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Get ready for interest rate hikes

Friday, January 13, 2017

With interest rates having remained suppressed for as long as they have, chances are many investors are not entirely prepared for the coming rate rises. And rise they will. There is nothing sinister or extraordinary happening.  The same economic entropy that has been pushing the rates down for so long is also responsible for nudging them upwards in recent months. And it is happening right now.


The effects interest rate has on your portfolio

It only takes an increase of a few basis points to topple a badly-strategised portfolio.

Let's take a look at a rough example. The Auckland median house price is currently $799,000*. Say for example you buy a property at that price financed entirely by a loan at 5.34%** (many assumptions made including using the equity of your own home to secure the loan). Your annual interest expense is $42,667. Every basis point increase will cost you an additional $80 a year. What would a whole percentage increase look like? If by this time next year interest rate is at 6.34% (which is still on the low end of the spectrum), you will have to find another $8,000 (or $154 more in rent per week) to afford the loan. So while rates are still relatively low and your buy-and-hold strategy is enjoying a great cash on cash return, it is time to start thinking about what to do when rates go up.

What happens when rates go up? 

Here at APIA, we encourage investors to develop a range of skills and crystal ball gazing is not one of them.  So, for the time being, we will leave any discussion about price point movements to the pundits.  That said because the market in the last few years had encouraged short-term FOMO investing, we are expecting the higher rates to gradually push out the short term flash-and-dash investors once the easy property money is not that easy anymore.  When you see a whole bunch of people dumping their portfolios, it is very easy to get sucked in and start panicking yourself.  Don't.  So long as you see the low-interest rate now for what it is (that is a fleeting moment in the market cycle) you will be able to prepare for rising costs without giving up on your portfolio.  

Some tips to help you prepare for higher interest rates

1. Charge the appropriate amount of rent - (Very) generally speaking, rates rise alongside the economy. Sure, the cost of borrowing money has gone up but so has the demand for rental accommodation. Demand, in turn, affects price. Chances are it will be easier during high demand periods to upward-adjust your rent (in line with the market). Seen in this light, you will realise that when rates increase, it is not all doom and gloom. Learn to look at interest rate increases in its entirety and strategise your portfolio accordingly.

2. Find out why the rates are going up - When you discover the reasons behind interest rate movements (upwards or downwards) it becomes easier for you to predict how much and how quickly they will move by. You will be in a position to plan your finances more definitely.

4. Buy at the right price and always stress test a deal - Many novice investors make the mistake of maxing our their borrowing capacity for no reason other than that they can. Learn to properly analyse a deal, not just from a cost and return perspective but stress test the deal on a higher interest rate that what you have now. When you invest on a buy-and-hold strategy, a deal is only as good as the years you can hold on to the property for.

5. Leverage appropriately and invest with cash if you can - Sure leveraging is one of the key advantages of investing in real estate. But excessively leveraging makes you extremely vulnerable to interest rate hikes. When it comes to financing a deal, act according to your risk profile. If you are low risk tolerant, consider putting in more equity/cash from the outset to minimise the impact of interest rate fluctuations on your portfolio.

6. Refinance and lock in favourable rates - Don’t just accept the advertised bank rates. Take advantage of the offers you are entitled to (such as the guaranteed 0.25% discount on ANZ rates for APIA members) and learn to negotiate for more favourable terms. Relationship is a banking currency, if you are a valued customer then your bank will bend backwards to help you achieve your business objectives.

7. Put a cash buffer aside - A cash buffer (either actual cash or a revolving credit facility) gives you some breathing space to cope with increased expenses.  Be disciplined with your buffer and give yourself strict parameters on when and how you can tap into that fund.  Remember, a buffer is not there to add to the comfort and pleasure of your life now, it is there to help you ride through the tough times.  

Have you been anticipating and planning for interest rate hikes?  What else are you doing now to get ready for the more expensive future?  Share your tips below!

* Figure sourced from QV

** Figure derived from current ANZ advertised floating mortgage rate of 5.59% p.a. less guaranteed APIA discount of 0.25% 




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