As an asset class residential investment property has proved its worth over the last 10-20 years, with average annual returns of eight per cent over the past decade and 10.5 per cent over the past 20 years (to the end of December 2015). These impressive results – over a difficult period that included the Global Financial Crisis – is one of the reasons many investors like the idea of some residential property within their investment portfolio. Of course, if investing was a historical game it would be easy – there is no guarantee that these historical returns are predictive of future ones.
Low interest rates, low inflation
The current environment for property investment is somewhat unique, with a combination of historically low interest rates and low inflation. The case that interest rates are currently historically low is not hard to make – National Australia Bank put some focus on this recently with their offer of a number of fix-rate home loans with interest rates of less than four per cent.
Relatively low inflation has been a reality since the GFC, with the latest annual change (measured to the March quarter) of 1.3 per cent. It is now many years since there has been concern about inflation being above the top of the two to three per cent RBA inflation targeting rate, a situation that would lead to the RBA cash rate being lowered.
The important role of inflation with borrowed money
In considering real estate investment, we often think strategically about the property, future income and future capital growth. However given the size of the loan that a person has to take out to buy an investment property, the characteristics of this loan are important too. Here is where inflation has a largely underappreciated role in property investment. Inflation effectively reduces the size of a person’s loan every year. Over the 1980s, inflation was much higher in Australia. According to the RBA, over this time inflation averaged 8.1 per cent per year. To put it another way, $10,000 of goods and services in 1980 cost nearly $22,000 by the end of the 1980s. On that basis, an outstanding investment home loan in 1980 was, in ‘real’ terms, halved in value over the next decade.
As a property investor, increases in inflation are likely to have three impacts that help you get ahead on your property purchase:
- The ‘real’ (after inflation) value of your investment home loan falls;
- The rent from your property investment is likely to increase, meaning more investment cash flow;
- If you are working, your own income is likely to be increasing to at least keep pace with inflation, helping you manage your property investment.
The current environment, where both inflation and wages are rising far more slowly, reduces these benefits for current residential property investors.
The unique opportunity of low interest rates
While this low inflation/low wage growth environment is challenging, there is an upside – property investors currently have access to interest rates that people in the 1980s, where mortgage rates were often well over 10 per cent, could only imagine.
With a variety of loans on offer with rates of under four per cent, and with the tax benefits for borrowing to invest reducing this cost even further, this provides a tailwind for property investors.
Thinking things through from a personal finance perspective
A core personal finance strategy for people over time has been the wisdom of repaying the home loan for the property that they live in quickly. This loan is non-tax deductible, and repaying it quickly provides lifestyle security and extra cash flow. The majority of early mortgage repayments are repaying mainly the interest and only reducing the value of the loan by a small amount. Making extra repayments early helps reduce the value of the loan.
Because of the tax deductible nature of debt for investment loan purposes, there seems to be considerably less discussion of the benefits of making higher loan repayments – however in a period of lower inflation and low interest rates, there is an argument for increasing investment home loan repayments.
Putting some figures on extra repayments
Let us consider the following scenario – a $500,000 investment property loan with a four per cent per annum interest rate. Repayments will be $2649 per month for a principal and interest loan paid off over 25 years. Total interest of $295,000 is paid over the course of repaying the loan.
Let us now assume that this same person holds the view that interest rates have the capacity to rise to seven per cent (well below the level of mortgage rates that existed as recently as at the start of the GFC). Monthly repayments with a seven per cent interest rate will rise to $3544. As a ‘stress test’ of a person’s financial position before entering into a loan, it is obviously wise to make sure that repayments of this level could be managed comfortably.
If a person was to start paying their investment property loan with monthly payments at the higher rate of $3544, they would be on track to repay their loan in 16 years rather than 25, and paying total interest of only $178,000 rather than $295,000.
The benefits of extra investment loan repayments
Making these extra repayments, even with an investment property where you are trading away some of the benefits of tax deductible interest repayments, leads to a number of benefits including:
1. A lower loan balance puts an investor in a stronger position to cope with future interest rate rises;
2. It becomes the mechanism whereby the 'real' value of the loan is falling, even when inflation is low – extra repayments above the minimum all go to reduce the outstanding debt;
3. If your strategy is to own an investment property with no debt, with the rent from the property providing extra income, then extra mortgage repayments allow you to get to this outcome sooner.
Many investment decisions are about balance – asset allocation, the balance between different personal finance strategies and the balance between how much income is spent and saved. The current unique circumstances of low inflation and low interest rates might influence some property investors to consider whether there is another balance that can be made – the possibility of directing more cash flow to extra loan repayments for an investment property.