Peter Churchouse is the founder of Portwood Capital, a leading real estate investment company. With more than three decades of experience in real estate investment and research he is widely considered one of the world’s foremost authorities on Asian real estate markets. He is also author of The Churchouse Letter, his financial newsletter which provides investment and wealth building strategies. In this 8-part series, he highlights key rules he feels investors should follow when purchasing real estate. This is Part 5 of the series.
Leverage is a powerful weapon, but must to be used prudently.
Leverage allows you to create wealth and income using someone else's money.
Real estate is one of the few assets where us mere mortals can build wealth by borrowing. Moreover, we can borrow for long periods. There are not too many other investments where investors can get the comfort of 20 to 30 year mortgages.
For example, you buy a property for $100,000 with a 20% down payment ($20,000) and borrow the rest on a long term mortgage. Let's assume that the value of the property grows on average about 5% annualised over a 20 year period.
That is not an unreasonable assumption for western markets. Many have done much more than this.
At the end of 20 years, the property is worth $265,000. This represents a thirteen fold return on the initial $20,000 investment.
And as an occupier the monthly mortgage payment is probably similar to the rental that you might have had to pay to rent a similar property. So, as an owner you have paid "rent" that you would have had to pay a landlord anyway. But your "rent" has produced a very nice return for you in the form of considerable capital gains.
Personally, I have made between 200 and 800 times my initial investment in some properties bought and held over the long term. Yes, 800 times my investment! The mortgage has long been repaid.
I’m not here to boast. The basic principles I followed are the ones I’m laying out here. There are no guarantees but by keeping to these rules when you buy property you GREATLY increase your chance of getting big gains and building substantial wealth.
My first ever real estate acquisition in London was made using a 90% mortgage and was sold 25 years later, mortgage repaid, giving a return of just over 200 times my initial down payment.
One current property still in the portfolio, bought nearly 30 years ago, again with 90% mortgage financing, if sold today would likely return my initial equity investment more than 800 times.
Most disaster scenarios in real estate are debt related
Debt carries its own clear risks. The key risk is the ability to service debt out of income, either personal income, or rental income for investment properties. Debt repayments are a function of interest rates and length of repayment. A longer repayment period reduces the monthly repayment amount, but means paying more interest over the life of the mortgage. It also means increasing your interest rate risk substantially if you have a floating rate mortgage.
Please be very clear on your interest rate risk. Most countries do not have long dated fixed mortgages available like the U.S. There are plenty of mortgage calculators on the internet. If you have a floating mortgage, you must allow for some breathing space, especially with interest rates as low as they are today. Could you afford to make the payments if my monthly mortgage payment doubles? It sounds like a stretch, but believe me, it can and does happen. I’m not saying you should only pay half what you can afford, but you must have a good understanding of your interest rate risk.
Stay in your financial comfort zone.
The table below shows some basic sensitivities of a 20 year mortgage of $150,000 you would face on day one.
An interest rate rise of 5% (not an unimaginable scenario) would increase your monthly mortgage repayment by 50%. And it would triple your total overall interest repayment.
In fact over 20 years the interest repayments would exceed the original price of the property!
|
20 Year Mortgage |
|||
|
Mortgage Interest Rate |
Monthly Mortgage Repayment |
Cumulative % Increase in monthly repayments |
Total Interest Repayment |
|
3.00% |
$832 |
|
$49,655 |
|
4.00% |
$909 |
9.3% |
$68,153 |
|
5.00% |
$990 |
19.0% |
$87,584 |
|
6.00% |
$1,075 |
29.2% |
$107,915 |
|
7.00% |
$1,163 |
39.8% |
$129,108 |
|
8.00% |
$1,255 |
50.8% |
$151,118 |
Optimising the Debt, Duration, Interest payment mix.
It’s also critical to understand the impact the length of your mortgage has on your sensitivity to interest rates. Balancing the monthly repayment amount, the length of the loan and the interest rate involve running through a few scenarios.
Don’t just opt for the longest mortgage tenor you can get just to maximize your buying power (assuming you can’t get a fixed rate mortgage).
Lengthening the mortgage period results in lower monthly repayments but a great deal more interest paid over the mortgage period. And a great deal more interest rate sensitivity. The table below takes our $150,000 mortgage and changes it from 20 years to 30 years.
Note that the percentage increases in mortgage repayments for each percentage point increase in interest rates is that much higher.
In the 20 year example, it took a 5% interest rate increase to take our total interest repayments to approximately $150,000…. In the 30 year mortgage, this takes an increase of just over 2%. That’s a big change in sensitivity.
|
30 Year Mortgage |
|||
|
Mortgage Interest Rate |
Monthly Mortgage Repayment |
Cumulative % Increase in monthly repayments |
Total Interest Repayment |
|
3.00% |
$632 |
|
$77,666 |
|
4.00% |
$716 |
13.2% |
$107,804 |
|
5.00% |
$805 |
27.3% |
$139,884 |
|
6.00% |
$899 |
42.2% |
$173,757 |
|
7.00% |
$998 |
57.8% |
$209,263 |
|
8.00% |
$1,101 |
74.0% |
$246,233 |
Always run the numbers.
It only takes a few moments to do the calculations. Is it worth taking a shorter mortgage and paying a bit more on the monthly repayments? By paying it back over a shorter time frame the amount you save can be substantial. If you can afford it, might it not make more sense to save the interest and use the savings for another investment?
CASE STUDY:
When I bought my first property I calculated that I could easily service the mortgage at the current rates.
In fact, I could have bought a much nicer, more expensive property. But this was the late 70’s in London. I could see inflation looming, bringing with it the likelihood of my bank raising the interest rate on my mortgage.
Rates went up sharply. My monthly mortgage repayment almost doubled.
I was able to continue to service the mortgage, but if I had pushed the purchase to the limit of my affordability, the rising interest rates could have been dangerous to financial health.
Maybe I would have been forced to sell?
Making a more conservative decision allowed me to stay on the property ladder.
As it turned out, I held onto that London property until a few years ago by which time the annual rent I received for it was 125% of my purchase price.
This concludes Part 5 of the series. I know that if you make an effort to follow even a couple of the rules that I outline in this series, you will be in a better position to successfully invest in property. If you have any questions or comments, I’d love to hear from you. You’ll find my details here.
