For many investors, saving for a deposit is a nightmare. Just thinking about repeating the process is enough to turn you off purchasing your next property.
Once you start building your portfolio, however, your options for sourcing the funds for your next investment greatly expand. In fact, you may already be sitting on another deposit hidden somewhere in your existing portfolio.
Drawing out that equity can help you to leapfrog into your next property. The strategy sounds straightforward enough, but there are many considerations along the way.
Monique Wakelin, co-founder of Wakelin Property Advisory, says investors with the right strategy can leverage off their existing portfolio to save time.
“If you’ve got a good investment property, the growth in equity should be well and truly surpassing what you could save in your after tax dollars in a reasonable period of time,” she explains.
“It’s a question of choosing properties that have a greater propensity for capital growth. If you get the property selection right, then you will build your equity more quickly, which means you can acquire your next asset faster.”
Investors must also structure their loans properly and be prepared to put in the hard yards to manufacture some equity. Used correctly, equity can be a powerful tool to accelerate your property investment goals.
The amount of equity available in your property is calculated by subtracting any loan balances owed from the property’s current value. For example, if your property is worth $500,000, and you have $300,000 left to pay on your mortgage, your equity is $200,000.
In order to unlock this equity, investors can refinance their mortgage. The bank will first carry out a valuation to determine how much your property is worth. They will then calculate a loan-to-value ratio (LVR) to withhold some of your equity as security.
Astute Dee Why’s Sam Ayliffe goes one step further and considers ‘useable equity’. He calculates this at 80 per cent LVR, so investors can avoid paying lender’s mortgage insurance (LMI).
Calculating useable equity
|BANK VALUATION OF THE PROPERTY||BANKS LEND AT 80% LVR||CURRENT MORTGAGE||AVAILABLE EQUITY (80% LVR - CURRENT MORTGAGE)|
In the case above, 80 per cent of the $500,000 property is $400,000. With the outstanding loan subtracted, this leaves the investor with $100,000 of ‘useable equity’.
Even though some investors may be able to borrow up to 95 per cent LVR, Aussie Home Loans’ Ross Le Quesne warns that this allows less margin for error if the market shifts.
Investors, he explains, need to be careful how much they leverage when they apply for the loan increase. If the market were to drop by 10 per cent, the investor may be unable to sell the property without having to raise additional funds, he warns.
Investors looking to refinance should sit down with a professional broker and consider the available options.
One method is to structure your loan as a line of credit (LOC). This way, you will have a pre-approved credit amount on your usable equity and you will only need to pay interest on the amount you use.
Investors will typically have the line of credit linked to one property. The equity in that property will then be used as the deposit mechanism for all future purchases, Ms Wakelin explains.
“Then what they do is use a small amount of equity in that one property as a deposit, and they use the next property as the major loan. So it’s one property, one loan,” she says.
Ms Wakelin believes this method is low risk and gives the investor more control over their loans and assets.
Having separate loans also gives investors the flexibility to switch lenders and take advantage of the market-leading interest rates, says Mr Ayliffe.
“Some will take a higher rental income percentage, some will enable you to leverage off fixed rates for investors, some will have higher negative gearing than others, so it really does mean that you can pick and choose the lenders,” he adds.
As growth will vary across your portfolio, having your loans spread between various lenders means you can also take advantage of your better performing properties and potentially leverage into more properties sooner.
“If you then want to go into a very busy portfolio – aiming for 10 properties or more – that’s when you can really look at splitting lenders because certain properties will have different equity levels,” Mr Ayliffe continues. “Sydney will move differently to Melbourne and Brisbane, Adelaide and the regionals.”
Alternatively, investors can consider cross-collaterisation – using two or more properties as security for the loan. This means investors can effectively buy an investment property without a deposit.
Resi CEO Angelo Malizis explains that some people are asset rich but cash poor. In these situations, some investors use the family home as security to borrow the 20 per cent deposit needed to purchase their investment property.
According to Mr Ayliffe, having a few properties secured together generally allows investors to obtain a better interest rate.
The downside, however, is that if the investment loses value or if you fall behind on loan repayments, you risk losing both the family home and the investment property.
Having the properties cross-collaterised could also limit the amount you’re able to borrow.
Unlike individually secured properties, where the investor can access equity from one investment regardless of how the other one is performing, Mr Le Quesne explains the value of both properties will be taken into consideration if they are cross-collaterised.
