You would be excused for thinking that developed economies all over the world are gradually making their way to a zero interest rate environment.
Long term fixed mortgage rates in the United States are less than 3% p.a. In the UK, rates are under 2% and even lower in Europe (circa 0.50% p.a. in France for example). In Australian this week, 5-year fixed home loan rate fell below 3% p.a. And in Demark the other week, Jyske Bank announced it would pay borrowers 0.50% p.a. to take out a mortgage! Anyone that had a mortgage in the early 1990’s would regard today’s interest rates as almost unfathomable.
What does this mean for investor, especially those that borrow to invest in property?
Interest rates lower for longer?
The market is predicting that the RBA will cut rates by 0.50% by mid-2020. If this turns out to be correct, Australian mortgage rates could fall even further.
In July, RBA Governor, Phillip Lowe said “Whether or not further monetary easing is needed, it is reasonable to expect an extended period of low interest rates.” Many commentators have suggested that interest rates may not increase materially for a decade or longer. Japan, for instance, has been stuck on zero interest rates for 20 years.
But the banks need to charge at least 2%
A measure called the ‘net interest margin’ is the gross profit a bank makes from lending money to its customers. The net interest margin must cover all the banks costs and still deliver a healthy net profit. In Australia, the major banks net interest margin is approximately 2%.
Therefore, even if Australia’s cash rate fell to zero, it is unlikely that variable mortgage rates would fall below 2%, as the banks would seek to maintain their profit margins. Of course, a negative RBA cash rate, which exists in some countries in Europe, could push variable mortgage rates below 2%.
Bye, bye negative gearing tax benefits for property investors
The most obvious consequence of low interest rates for property investors is that it significantly reduces negative gearing tax benefits. When interest rates were 7% p.a., property investors where crystallising large income losses. That is because the interest costs and property expenses were a lot more than the property’s rental income. The investor could offset this loss against employment income and enjoy a sizable tax refund (which is referred to as negative gearing).
According to CoreLogic, Australia’s gross rental yield is 4.1% p.a. Compare that to the current interest only investment mortgage rate of circa 4.5% p.a. and you will see why an investment property’s income loss today is only 40% what it was when interest rates were much higher. As a result, taxation benefits derived from borrowing to invest in property are consequently 60% lower.
In a low interest rate environment, saving tax is no longer a big draw card for prospective property investors. This is a good thing as you should never invest predominantly to generate tax benefits. However, if you were banking on your property investments helping you reduce your tax liabilities, think again.
Don’t use your own money
In a low interest rate environment, using your own cash carries with it a higher opportunity cost. That is, you must consider what investment returns you can generate by investing your cash elsewhere (and using borrowed funds instead). If you believe you can achieve an investment return greater than the mortgage rate, then you are better off to use borrowings to invest in property or shares, not your own cash.
With such low interest rates, why would you use your own money (assuming its safe and prudent for you to borrow)? Of course, if you are already leveraged to a sensible limit, then this comment doesn’t apply.
The cash flow ‘cost’ to invest in property is very low
Historically, one of the downsides to investing in property is the cash flow cost of doing so. That is, borrowing to invest in property would usually eat into your personal cash flow, as the property’s rental income typically would not be enough to pay for all expenses and costs. Whilst this cost is not eliminated in a low interest rate environment, it is greatly reduced.
For example, I estimate a $750,000 investment property would cost you a total of $60,000 in today’s dollars to hold for 15-year period compared to $220,000 at an interest rate of 7% p.a. A property investor is in a much better position today, assuming the property produces the same capital growth returns, which it should do, if well selected.
According to Real Estate Institute of Australia data, the housing growth rate in Australia’s five largest capital cities ranged from 6.44% and 7.96% p.a. since 1980. Remember, that is the median house price. That doesn’t even account for the impact ‘asset selection’ has on returns (i.e. selecting an investment-grade asset). Therefore, if you can invest in an asset that produces similar capital growth rates in the future, and it costs you one third of cash flow to hold said asset, your net investment returns are greatly improved.
Investing in shares can be positive cash flow
Investment mortgage fixed and variable interest rates currently range between say 3.60% and 4.50% p.a. A broad-based Australian share index such as the ASX200 or ASX300 has generated a grossed-up dividend yield of over 5% over the past year. Compared to property, there are fewer direct expenses with investing in shares. Therefore, in a low interest rate environment, and assuming dividend yields don’t change, you can borrow to invest in the share market and the investment income should cover the interest expense. Of course, if you invest in international markets, which you probably should, this will drag on the portfolios income as yields tend to be closer to 2% p.a.
Property rents could stagnate or even fall
Low interest rates may also create downward pressure on property rents. If interest rates are very low, particularly for owner-occupiers, at some point it will become cheaper to own your home compared to renting. In this case, there will be less demand for rental properties and that may result in the depreciation of rental income for investors. Of course, not every renter will qualify for a mortgage, particularly in this tight credit market.
Asset bubbles and mispricing
When capital (money) is priced so cheaply, investors tend to think less about potential investment returns and risk. This can result in money flowing into inferior investments and this can cause asset price bubbles – in many markets including both shares and property.
The best way to mitigate this risk is to level up on quality.
Property prices, in the long run, are driven by the laws of supply and demand. A location that is in high demand, but short supply, will usually benefit from price appreciation.
Long term returns in the stock market are heavily impacted by your portfolio’s starting valuation. That is, if you invest in share markets/indexes when they are ‘cheap’, your returns in the long run are inevitably good. But the reverse is true too. Therefore, you must skew your asset allocation to markets that are more attractively priced and adopt value-based methodologies for markets that are fairly valued or appear over-valued. In short, get independent financial advice, don’t try and do this yourself, as the way you construct a portfolio will have a big impact on returns.
In essence, you must invest in an asset that will perform well in both a low and normalised interest rate environment.
Zero interest rates is a new world so be careful
In some ways, we are entering unchartered waters. Quality is the best refuge for long term investors. A quality investment will produce quality returns in the long run. Feel free to reach out to us if you want to chat about how low interest rates will impact your financial plans.