When you own property, whether you live in it or rent it out to others, you love to see the value of it rising. That’s because your equity (or share of the value) rises by the same amount.
There are only 2 ways to increase your equity in a house; by paying off some of the debt (the home loan) or by the value of the house increasing. Of course you can’t actually use that equity unless you sell it or borrow against it to buy more property but it certainly makes you feel richer.
That’s the reason that so many people want to own property in areas of rapidly rising values. Unfortunately it is also the reason that many people make stupid buying decisions.
Rises in values or capital gains as they are often referred to have been a certainty in the long term in New Zealand but they are much more of a gamble in the short term. House prices do go up, down and sideways in unexpected patterns. That’s ok if you are capable of waiting out an unwanted trend by buying long term but it can be a problem for short term buyers.
This is because rapidly rising values lead to rapidly rising loan amounts and to the necessity of finding more income to meet the repayments.
This situation is often experienced by investors whose rental income is insufficient to meet the outgoings so they pay part of the outgoings from their personal income. Some even decide to use interest only loans to reduce their outgoings. They are often very focused on the effect of capital gains on their equity and overlook factors which can impact their position in a very negative way.
There are 2 types of factors that can occur here; external and internal. The global financial crisis was an example of an external factor which had huge impact on New Zealand. Internal factor examples include interest rate rises, job losses and family changes.
When an investor is negatively geared (outgoings are higher than rental income) then if there is a time period when values go down rather than up the banks may restructure their lending and they may require those borrowers to reduce their debt with a large capital injection. In other words you may be asked to pay back a percentage of the loan immediately. It has happened to investors in the past.
So what other option do you have if you want to buy an investment property? Well, many wise investors buy based on yield or the return they get from their rental property. They pay a deposit as well as using their equity to finance it and use principal and interest loans. They ensure that their equity in a property is high enough to ensure that if values go down their bank will still be comfortable with their lending.
These investors buy in locations where the capital gain may be smaller but the return is better so they are more comfortable in the short term and still enjoying growth in the long term. And it’s because of their strategy that they can afford to hold them long term.
You need to decide if you will gamble on short term gains or accept slower, long term gains with much less risk of it disappearing. It comes down to your risk profile, personal situation and financial stability. Most importantly, seek professional financial advice rather than following a plan just because it looks like everyone else is doing it.
Advising Auckland property buyers