Interest rates are rising faster and higher than many property investors may have foreseen and in this climate it is crucial to concentrate on an investment strategy that focuses on the relationship between interest rates and rental yields.
Rather than panic about a seemingly growing gap between rental income and loan repayments, there are steps investors can take that could make it easier to hold quality assets for the long term and ride out the current inflationary environment.
Let’s start with a simple calculation that illustrates the interest rates/rental yield relationship. If an investor has a $400,000 mortgage at 8% and the rental income is 3% of the property’s capital value, then the difference between income and loan repayment is $20,000 a year. If the interest rate rises to 9% and the yield remains the same, the repayment gap widens to $24,000 a year.
In this scenario, investors need to look at two key issues. The first is the level of tax deductibility they can claim against their income level. For instance, an investor on the highest marginal tax rate can claim up to almost half of that shortfall. Therefore, each percentage point rise in the mortgage rate is effectively a half a point rise for the negatively geared investment property owner on that tax level.
But even if an investor is on a lower tax rate, some of the sting will be removed from the repayment gap. What becomes important here is the investor’s ability to manage the repayments across the financial year until they can claim their deductions. Many investors are actively encouraged to borrow 100% of an investment property’s purchase price, plus entry costs, in order to maximise this tax deductibility. But I would urge new investors to avoid this in the current inflationary climate and aim to have some valuable equity in any purchase they make. The greater their equity, the less the repayment gap, making them better able to cope with further rate increases.
Some investors successfully exploit the pay as you go (PAYG) tax variation, to have tax allowances paid in advance. This variation allows a property investor to project their losses for the year and claim the amount by way of reducing net income on whatever basis they are paid a salary: fortnightly or monthly.
Under this arrangement, an investor who projects through a PAYG variation that their investment property losses will be $20,000 a year will have their taxable income reduced by that amount. This effectively spreads the losses over the year and, gives the investor an extra amount in their net monthly pay. Although, assuming you have enough cash to wait for your tax allowances, you may prefer the more conventional tax return method of receiving a lump sum tax return at the end of the financial year because this provides more flexibility as to how this money can be used.
The second critical consideration is the rental yield itself. Over the longer term, a properly selected inner-urban asset should return 3% to 4% of capital value based on current conditions; that is it will “yield” 3% to 4%.
Still, I am constantly surprised by the subscriber questions I receive that indicate investors are not regularly reviewing their rent levels. As interest rates rise, there is likely to be an upward effect on rents as more people remain tenants longer in what is already an extremely tight supply situation. Further, as interest rates increase fewer investors buy properties, which constricts the level of supply and causes further rent rises.
Although it is sometimes more prudent to retain a good tenant on a slightly lower rent rather ask more only to have the property empty, investors should still ensure they are fully reviewing their yield when a lease expires.
This is not about taking a managing agent’s word as gospel on what that rent should be, but proactively determining what the property would fetch if it were placed on the current market for the first time. Even a modest increase could mean the difference between being secure for a further year’s income rather than having to stretch personal finances to cover mortgage repayments.
This first appeared in Eureka Report