Oh Property!

Property, it is the most commonly perceived "good" investment. I have just finished reading 47 Biggest Mistakes Made by Property Investors and How to Avoid Them by Helen Collier-Kogtevs and the book drips with a bias but it does have some interesting points.

The bias is common among Australian's who have seen a large appreciation in their residential property over the past 20 years. Helen in her book mentions many times a 15% return or that property typically doubles every 7 (10.4% per annum) to 10 years (7.2% per annum) plus net rental yields of say 2.60% which implies an expected yield of between 9.8% to 13%. This return over the long run is unsustainable, if someone can explain to me why property can appreciate at such a rate, almost double that of the median wage increase, I would be happy to listen. Essentially, people are wage earners and their wages pay for the rent or mortgage repayments, if the wage appreciates at a lower rate to property value, of course the prices will eventually get to an unsustainable level. Property is only good for an investment so long as people can afford to live in the area.

Despite this common bias, Helen does have some good points, namely:

• negotiating: Helen suggests aiming for a 10% discount and the discount can vary between 5 to 20%
• balancing the portfolio with negative and positive cashflow investments

These two points are significant. The first highlights one of the things I like about property investment the ability to negotiate, the only thing that you may get is a "no", the best possible outcome is a "yes". There are few other places where you are free to negotiate in such a way, I would love to be able to offer a stock holder a 20% discount for their shares. This used to be possible in unsolicited offers however ASIC has cracked down on that, and for good cause. Whilst I would love it, I know that it is unfair to the seller in a liquid market to accept anything than the best possible price. With property, the market is much less liquid and so negotiating becomes a fair and reasonable expectation.

The book also highlights the ability to borrow, while borrowing is great, one should prepare for the worse. Australia is certainly a lucky country but if you look over at countries like America, you can see the pain of too much debt. The only thing between a negative and positive cashflow investment is the amount of equity you put up. Helen agrees that the property portfolio should be balanced, this way, the investments as a whole are not taking cash out of your pocket.

Another interesting thing about property which wasn't covered in the book is that it is a mixture of two time frames, firstly, the land which is perpetual in nature and secondly, the building which decays, dates and depreciates. To be honest, the only appreciation should occur with the land, the building itself is a money drain (although rental income helps stem the tide).

So while I am not a huge fan of borrowing to the hilt to buy property there are a few key points that I like about property:

• Leveraging: the ability to borrow up to 95% of the value of the property is extremely attractive, I would suggest that the prudent buyer has atleast 20% of the equity and borrow 80%, there are significant savings as Lenders Mortgage Insurance (LMI) isn't required if you have 20% equity in the home. Also attractive is the significantly low rates of interest that one can borrow at and strategies that you can incorporate for tax purposes including tax deductions and an interest offset account.
• Cashflow: the property pays a weekly income of rent, this is attractive, particularly to retirees and I would suggest that property should be considered as part of a retirement strategy
• Negotiating: as mentioned, property is one of the only investable asset classes that are illiquid enough to be able to have some power in negotiating

What is the rate?

Owl Rating: Owlet

Interest rates are one of the most well known numbers in finance. People see them offered for term deposits and other cash investments, they see them on their mortgages and it is widely covered by the media.

However, despite this, there is sometimes confusion about the underlying interest rate. The Reserve Bank of Australia (RBA) sets the interest rate at a meeting on the first Tuesday of every month (except for January). This interest rate sets a benchmark for all of the other interest rates in the market. Generally, financial institutions will need to move their interest rates in the same direction and by a similar magnitude as the RBA. Why the financial institutions need to do this is beyond the scope of this article however if a bank decided not to cut interest rates, other banks will force it to cut interest rates by cutting theirs (and competition brings the market down).

So the question often asked by people is where I can see interest rates in the next twelve months. In no way is this an exact science but we do have a few guiding principals:

• The inflation target for the RBA is between 2 and 3%
• If the above target is met, the RBA will consider the general economy

If the economy is going very well, inflation picks up and so the RBA will raise interest rates to keep the inflation rate in check. By raising interest rates, it reduces the amount people want to borrow and also their disposable income (on floating variable mortgages). When the economy is not going so well, the RBA will cut interest rates to make people consider spending more (larger disposable income and lower rate of borrowing).

Interestingly, the central bank (the RBA is just one of the global central banks) in other economies where a majority of mortgages are fixed (i.e. set interest rate), this tool becomes less effective than it does in Australia where a larger percentage of mortgages are variable. In the US, a fixed mortgage for up to 30 years is actually quite common.

