Will interest rates hit 10%?
Let me start by saying I’m sure that at some point in my lifetime interest rates will return to the dizzy heights of 2007/08 and hit about 10 per cent per annum. But rest assured it won’t be happening any time soon. The indicator that I look at to determine where interest rates are heading, and in what timeframe, is typically a three-year fixed rate offered by the banks.
A quick snapshot of most fixed rates on the market today will have a three-year fixed rate at approximately 4.7 per cent per annum. Make no mistake, while this sounds cheap and banks like to promote fixed interest rates because it gives them certainty, and brokers like to promote them as they’re guaranteed their trail commission for that period of time, they’re not providing these rates by way of charity.
Banks are billion-dollar corporations, making billion-dollar profits for millions of their shareholders and they’re making substantial profits on these products. So, while it’s really easy to get caught up in the “will interest rates rise in 2016?” debate, it’s important to realise that while interest rates might go up, they won’t be going up rapidly and they won’t be going up by a lot at least in the near term.
While the purpose of this column isn’t to predict interest rate movements, it is designed to inform all of you out there whose heart skipped a beat when you read the headline. It’s designed to help you understand what drives interest rate movements, what that means for investors and how you can protect yourself.
In my 13 years involved in the property industry, without doubt the number one concern I’ve seen investors have relates to dramatic increases to the interest rate. This fear typically comes from owner-occupiers who had mortgages in the late 1980s when interest rates were around 18 per cent per annum.
For those younger investors out there, just ask your parents what it was like!
While that had a massive cash flow impact on any owner occupier with a mortgage, it was a very different scenario for investors. To overcome the fear, it’s even more useful to understand the cause and effect relationship of why interest rates rise, because that’ll give you some perspective to allow you to continually invest with confidence.
CASH FLOW CONSIDERATIONS
Let’s start with cash flow. There are three sources of income that contribute towards holding costs for most investment properties. The majority of the holding costs are covered by the rental income. Tax benefits also provide some cash flow and in some cases there will be a small out-of-pocket holding cost. When interest rates rise, landlords pass on some of those costs to the tenants by increasing the rent.
When rates increase, you obviously pay more loan interest, which gives you greater deductions and therefore greater tax benefits. So, while there’s no doubt that you’ll see a small increase in the holding costs with an investment property if interest rates rise, it’s not nearly as dramatic as you might think, given that rents increase and tax benefits increase as well to lessen that burden on your cash flow. The smarter you can be with what you buy to maximise the rent and tax, the more you’ll reduce your out of pocket exposure.
But personally I love it when interest rates are rising.
Something else that’s important to remember is that interest rates don’t go from five per cent to seven per cent and beyond overnight. There are small incremental increases that happen over an extended period, which allows you to build in these cash flow buffers and increase rent systematically, to continue to minimise the out-of-pocket impact on you, the investor.
So, while this gives you some peace of mind that there isn’t going to be a major cash flow impact should interest rates rise, fear simply comes from a lack of knowledge.
More relevant is an understanding of the direct cause and effect relationship behind why interest rates rise. This is fundamental knowledge for any property investor.
WHY DO RATES RISE?
When the economy is in a growth phase interest rates increase and when the economy is in a tightening phase interest rates will fall. Therefore, low interest rate environments are fantastic for maximising your borrowing capacity and being able to hold property with a minimal holding cost, at worst.
But personally I love it when interest rates are rising. The reason for that is rates rise due to the economy moving in a positive fashion, which is the result of several factors. To name a few, spending and consumer confidence is up, so is job security, with unemployment down, wage growth is up and all of these factors lend themselves to an environment where owner-occupiers buy houses because they feel stable in their jobs.
It’s fundamental to understand that interest rates rises are the effect, caused by these positive behaviours occurring.
Interest rate moves aren’t predictive of what’s going to happen in the economy at any time. We can anticipate with some confidence when interest rates are going to rise, based on the available data and be able to protect ourselves against that.
If owner-occupiers are buying more houses and spending more on them, and fewer investors are buying property because they’re worried about the same things you were worried about when you saw this headline, that has numerous positive effects on those that are already in the market with an investment property, namely prices being pushed up, so we’re creating
equity for the small amount of money that we have spent out of pocket.
I’m more than happy to have a $50 increase in my holding cost per property if it means that I’ve created tens or hundreds of thousands dollars of equity in a reasonably short timeframe.
Take Sydney, for example. In 2011, if I’d said to you for $100 a week, you could hold a property that could grow by $300,000 or $400,000 in value in the next four years, that would seem like a good investment. What that does is create equity, whereby if the cash flow increase that we’re hypothetically experiencing due to interest rate rises is prohibitive, we have equity there that we can borrow against to increase our buffer.
In low interest rate environments, while properties pay for themselves, there’s more competition among buyers and there are fewer renters as those with marginal borrowing capacities can actually achieve finance approval based on more favourable servicing calculators and, as a result, greater vacancy risk.
So, like most things in life, don’t judge a book by its cover.
Understand what drives interest rate increases and embrace it knowing your investment is growing in value, but as always protect your cash flow in the process.
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