealth for its clients through independent, unbiased property advice and advocacy. He is a best-selling author, one of Australia’s leading experts in wealth creation through property and writes the Property Update blog.
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Disclaimer: while due care is taken, the viewpoints expressed by contributors do not necessarily reflect the opinions of Your Investment Property.