Finally, the inflation rate has a lag, that is, we aren't seeing the inflation rate today but the inflation rate a few months ago so once again, some judgement is needed. The RBA website (http://www.rba.gov.au/) contains the most recently recorded inflation rate on their home page. If you see this number up in the high twos or over three, you should expect interest rate rises. 

Cake it and Eat it

Owl Rating: Owlet

Savings, it seems to be something that people, even people in debt want to have. It is understandable to have some level of savings for emergencies and the like. Generally, I like holding around three month's worth of salary as savings, this way, I can obtain 90 day waiting period personal protection insurance thereby lowering the premium of the insurance while still being prepared. In any case, three month's worth of salary as savings tends to give a healthy buffer in the event that life interrupts with your plan.

The problem is, people with debt should not have savings unless of course their return on savings after tax are greater than their return on debt. Remember, it is advisable that someone has some level of savings, it is a typical case of having your cake and eating it too. However, in finance, it is possible to have the cake and eat it as well. The solution is in the form of mortgage offset accounts for mortgages, some personal loans allow redraws as well.

Mortgage offset accounts:

A mortgage offset account is an account that runs concurrent to your mortgage. Suppose you have a mortgage for $150,000 and have $20,000 in the offset account. This would effectively reduce your mortgage to $130,000 on which you will pay interest. When seeking a mortgage offset account, see something that:

• has no balance limit
• where the total balance is offset, that is 100% mortgage offset
• has an equal interest rate to your mortgage

Another thing that you really should pay attention to is the difference between the interest rate for a loan with a mortgage offset account attached and a basic variable loan (for which an offset account cannot be obtained). Sometimes the difference can be 0.75% or more which is significant over the life of the loan and certainly reduces the benefit of the mortgage offset account.

Advantages:

• you pay tax on your interest earnt at your marginal tax rate, with a mortgage offset account, you do not pay tax on the interest savings, it is in effect, a tax savings
• you save on interest, suppose the example I gave of $150,000 has an interest rate of 6.50%. Without any offset, you would pay $153,843 in interest over the course of a 25 year mortgage, with the $20,000 offset you would pay $133,330 over the term of the loan, significant savings by all accounts.
• you can deposit all excess funds in the account knowing that you can withdraw at any time. This means that the above interest savings can increase even further by depositing your salary into the account and just withdrawing what you need to live on.

Disadvantages:

• Not really a disadvantage, but discipline is required, once the mortgage offset account gets very large, it becomes tempting to tap into it to increase your lifestyle
• Time-consuming, this is perhaps one of the biggest factors with a lot of finance, it is considered time consuming to shop around for products to find the most appropriate one

In short, the right mortgage offset account can provide significant benefits to you. The key thing is to look into the products carefully and factor in the differences. Loans which allow a re-draw are fairly similar to a mortgage offset account loan. A simple calculator that I created to compare a standard mortgage, standard mortgage with an offset and a basic mortgage can be downloaded here. 

Credit Crazy or Credit Cluey

Owl Rating: Owlet

Credit, it has been known for a long time as a dirty word, many suggest cutting up credit cards and when I say that I love credit cards, I always receive strange looks.

So why do I love credit cards? Well there are a few reasons but the key is, the credit (provided it is structured right) which can be the closest free lunch that any economist can find. The secret to using a credit card correctly is to always have the funds in your bank account, that is, for every dollar that you put on your card, ensure that you have a dollar in your high interest savings account. This way, you receive interest on the funds that you have in your high interest savings account and you don't pay for the credit that you are using.

This may sound too good to be true but I can assure you that it is. You do need to ensure that your credit card has a two key characteristics:

• Annual Fee: there should be no annual fee on the chosen credit card or you should be able to spend enough to have the fee waived. If there is an annual fee, it will take a significant bite out of your free lunch.
• Interest Free Days: this is the number of days that it takes before you start paying interest, the greater number of interest free days, the better, typically this is 55 days.

So the key to the success of this strategy is to pay the credit card balance owed every month which should show on your statement.

Lets suppose that a couple spend $2,000 on a credit card each month, I am sure the interest rate on such a card would be in the double digits, maybe 17% or more, however, this particular card offers 55 days interest free and no annual fee. Over the course of the month, the couple keep $2,000 in their high interest bank account earning 4%, they can hold it in this account for up to 55 days before repaying the credit card (it is vital that they do repay it on time though!). So in summary, they would spend $24,000 every year, repay every 55 days or around 6.6 payments per year. This means that they would have around $3,600 in their high interest bank account for every day of the year. So the total free lunch? $144 in this particular instance. Sure, it isn't that significant however it will certainly buy you lunch!