At the moment, lenders are offering investment loans on a 5 year fixed rate for only 4% p.a. Perhaps this is a once in a lifetime opportunity. Maybe interest rates will never be this low ever again. Let me caution these comments with two contradictory arguments.
Two contradictory arguments that both have merit
You should not get seduced by the low interest rate environment. Interest rates are cyclical. They will rise again – it’s only a question of when. And as this chart demonstrates, the RBA tends to adjust interest rates relatively quickly (i.e. over a 3 to 9 month period). Therefore, when borrowing today, you must ensure that you can afford to service the debt at normalised interest rates (I suggest 7% p.a. is a good number to use).
A contradictory argument to this is that you would be silly not to recognise the current opportunity. You can borrow today at 4% p.a. and not have to worry about interest rate rises for 5 years. If you are borrowing to invest, your after-tax cost of debt will be close to 2.5% p.a. (because you get a tax deduction for the interest cost). If you can’t afford to invest today, you probably will never be able to do so (unless your financial situation changes of course). It’s a great opportunity.
I think both these arguments have merit because debt is a wonderful servant but a terrible master.
The solution that takes into account both viewpoints
The chart below estimates the after-tax cost of investing in a $600,000 investment property (see assumptions in the footnote[1] below).
The red (thick) line assumes an interest rate of 7% p.a. and as you can see the investment property costs $365 per week after tax in the first year.
The blue (thinner) line assumes the investor fixes the interest rate for 4% p.a. for the first 5 years (then rate reverts to 7% p.a. thereafter). In this scenario, the property only costs $135 per week after-tax in the first year.
The black horizontal dotted line is the average cost of holding the property over the first 15 years (i.e. fixed for the first 5 years and then variable thereafter) which is $195 per week after-tax.
I have been quite conservative with the property’s growth rate (assumed to be 6% p.a.) and as such, the property takes 20 years to become positive cash flow (i.e. pay for itself). Over the past 30 years an investment-grade property has typically appreciated in value at a rate of 7% to 11% p.a. This means that properties have become positive cash flow sooner (usually within 10 – 15 years). But I would rather be conservative with this analysis than too bullish.
Can you afford $195 per week?
If you buy a $600,000 investment property today, fix the interest rate for the next 5 years and contribute $195 per week towards this property you will accumulate a cash buffer (because the actual cost of the property initially is only $135 per week). You can then use this buffer to help fund the investment property in 5 years time when interest rates may be higher. Under this scenario, the property should never cost you more than $195 per week.
This approach takes into account that interest rates are low at the moment but still prepares you for a higher interest rate environment.
Don’t borrow to invest in ‘any’ property – it has to be investment-grade
It is only ever worth borrowing to invest in investment-grade property because it’s important that we are confident of enjoying strong capital growth over the long term (to compensate us for the cash flow cost of holding the property). Click here for a reminder of what makes a property investment-grade.
Is it appropriate for your circumstances?
You need to review your cash flow and consider the possibility of any changes to your financial position in the future. As noted above, you need at least $195 per week (or $10,000 p.a.) of surplus cash flow (i.e. money left over after paying for all expenses and commitments) to be able to afford to invest. It is prudent to include an additional buffer too.
If you feel that you have sufficient surplus cash flow to invest, speak to an independent advisor to get their opinion on whether it’s the best course of action for you – taking into account your current assets and goals. Make sure you speak to someone that doesn’t have an investment to sell you (be it shares, managed funds or property).
Of course, as independent advisors, we would welcome the opportunity to discuss this with you.
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[1] Financial projections assumptions include a 6% p.a. capital growth rate, 3% p.a. gross rental yield, property expenses equal to 20% of gross rental and an interest rate of 7% p.a. unless otherwise specified. I have assumed that the investor borrowed the total cost of the investment including stamp duty and property advice fees.
