How to get funds after your second property (Part One)
So you're already on the property investment path with one or two tucked into your basket? Well done! However, are you now starting to struggle to get the "nod" from lenders? Master investor and Rocket Property Group CEO Ian Hosking Richards and Investment Mortgage Broker Alan Dean explains the how and why banks and lenders are turning you back. Ian and Alan explore this through case studies and show you how to get over this hurdle.
case study couple + two investment propertiesGlen and Michelle are ready for their third investment property and have $45,000 in savings - and yet, they cannot get funding.
- Own two investment properties and their own home - Total Value = $1.86m
- All loans with one lender, one of the big four banks
- $1.42m in total lending against these properties – all cross-collateralised
- 76.3% Loan-to-Value Ratio (LVR)
- $45K in Savings
Why can't get they get the funding?
A quick review of Glen and Michelle’s ﬁnancial structure immediately reveals a basic mistake – all of their properties are cross-collateralised. This means the bank has taken the entire portfolio as security against their total borrowings.
As their LVR (loan-to-value ratio) is currently sitting at around 75%, the lender has in effect oversecuritised the total loan. This is in the bank’s interest as it reduces the risk. It also is a good business retention policy as it makes it more difficult for individual properties to be reﬁnanced with other lenders.
However, for Glen and Michelle this is not such a good arrangement as they currently have no security to offer another lender.
| CURRENT STRUCTURE
| OWN HOME
|| Big 4 Bank
|| Own home, Inv Prop 1, Inv Prop 2
| INVESTMENT PROP 1
||$550,000||$575,000||104%|| Own home, Inv Prop 1, Inv Prop 2
| INVESTMENT PROP 2
||$410,000||$435,000||106%|| Own home, Inv Prop 1, Inv Prop 2
|TOTAL||$1,860,000||$1,420,000|| Own home, Inv Prop 1, Inv Prop 2
What's the solution?
Step 1: Approach the lender and request that each security becomes standalone.
In theory, this should be relatively easy to do, as the LVR is under 80%. However, a quick look at the individual loan amounts reveals that the individual LVRs vary considerably.
Glen and Michelle have owned their home for several years now. They live in an area that has experienced strong growth over the years, and they have built up a considerable amount of equity.
Much more recently the bank has allowed them to use this asset to purchase two investment properties, and have lent 100% of the purchase price as well as funds to complete (stamp duty and legals, etc). As these properties are recent purchases and have had little time to grow in value, the loans against these properties are more than their value, and they have negative equity in both investment properties.
So what should they do?
Step 2: Reduce the Loan
The way this needs to be done can be referred to in the Table 1 below.
The loan against Investment Property 1 needs to be reduced to 80%. Assuming the value of the property has not decreased since it was purchased, the loan needs to be decreased to $440,000. The original loan for this purchase was $575,000, so the difference of $135,000 appears as a second split against the owner-occupied property.
This simple restructuring exercise immediately frees up some equity loan, thus reducing non-deductible interest payments.
Taking the owner-occupied debt to 80% LVR ($720,000), we immediately potentially have another $68,000 which we could take as an equity release for investment purposes.
| OWN HOME
| INVESTMENT PROP 1
||$440,000||$440,000|| Inv Prop 1
| INVESTMENT PROP 2
||$410,000||$328,000||$328,000|| Inv Prop 2
But hang on – all we have done is play around with the numbers. Glen and Michelle’s overall equity position and capacity to borrow remains unchanged. If they couldn’t borrow before, how have we suddenly manufactured greater serviceability?
Well, the simple answer is that we haven’t. Not yet, anyway. That would be Step 3. But first, let’s have a look at how banks assess borrowers.
How banks calculate your borrowing capacity
Most lenders are conservative.
When they are calculating your borrowing capacity, they build in buffers to protect themselves as well as the borrower.
For example, interest rates can vary over time, and the lender wants to make sure you can meet your obligations if interest rates rise. So you may be borrowing at 4%, but the lender is likely to be using an assessment rate of 7% or even higher. As an investor you will be choosing to make interest-only payments, but the bank may do their calculations based on principal and interest repayments.
