CityLivingYou'll miss out if you don't borrow in this housing market says Jane Suiter
As the spring selling season moves into gear thousands of people are considering taking on large amounts of debt. For some that means using some of the money built up in the family home to buy a holiday home. For others it means holding onto old properties to rent when buying a new one.
The huge surge in Irish property prices over the past decade means that most people have large amounts of equity built up in their family home. They can now borrow more on the back of that and trade up or buy for investment. But even first-time buyers are borrowing large amounts of money to enter the market.
What all these people are doing is leveraging. It is the new buzzword in banking circles. "Of course we have always lent money but now we are telling people when they come in for financial reviews that they ought to look at whether they are leveraged enough," says one banker. It's a far cry from the days when to be respectable meant not borrowing.
But what does leverage mean and how much is enough? Essentially leverage means borrowing. First-time buyers can borrow 40 per cent of their net earnings, others far more, depending on how much equity they have already built up. And it is leverage that allows property to outperform almost all other asset classes.
Many investors believe that borrowing for property investment is one of the best routes to saving for retirement. At the end of the day you probably need a €500,000 pension fund when you retire just to ensure an inflation-proofed income of €27,000 a year.
That is very difficult to build up without huge monthly payments. Many believe that it will be easier to buy property 20 years before retirement and then take all the rental income as a form of pension.
Brian MacManus of IIB Homeloans points out that housing is the only form of leveraged asset. After all, no banker will lend you the money to invest in the stock market but he will fall over himself to lend you the money to invest in property.
And the key advantage is that you get the return not only on your original investment but also on the borrowed amount.
For example, if you had bought a house for €250,000 in 1992 with an 80 per cent loan, it would be worth around €1.3 million today.
If you deduct the loan and costs of the sale, that would be €1 million, a return of almost 20 times your original investment.
In other words the €1 million appreciation in market value averaging across the 14 years is €71,000 a year, more than a 100 per cent annual return on the €50,000 down payment.
On the other hand, suppose you had paid €250,000 cash for that property in 1992, thus reducing leverage advantages to zero. The €71,000 average annual appreciation in market value would be about a 28 per cent return on the investment. And you would have tied up €250,000 in cash instead of just €50,000.
The sums work out even better if you are planning to rent out the property, although with rents levelling off this is more difficult than it used to be.
A rough rule of thumb may be that you would actually need to put down 40 per cent of the value of the property to ensure rent pays off the loan, not 10 per cent, thus limiting your upside somewhat.
Even if Irish house price growth slows right down the advantages of leverage are clear. For example, if house prices grew by 5 per cent on average for the next 10 years, a home worth €250,000 today would be worth €387,000. According to IIB Homeloans figures, if you had put down a 10 per cent deposit or €25,000, that would have grown to a net investment of €257,000 after 10 years.
A 40 per cent deposit would have grown to a net investment after mortgage owing of €301,000 after 10 years. These figures assume an IIB tracker rate of 3.25 per cent.
When deciding how much equity to put in and how much to leverage you need to consider how much rent you can realistically expect as well as thinking about how constant your own income is going to be and how much free income do you need to fund your lifestyle.
One way to really cut mortgage payments is to go for interest-only repayments, which can dramatically cut the cost of your borrowings. However, you will still have the full capital amount to pay off at the end of the term so unless this is a short-term strategy it may not be helpful.
In the above example an investor paying off the €225,000 loan would have paid back €77,000 in interest in the 10 years and €154,000 if paying back both interest and capital.
Of course it is impossible to forecast what property prices will be into the future. However, most experts say that assuming growth of about 5 per cent a year for a well-located property is reasonable.
At the end of the day if you pay cash and don't borrow or leverage, you miss out on the benefits when prices are going up and leave yourself open to almost unlimited losses in a falling market.
jsuiter@eircom.net