Having additional equity is great, but do your sums to make sure you can afford to pay the additional interest on the equity and keep a buffer for a rainy day.
Mr Malizis says just because an investor has been repaying their loan for several years, doesn’t necessarily mean they have built equity. Instead, he explains, there are other ways investors can create equity.
“The most common mechanism people use to create equity is to get ahead of the amortization curve. That is, to make more than the minimum principal and interest repayment on their home,” he says.
Similarly, investors who have interest-only loans, typically during the first 10 years of the loan, can also create equity by making additional repayments.
The alternative is to carry out a valuation on your property if you believe it has improved in value.
With positive signs that the property market is improving, property values should be on the up in the coming years, Mr Malizis says.
Even if investors are only making the minimum payments on their home loans, “They may find their property has increased by $30,000 or $40,000 or $50,000 in value, and the bank would be happy to allow them to borrow 80 per cent of that increase,” he says.
Recycling equity faster
There are two types of property investors, according to Paul Wilson, CEO at Educating Property Investors: the passive and the active. The passive investor will wait to ride the capital growth wave, but the active investor will manufacture the growth regardless of market movements.
Active investors, however, have to be careful not to overcapitalise and overcommit, he warns.
If you are taking on a project to manufacture equity, you need to do your research up front, understand all the expenses, have a clear plan to avoid going over budget and cover all your bases, Mr Wilson says.
Investors also need to make sure there is enough of a buffer and be realistic about what they are likely to achieve.
He points to one renovation that is simultaneously creating income and cash flow.
“I’m converting a two-bedroom one-bathroom property into a three-bedroom two-bathroom property. That automatically increases the value of the property by at least $50,000, and it’s only cost me about $20,000 to do,” Mr Wilson explains.
On top of this, it boosts the income generated from the rent and increases the serviceability as well, he adds.
Mr Le Quesne says he has found investors can generally recycle their equity more quickly if they renovate their property shortly after they purchase it.
“That changes the nature of the property, and the valuer is more likely to say ‘Yes, I can see where you’ve increased value’,” he says, adding that the investor can also show the valuer before and after shots of the property.
Even though the investor may have purchased well, the valuer is unlikely to provide a valuation of $30,000 to $40,000 above the purchase price six months later because they will be using comparative sales, Mr Le Quesne explains.
Despite this, performing your due diligence and providing valuers with your own set of comparable sales can make a difference.
“If the client can make it as easy as possible for the valuer, they’re more likely to get a favourable and on-market result,” Mr Le Quesne advises.
To make this process easier, you can build your own property investment team to help you with the different stages of unlocking your equity.
Mr Ayliffe explains there are a number of professionals who can help you take the best course of action.
“Your professional broker will structure the loan correctly for you and get you market-leading interest rates, your financial planner will give you the advice around what you’re doing to make sure you know you’re heading in the right direction for your future, and then your accountant will make sure the right deductions are claimed for you,” he says.
Before rushing to unlock equity, investors need to be aware of the common pitfalls.
The most common misconception around drawing equity out of an investment property is that no matter what the funds are used for, it will be tax deductible, Ms Wakelin says.
“That’s a fundamental mistake people make – they don’t realise it’s the purpose of the borrowing that determines the tax deductibility,” she says.
Investors also need to consider whether they are capable of repaying the interest on the additional amount they are borrowing.
“Whilst you may be making an investment property purchase and the interest is tax deductible, you still need to come up with some of the cash,” Mr Malizis says.
“Investors should do their sums to determine if they can afford to pay off the increased loan and the interest attaining to that increased loan.”
Rather than speculating and overcommitting, he recommends investors should keep a buffer.
“Having additional equity is great, but do your sums to make sure you can afford to pay the additional interest on the equity, and keep a buffer for a rainy day,” he advises.
To ensure the refinance is approved, Mr Le Quesne also recommends investors don’t apply for a refinance during a renovation.
“When you come to do a loan increase, you don’t want to be halfway through a renovation.
“Banks don’t like incomplete security properties, so you’re better off applying prior to doing a renovation because if a valuer goes out there and sees the property is not complete, you won’t get the finance,” he says.
Mr Wilson advises investors to plan ahead and use their equity in a way that won’t threaten their financial stability.
Investors should consider a budget, risk profile and strategy that will serve their future financial goals and enable them to continue to build their equity.
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