Is there a brick wall ahead?

Let's say that an investor has 3 or 4 IPs. Let's assume the intention is to keep buying to accumulate a significantly large portfolio, let's say over 20 properties or more.

If every single IP is cash flow positive, and the investor's employment is stable, will there come a point when the bank will refuse to finance or make it more difficult to obtain finance for further purchases, and if yes, when?

Cheers
SD

 

Yes there will be, properties may be cash flow positive at 4.5% interest only, but the banks will assess your ability to service the loan at an interest rate of 7.25% - 8% principle and interest.

You can see that the link between the money you are actually paying out and how much the bank will lend your diverges pretty fast.

Additionally most banks will only include 80% of rental income for servicing.

Does that make sense?

 

Thanks for the swift response.

So when the brick wall arrives, it's becomes a waiting game for the IPs to rise in value before more funds are made available, or are there alternate options?

 

Buy deals that allow for scope to add value. It will give you more options as you build your portfolio. Also you wont necessarily have to wait for more serviceability to buy ips to build more equity, you can manufacture your own. But has to match your risk profile and overall strategy/goals.

 

As above.

As an example, look at the following scenario:

Single Applicant, earning 60k yr, renting at 300wk. We'll stress test their ability to borrow by purchase 300k properties at 400wk rent at a 90% LVR 5 years interest only, with a single lender until it goes bust.

Purchase 1:
Gross Income: $60,000
Net Income: $47,853
Rent: $20,800 (80% useable: $16,640)
Total Income: $64,493 (47,853 + 16,640)

Loan: $270,000 (90% LVR)
Interest: $12,150
Lenders stress tested interest: $23,943.36 (7.5% interest rate, 25 years remaining term principal and interest as the loan is interest only)
Living Expenses: $14,400
Rent Paid: $15,600
Net Expenditure: $53,943.36

Net position post purchase: +$10,549.36

Purchase 2:
Gross Income: $60,000
Net Income: $47,853
Rent: $41,600 (80% useable: $33,280)
Total Income: $81,133 (47,853 + 33,280)

Loan: $270,000 (90% LVR)
Interest: $24,300
Lenders stress tested interest: $47,886.72 (7.5% interest rate, 25 years remaining term principal and interest as the loan is interest only)
Living Expenses: $14,400
Rent Paid: $15,600
Net Expenditure: $77,886.72

Net position post purchase: +$3,246.28

Purchase 3:
Gross Income: $60,000
Net Income: $47,853
Rent: $58,240 (80% useable: $46,592)
Total Income: $94,445 (47,853 + 46,592)

Loan: $270,000 (90% LVR)
Interest: $36,450
Lenders stress tested interest: $71,830.08 (7.5% interest rate, 25 years remaining term principal and interest as the loan is interest only)
Living Expenses: $14,400
Rent Paid: $15,600
Net Expenditure: $101,830.08

Net position post purchase: -$7,385.08

So in this scenario the borrowing capacity dies at purchase three for the hypothetical.

In reality the properties would be reasonably cash flow positive, if not neutral - however the way lenders calculate servicing it's still seen as significantly negative and the investor will see their borrowing capacity erode with each purchase. A number of lenders have now also begun scaling the living expenses, so for each purchase you make your living expense cost will ALSO rise, accelerating the reduction in capacity.

Savvy investment focused brokers can mitigate this somewhat by utilising specific lenders at certain times, but the serviceability rot will still take place, just at a slower pace.

 

As Leo says, adding value is the best way of getting deposits.

Decent yield will probably erode your borrowing capacity at a slower rate than poor yield will but using the right lenders in the right order is more important.

Using a broker who invests themselves, such as Corey above, is probably the best way to ensure you get on the right path.

 

Wow, thanks Corey for the detailed and in depth reply! That is quite eye opening.

I'm now curious if there's much difference if the above figures were an LVI of 80% on each loan and the properties were cash flow positive on P&I loans?

 

There's a marginal difference with some lenders if the loan is P&I, but then it likewise will penalise you with others which you generally use later in your investment journey - so it's a catch 22. Likewise you can fiddle with the LVR if you have cash deposits, but for the average scenario the purchase has an owner occupied debt which those cash funds could better be redirected to.

To give you an idea, even if the loan was P&I, the rent on said 300k property at 80% LVR with cash deposit funds, the rent would have to be at least 485/wk. When you factor in funding all costs traditionally through investment equity, the rent needs to then jump up to $620/wk - there aren't going to many properties in Australia pushing those kinds of figures.

 

That's excellent information Corey. Thanks very much

 

It's important to note that a property can grow all it wants, if you don't increase INCOME, you can't buy more. Banks don't lend on assets, they lend on income.

So, while manufacturing growth is great for your LVR and risk, and the additional rental income is somewhat helpful, relying on growth for deposits only works when you have the income to service the equity release and subsequent purchase/s.

Lending used to be a bit like the magic pudding - there was no bottom to the pot. Now, there is a bottom, it's not that far away and the only way to get more is to increase income.

The best way to increase income is through increasing PAYG (or biz, if you're patient) as rental income is used at only 80%.

 

Great post! So net position post-purchase is the key figure the banks look at when assessing additional finance using the serviceability calculators? For the scenario above, what impact would bringing the LVR down from 90% to 85% have? Would the combined effect of reduced interest across 3 purchases allow for an additional purchase?

 

Great explanation Corey, couple of thing I would add to Corey's calculations.
1. The living expense of $14,400 is too low for the banks now, it's more like $20,000 pa
2. @SirDingo (assuming he does not own a owner occupied outright) will have an existing loan on his OO property or will have to add his rental expense to the living expenses.
3. 5.2% rental yield is a high assumption considering Melbourne & Sydney unit rental yields are only ~4.2% & 4.3% respectively.

You can have a ten million bucks equity in your portfolio, but if you can't service the loans the way the banks calculate it (7.25 - 8% P&I) then they won't lend you more money. As Corey stated you can put loans with different lender to make use of their reduced servicing on loans not with them, but you will run out eventually. At the end of the day to get a loan you need both equity and cash flow.

 

Zero - there's no additional income in bringing down LVR.

With most lenders it makes no difference as they assess at 7.25% (their lowest base for assessment) regardless. With a couple it can make a small to moderate difference, depending how how much the reduction is and how big the existing lending.

 

Net cash flow position post purchase is essential - the lenders logically aren't going to lend to people they don't believe have the cash flow to support based on their calculations.

Changing the LVR is just shuffling the margins - it doesn't change the maximum amount that you can borrow in the end.

Likewise in terms of interest rate - early lenders used will not see a noticeable different from lower interest rates, later game lenders may give a slight boost to borrowing capacity based on a lower rate, but nothing game changing (<5% increase in borrowing capacity).

 

@wombat777 Generally not, the lenders assessment rate it generally something like "the higher of the actually interest rate +2.25%, or 7.5%". Everyone is currently sitting at the 7.5% so reducing the actual interest rate paid makes not difference to servicing in the bank's eyes.