JUNO Spring 2020

Just about everyone borrows to buy rental property.

This is certainly true when you buy, although it’s fair to say that there can be a few people who, over the decades, repay the debt, so that they have a debt-free rental property (or two) to fund their retirement.

Nevertheless, whatever might happen later, when you first buy property, you do it in part with debt.

This is usually because few of us have enough money to buy a property without taking on debt.

What is gearing?

In any event, most people want to ‘gear’ their properties. This gearing simply means borrowing, and, if all goes well, it has a remarkable effect on returns.

Gearing increases your returns hugely if the property rises in value, but it’s a double-edged sword – if the property falls in value, your losses are boosted hugely, in the same way.

Debt you take on to buy a rental property (or indeed any asset intended to produce ‘assessable’ income) will be tax-deductible. This, of course, reduces the cost of your debt.

It doesn’t matter what you use for security to borrow for a rental property: you can borrow on the family home and use the funds to buy a rental property and your interest payments will still be deductible for tax purposes.

In fact, this is something that many property investors have done quite satisfactorily over the years.

Borrowing 100 per cent

Many have borrowed 100 per cent of a rental property’s cost by using both the family home and the newly purchased rental property as security.

In doing this, they’ve put no cash into the deal at all. With 100 per cent of the rental property purchased by debt, their gearing rate is as high as it can be.

Returns will, therefore, be high but, losses, or course, will be similarly high.

These arrangements have been common for years. They’re very tempting because they require none of your cash.

Your home may be at risk

Don’t forget that if anything goes wrong, the family home will be mortgaged and is directly vulnerable.

Any available cash flow should go to repay debt on the family home first. This is not tax-deductible, so it should be paid off as a priority.

Then, when the home mortgage is repaid, you should reduce your rental property debt.

Lending now

Over the 40 years that I’ve followed and invested in property, I’ve noticed that the policies of banks and other lenders are always changing.

There are times when banks forked out loans to all sundry, as easy as you’d like. There’ve also been times when they’ve been as tight as a drum, holding onto their money and making few loans.

It would appear that we’re in a ‘tight as a drum’ phase at the moment. Banks aren’t lending easily.

This means thinking about how lenders assess your proposal and decide who they want to lend to.

Knowing this can help you tailor your loan proposal so that the lender wants to lend to you (and not someone else).

The three Cs of lending

Banks assess loans using the three Cs: Character, Cashflow and Collateral.

• Character. This is about you, the borrower. The most important of the three Cs, banks assess your character, both objectively and subjectively.
  
  The objective assessment will involve a credit check to make sure there’s nothing bad in your past and you’ve always met your obligations. The subjective assessment is important when borrowing large amounts (for example, for multiple properties).
  
  The lender is likely to want to meet you and make a subjective assessment of how honest and competent you are.
  
  
• Cashflow. If you get over the first hurdle, the lender will then look at your cash flow and consider if you have enough to meet the repayments.
  
  This isn’t just about quantity of cash flow but also its quality – when the economy’s poor and people are losing their jobs and businesses, lenders like as much certainty as possible about where your income’s coming from.
  
  
• Collateral. This is the security you offer. When it comes to rental property, the important thing is the Loan to Value ratio (LVR).
  
  It’s the least important of the three because from a banking point of view, moving on security and selling up assets is expensive.
  
  In any event, if they do have to take your property and sell it up, it means the lenders were wrong when they judged your character and cashflow.

If you can present yourself well in these three areas, you’re more likely to get a loan offer.

In times like these, when loans are not easy, thinking about these three factors and presenting yourself well will help you get the loan you need.

Martin Hawes is the chair of the Summer Investment Committee. The Summer KiwiSaver Scheme is managed by Forsyth Barr Investment Management Ltd and a Product Disclosure statement is available on request. Martin is an Authorised Financial Adviser and a Disclosure Statement is available on request and free of charge at www.martinhawes.com. Martin is a director of Lifetime Income, an annuity provider and a board member of the New Zealand Shareholders Association. This article is general in nature and not personalised advice.

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