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The in's and out's of leveraging

27/10/2010

Buying your first home or investment property can be easy from the ground up with the power of leveraging.

While every person and their situation will be unique, first time investors can position themselves so equity in an existing home can help them as a buyer. Alternatively, first home buyers can buy with the foresight that their purchase could go on to provide equity for future purchases.

“The first step borrowers should take before venturing into this territory is to run the figures,” Smartline Personal Mortgage Advisers Managing Director Chris Acret said.

“Generally speaking, if you’re currently looking to buy an investment property, lenders will lend about 90% of the cost to purchase that property, so you need to come up with 10 % of the total cost – or 20% if you wish to avoid paying Lenders Mortgage Insurance (LMI).

“If you’re planning to use the equity in your existing home, you’ll need to obtain a bank valuation, which is typically quite conservative and is coordinated as part of the loan application and assessment process by the lender.”

As an example, if your home is valued at $400,000, you will have access to at least 80% less the existing loan debt against that property - $320,000. Assuming you still owe $200,000, the available equity you have in this property is therefore $120,000, which can be used as a deposit for your investment property.

Let’s say you’ve found an investment property you’d like to purchase for $400,000.  Assuming fees and charges come in at around 7%, which is quite generous, you will require $428,000 to fund the purchase – this is referred to as Funds to Complete (FTC).

At 90 % LVR (loan to value ratio), your loan amount will be $360,000 meaning you have a shortfall of $68,000 to fund.  Given you’ve already established that you have $120,000 in available equity in your home – also known as your principal place of residence (PPR) – and assuming all other loan application criteria have been met, including your ability to service the debt, you’re able to fund your first investment property.

However, the choice of property is a key consideration. While purchasing a studio apartment or an executive rental or serviced apartment could look like a cheaper option, many lenders require a much larger deposit – up to around 40%.

In this example, having established your access to $120,000 in equity – minus $68,000 you used to fund your first investment property – you decide to leverage the remaining $52,000 in equity to purchase another investment property valued at $300,000.

As with the previous example you add approximately 7% to fund fees and charges meaning you require $321,000 to fund the purchase.

Assuming your loan is taken out at 90% LVR, the loan amount will be $270,000 requiring you to fund the shortfall of $51,000 against the equity in your home – leaving $1000 of available equity.

Mr Acret said it was important to consider the structure of your investment loan security as it is best to avoid cross-collateralisation as much as possible.

He recommended investors keep tab of their investment properties’ values and to obtain a bank valuation if they believe the property has increased in value.

“Based on the assumption that on average real estate values increase conservatively by about 4-8% per annum, you could reasonably expect to see the value of your property portfolio increase and, therefore, allow you to either release a property being held as collateral security or use the equity to fund additional purchases,” he said.

For buyers looking to build a property portfolio it is important to have clear goals, and a plan which details how you are going to achieve those goals.

“You need to ask yourself the reasons why you are looking to invest,” Mr Acret said.  “Are you building a nest egg for retirement, fuelling a passion for buying and renovating property or looking to eventually give your children a home?

“Someone looking to purchase two to three properties over a long period of time will have a different plan to someone looking to build a substantial portfolio of 10 or more properties within a couple of years.

“Also ask yourself how comfortable you are with debt, what is your appetite for risk, how will your investments affect your tax position, and whether or not you have the will and determination to maintain the property’s upkeep and keep abreast of property market trends and news.”

Mr Acret also suggested that, in addition to seeking the advice of a mortgage adviser, investors speak with their accountant as a priority.

“Particularly if it’s your goal to hold more than one investment property, the structure of the loans, your cash flow and tax position are all very important considerations,” he said.

“While the interest, fees and charges associated with your investment loans are tax deductible, an accountant can advise which expenses are claimable up-front and which ones are amortised over a period of time.”

The structure of your investments very much depends on your investment goals and appetite for risk – the more properties you have in your portfolio, the more there is to contemplate.

“The more debt you have to service the more dependent you will be on rental return and cash flow which can be severely impacted by unexpected costs such as replacing a hot water service or an increase in interest rates,” he said.

“That’s why it’s important to work with trusted professionals such as a quality mortgage adviser and accountant to ensure you are aware of all the implications of your strategy and have measures in place to manage all eventualities.”

As always, talk to your Smartline Personal Mortgage Adviser for more information.

 

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