A debate amongst family...

In the Timaru office we have an ongoing debate about capital gain in various asset classes over the next 5 years. Because there are three headstrong and slightly argumentative Lamings' in this particular office, we each took opposing views.

As you’ll see, it’s led me to want to share some insights about residential property.

If you are a reader of our content, you’ll know capital gain often follows where there are lumpy flows of credit.

The credit flow has been well and truly pumped into the housing market, due to the banks preferring the simplicity and profitability of home lending. This, coupled with ultra-low wholesale borrowing rates, The RBNZ "Funding for Lending" programme (RBNZ lending to retail banks at the OCR) and Large Scale Asset Purchase Program (printing money and buying bonds), has contributed to historically low retail housing rates and investors chasing assets.

The Corelogic NZ House Price Index shows properties in New Zealand lifted 14.50% in the 12 months to January, 7.6% in the last 3 months and a mind boggling 100.1% since the peak of 2007 pre GFC. You can’t ignore these numbers. Whether it be the interest rate story above, or the lack of supply, or perceived immigration, the stats are the stats.

The power of debt leverage amplifies the returns.

So, house prices have increased 4.88% year on year since the last peak in 2007.

Compare that to the performance of the NZX50 over the last 10 years being 13.90% per year (total return).

Let’s say you had $100,000 to invest in either NZ residential property or NZ shares mirroring the NZX50G’s performance. You would probably have bought $500k worth of residential property (using an LVR of 80% which was allowable at the time) or bought $100,000 worth of shares.

Today your shares would be worth $367,483 or your equity within the property would be worth $405,187.  Closer than you might think.

But residential investors are reaping the gain as they stick at it longer and are unaffected by normal market swings

This is where the debate got interesting.

“But you can borrow against shares!” said one of us. Yes, you absolutely can!

There are many bank and non-bank providers that offer lending facilities against approved shares as security.

The question is, would you? Under a margin lending facility, you have an agreed limit, and that limit is subject to the LVR for the share(s) security. If the share value drops, you will need to “right-size” your loan in order to prevent a margin call, or your shares will be liquidated.

For example, through one provider you can borrow up to 60% against A2 Milk shares (ATM). Say you used your $100,000 and bought ATM at $15.00/share (in October 2020). It was 28% below it’s peak and it has a sound balance sheet.

But you also used a margin lending facility, borrowed $100k and bought $200k worth of ATM – maintaining a 50% LVR.

Unfortunately, the trouble continued for ATM’s sales channels and the shares are worth, at the time of writing, around $11. You would have had to deposit a further $24,000 of cash to stop your shares being sold. You could also be reading plenty of “advice” (via keyboard warriors) telling you the shares are going to be worth even less.    

Having to “prop up” your position when things are going backwards can have a negative impact on your decision making, causing you to cut your losses, when perhaps the right strategy is to ride it out

Contrast that to residential property leverage. The bank isn’t watching your property value after you take out the loan. It will certainly become important if you want to refinance, grow or if you default, but in general terms, housing loans are “set and forget” from the bank’s perspective. They’re also set and forget in your own mind too – there’s no stock exchange giving you an up to date valuation of your house. This means, psychologically, you’re less likely to react to falling prices.

It’s a very interesting debate in mindset and its one of the reasons that property (and that includes farmland as well) becomes a favorite for investors over shares – regardless of the economic merit of each class of investment.

However, farm lenders can struggle with lending for residential property investment.

It falls in the “grey area”. It's a housing security but it’s supported by business income – so where does it sit?

We’ve seen prospective bank clients' bounce around between different departments trying to work out who should even look at the deal.

Currently, the best course of action is to recognise that housing investment is a completely different business prospect than turning grass into meat or milk. As such, a better way is to run it separately, sometimes even under a different ownership structure, as stand-alone and probably through a different bank to where the core business sits.

Having the housing separate to the core bank is key to navigating the LVR rules and potentially debt servicing or affordability measures.

For a truly stand-alone investment in property, you need to understand specific bank’s servicing tests i.e. one main NZ bank’s basic criteria is gross rent reduced by 25% (to cover rates, insurance and lost rent), and then the debt needs to be serviced and repaid from this income over 25 years at a 5.80% interest rate and a maximum LVR for an existing house of 60%.

Therefore, to meet their criteria at 60% LVR, with no further external income to support it, you'll need to find a property that has a gross rent of 6.14%.

BUT, don’t confuse bank policy with your own investment policy and strategy.

It might be all well and good finding a rental property with gross yield of 6.14% but what are it’s capital gain prospects?

Firstly, understand what you are actually looking for out of investment property. There are lots of coaches and specialists who can help you out here. Why are you doing it? Is it to create wealth? Is it to assist with succession or retirement? Is it to improve overall cashflow?

When you understand the WHY, you can develop the strategy in behind, i.e. “criteria for investment is properties that will grow in value at 5% per year, and comfortably achieve a gross rent of 6% per year.

And let’s not be blind to the risks here.

Just because property has gone up in the past doesn’t mean it will go up in the future.

Not all locations are as good as each other, tenants can be difficult (or you may not get a tenant), and increasing regulation is going to mean further costs of upkeep and development.

Banking regulations can change or supply of housing could materially increase.

These are all things that need to go into the melting pot when considering an investment into property - no different than other investment classes.

A recent NZAB client example of investment criteria

I have a client that has an excellent cashflow business, and we are actively working out how to grow his wealth. The criteria we have jointly come up with is as follows:

• Building and maintaining a residential investment portfolio with an LVR across the portfolio of 60% or less
• Target properties with a gross yield of 5-6% and costs excluding interest of around 1%, and properties in locations where 5% gain is achievable.
• We have assumed rents will rise at 4% and costs will rise at 3% pa and assumed a 4% interest rate.
• We have assumed the properties will each be in PAID rent for 50 out of 52 weeks every year
• We need to find an excellent property manager(s) as the client certainly does not have the time or ability to self-manage.
• The properties sourced will be new or modern to both reduce LVR restrictions and reduce maintenance.

• We will be extracting around $600k of equity out of the business to begin to buy around $1.500m of investment properties, and by the third year, we should be able to buy around $400k of investment property per year, and we assume he will do this with all additional bank funding and no further equity from the existing business). Depending where bank criteria goes, this should be achievable.
• The Client Goal is to have around $3m of net investing equity out of business by 10 years, from that initial $600k investment. Our modelling shows he will own circa $6.500m of investment property and have circa $3.000m of equity within them
• The assumptions within the strategy and investment criteria will need to change and adapt to the market realities.

As above, an excellent Agri banker may not be the right banker (or with the right bank) to help you fund and carry out a housing investment strategy in parallel to your business growth strategy. Consider the process of understanding your existing borrowing capacity with your incumbent bank, from there you will know what kind of “deposit” you have.

Like any approach to a bank, a clear and concise strategy is the best way to achieve a favorable outcome.

Our process remains the same:

1. Understand the core capital and resources within the business
2. Help you build, understand and articulate your own Strategy
3. Present your strategy and along with the required funding application to your bank(s) and help you obtain and negotiate the funding solution
4. Assist with the execution of that strategy.

Talk to us at NZAB to find out how to get what you deserve.

Give us a call on 0800 NZAB 12 or email info@nzab.co.nz. We’d love to hear from you.