Rental Yield & Borrowing Power: Is the Cash Cow Dead?

Rental yield is one of the main ways investors can generate a return on their investment. The return profile is an important factor to consider when purchasing property – but what impact does your portfolio’s rental yield have on your current & future borrowing capacity?

Today there is a misconception that ‘cash cows’ or ‘high yielders’ are key to solving serviceability issues investors face. There was a time not too long ago where it was possible for 6% yielding assets to increase your portfolio’s borrowing power. Median income investors accumulating property during the 2011-2015 period used this fact to build very large investment portfolios in high yielding areas.

However, like most sources of income, the role of yield has lost much of the leveraging potency it once had. Let’s look more closely at the numbers:

Impact of yield on individual purchases:

With most lender calculators, an extra 1% rental yield on $1 million worth of property adds about $50-60k to your borrowing power. That is, an extra $10,000 p.a. in rental income, increases your borrowing capacity by around $50-60k. Some lenders are more favourable than others, depending on whether they take gross or net rental income.

As an illustration, this has been modelled with each of the big 4 banks.


The figures above are based on a test case of an 80% LVR portfolio for a 140k gross income couple, renting at $500 p/w and a $6k credit card. Also, note that Westpac have had recent serviceability changes since the modelling & charting was done for this post.

Impact of yield on your ability to generate a portfolio:

To take things one step further, I have also modelled out a more dynamic scenario. These charts show borrowing capacity as more debt is acquired at different yields. Note, many lenders don’t allow yields above 6% to be factored into serviceability.



Observations:

• Your borrowing power falls as your portfolio grows, regardless of the yield your portfolio is at. Additional yield has a positive impact, varying slightly depending on the taxation treatment of rental income of individual lender calculators.

• An additional 1% rental yield across a $2million portfolio increases your borrowing power by around $100k with individual lenders. Using a structured lending approach & using non-bank funders, you can double this borrowing power impact your total portfolio (finance multiplier).

• That is, an additional 1% rental yield on a $2million portfolio may grow your portfolio size by around $200k. Said differently, an additional 1% yield across your portfolio will increase your total portfolio size by around 10%.

• Additional yield works best is for individual purchases, where the extra % yield can stretch the budget marginally further.

How investors may react to this information:

• Yield is certainly an important consideration to your purchase decision. In 2017 though, it does however have a smaller borrowing capacity impact than most people would think.

• Yield is no longer the fuel to leveraging very large portfolios. It will marginally increase your total portfolio size. If you are a ‘yield investor’ because you want to have a bigger portfolio size, you may want to consider how much bigger your portfolio is actually going to be.

• For most early stage investors who are attracted to ‘larger, high yield’ portfolios, the yield return itself is unlikely to build you the capital you need to achieve standard long term wealth creation goals.

• In my opinion, property investors borrowing capacity is now scarcer than it was before. Quantity of borrowing power/properties is now more limited. This should translate investor strategies to focus on quality, not quantity. Note that yield doesn’t necessarily mean lower quality or a lower growth rate.

I hope this information helps educate property investors about their overall property strategies in the 2017 & beyond credit environment. What worked in previous credit environments may not necessarily be the same formula to success in this one.

 

Top notch info as per usual @Redom

 

Great post. It's interesting, the government is concerned about property price inflation, leans on lenders to change, the outcome? Potential investors are now less concerned with yield and just chasing growth, exactly th outcome the government didn't want.

Shouldve just changed/adjusted/removed negative gearing and CGT if that's the outcome they wanted.

 

Fundamentally to have rental income push borrowing capacity upwards, the rental yield needs to be about 12% on the amount borrowed to reach a 'lender neutral' position.

Given that this is almost impossible to achieve in a basic purchase scenario and without significant risk, this reinforces my belief that growth is the key to success:

Growth of value generates wealth.
Growth of (rental) income allows longer term accumulation.

 

I suspect STG would have literally been off the charts prior to the negative gearing changes this month

 

These debates always ignore the value that strong cash flow , reinvested towards debt reduction , produces ; specifically the removal of non income producing, non deductible debt. The modeling doesnt take that into account , and it really should in order to get a balanced view on things.

When presented this way, the argument that cash cows offer little to improve borrowing capacity seems reasonable. But it's not the whole story, because when you factor it in the impact of compounding debt reduction which surplus income can provide, the story starts to look very different indeed.

To see what I mean, all anyone needs to do is open up any extra repayment calculator and key in what an extra 5,6,7,8K paid onto a 30 year P&I PPOR loan each year, will do. And after you see that result, if you still believe that doesnt improve your situation.... well 2 + 2 obviously adds up to 17 for you

These debates also tend to ignore the defensive value of cash cows, when a job loss, injury or incapacity comes along, or when a P&I cliff comes along... or when rate rises come along .... something that can devastate a less mature portfolio that's just keeping its head above water. While thats unrelated to the specific topic of borrowing power, its still overlooked all too often in these debates. perhaps its because Australia has had 25-30 years of almost uninterrupted growth, but it seems to me that its foolish not to have at least some form of defensive position within a portfolio.... if for no other reason than to have a safety net in place which allows you to continue to service your debts and to buy you time , if and when circumstances change...

 

Exactly. I have a few of these and am thousands of dollars cf+ each month. Any extra money I have as a result goes to provide deposits for more investments or to pay down ND debt. The other thing that people just can't seem to absorb is that cf+ properties can and does grow. I've had 20% growth on some of mine in the last 18mthe or so. Better than some people would have had in Brisbane. Just buying my 6th property for this year and I very much doubt I'd be doing that if I gone with a lower yield. Everything I bought either has equity already in there or has potential to subdivide or add rooms. So not sure why people see this as an inferior strategy to say sitting on a couple of cf- ips in Brisbane for example.

 

I wasn't questioning whether purchasing yield is 'matter of factly' worse than growth. Plenty of yield assets have grown and will continue to do so. Plenty bought in Western sydney 4 years ago because of yields, and look at how that's turned out. They've nearly doubled in value inside 7 years.

Yield specific investing is just a different way to earn a return. The income stream types of return is powerful too - it's real cash in your account, doesn't need to be asked for (equity), can act as insurance, pays for holding costs, allows debt recycling, debt reduction, lifestyle, etc. Using the yield to harness other benefits can be powerful, as Ultan has mentioned.

The point of this was the quantify the impact of what the additional rental income has on your borrowing power. Plenty question how purchasing 6-7% yields impacts their borrowing power today, unaware of how things have changed. The downward trajectory of every single yield curve shown across different lenders is one way to quantify & answer this misconception.