If you are purchasing an investment property, lenders will routinely allow you to add any anticipated rent to your other income for serviceability, but often they will discount it by 25% or more. So your $400 per week in rental income becomes $300 per week for the purposes of the bank’s ‘stress test’.
Let’s have a look at what that means in real terms below.
| INVESTMENT PROP 1
| INVESTMENT PROP 2
Taking Glen and Michelle’s two investment properties as an example, their total actual monthly repayment would be $2,816 per month for their interest-only loans.
Although these two properties are cash flow positive ... they look on paper as if they are hugely negatively geared
However, at an assessment rate of 7.25% and with principal and interest repayments, they need to prove to the lender that they can afford to make repayments of $6,710 per month, almost $3,900 more than they need to pay.
Not only that but the $1,000 per week that they receive in rent gives them an income of $52,000 per year, but the bank only takes $39,000 (75%) of that into account. Basically, the lender is doubling the repayments and reducing rental income by a quarter.
Therefore, although these two properties are cash flow positive for Glen and Michelle after tax, after the lender’s stress testing they look on paper as if they are hugely negatively geared.
No wonder they have hit a wall in terms of borrowing capacity! So what can be done?
Not all lenders are equal
The first thing to bear in mind is that all lenders are different, and the way they calculate your borrowing capacity can vary. For example, you can go to one lender and they will lend you $450,000 based on your financials. You can take exactly the same financials to another lender and they will give you $680,000.
Some lenders will be more generous to owner-occupiers. Other lenders will be more generous to investors. There are lots of lenders in the marketplace, and infinite small variations in credit policy.
If you do not want to have your borrowing capacity compromised, it is essential to find a really good and experienced broker who has access to multiple lenders and can assess your situation and find the right lender for you. They will be able to make sure that you have a sound financial structure in place that will support your long-term financial goals.
This means getting you a great interest rate, and recommending loans that have the flexibility that you will need in order to grow your portfolio.
But how do we get around this stress testing? Even small variations in credit policy from lender to lender will surely not make that much difference? This may be true, but read on…
Are all investment properties treated equally by the lenders?
The simple answer is no. Banks will stress test their own deals.
If you only use one lender the effects are cumulative, as in the case of Glen and Michelle. However, if you have properties separated out with different lenders, they seem to care less about the risk of each of your other properties. After all, it is not their risk, so they will take the actual interest rate and the full rental into account when they do their calculations. This makes a huge difference.
As you can see, the reason why Glen and Michelle have no borrowing capacity (despite the fact that their investment properties are cash ﬂow positive) is that they only use one bank.
Now that we have completed an internal restructure with their current lender, and created three standalone properties, we can start to refinance the properties and reduce the buffering effect that has stopped them in their tracks.
Borrowing capacity reinstatedStep 3: Add new lenders to the portfolio
Simply by throwing a couple of new lenders into the mix, Glen and Michelle’s borrowing capacity goes from zero to an astonishing $980,000!
Their income is still exactly the same; nothing has really changed except their financial structure.
It seems so simple, so why did Glen and Michelle end up with a ﬁnancial structure that did not suit their long-term plans?
It is quite simple really. Their structure was never set up for or intended to benefit them. It was set up to benefit their bank. The bank wanted all of Glen and Michelle’s business, not just a measly third of it, and they did a good sales job!
Most people, including Glen and Michelle, are time poor. They want someone to make it easy for them. Less paperwork, less hassle. Your current bank has a lot of your information already, so they can make it easy for you. They can do all the hard work, put you in the right loan, make it easy.
You are relying on the bank as your trusted advisor who will give you the best advice. But as you can see, it doesn’t always work out quite like that.
To be continued...
Next month, we'll release Part 2. In part 2 of the 'How to get funds after your second property', we will look at how Glen and Michelle can re-plan their investment future and what got them to this challenging position in the first place.