High LVR Investing: Less Skin, More Game

For first-time buyers, the property market is daunting.

It took me 2 years to buy my first place.

Between challenges like Loan-to-Value Ratio (LVR) and rising interest rates, it's easy to return from a crowded unit inspection in some swanky inner-west corner and feel discouraged.

But despite being a dirty word for a long time, leverage is still very much alive.

Understanding LVR and Leverage

LVR is the percentage of the property value your loan covers. A higher LVR means a smaller deposit, but also potentially higher mortgage repayments due to larger loan size and higher interest rates. Leverage, on the other hand, is the power of using borrowed money to amplify your returns. In property terms, it allows you to get on the property ladder sooner and benefit from potential future price growth with a smaller initial investment. In very simple terms, without taking much else into account, one can see how leverage works:

Leverage: Less deposit can mean higher returns.
Source: Cardinal Finance

Why leverage is a dirty word…

While leverage can be powerful, it's crucial to be aware of the risks:

• Interest Rate Fluctuations: Higher interest rates can significantly impact your repayments. Factor in potential rate rises when calculating affordability.

• Market Downturn: If property prices fall, you could end up owing more than your property's worth (negative equity).

The GFC in 2008 resulted in lots of pain and misery for households because of that last point. Lots of people learnt their lesson then, and it is important to not forget them now.

The (lending) market is telling us: game on

For as long as I can remember, any lending above 80% LVR (that is, where the loan size represents more than 80% of the purchase price) incurs lenders mortgage insurance (LMI). This is a one-time premium paid by borrowers with a deposit less than 20% that protects the lender if you default on your mortgage.

But there are ways to get out of LMI — such as being in the right profession, participating in the Federal Government’s First Home Guarantee and having a guarantor.

Even if one paid the LMI, it is normally capitalised in the loan, meaning you pay higher repayments, without the upfront cost. A common strategy is to pay the LMI and then refinance once the property value increases, enjoying a slightly lower interest rate.

Given my previous article about the Boomerang sale, Sydney real estate on average has gone up by 9% each year. This means a 90% LVR loan could get to 80% in under 2 years.

The more one borrows, the more the value of the underlying asset needs to rise to get to an 80% LVR. Source: Cardinal Finance

An example

With that said, let’s do some analysis:

Scenario: Consider a $1 million apartment. You could save a $200,000 deposit and borrow the remaining $800,000 — or just save $100,000 and borrow $900,000. The latter option incurs lenders mortgage insurance of around $25,000, which is added to the loan amount. Let’s assume a tax rate of 30%. I don’t take rent, operating costs and maintenance expenditures into consideration, which are real cash items and ought to be considered, but I have omitted them for the purposes of this exercise — which is only to demonstrate the after-tax effect of leverage.

In today’s market, the first scenario could get a loan at 6.3% and in the second situation, there are some lenders that are pricing ~6.5%. That’s a 0.2% higher interest rate for needing half the deposit. Is it worth it?

It all depends on how much property prices go up.

After 2 years and prices rising by 6% a year, the first scenario would mean just under $143,000 of equity gain (including principal repayments) and the second scenario $145,000. That is, more wealth generated in dollar terms with a lower deposit.

If we consider the time value of money and weight each interest repayment and include the tax benefit of paying interest (negative gearing), we can calculate an average annual rate of return for each scenario (also known as an IRR).

The IRR of scenario 1 is 7.8%, and the IRR of scenario 2 is 8.4%. However, this assumes prices rise by 6%.

Above a certain point, leverage can be your friend. Source: Cardinal Finance

As you can see from the chart above, you would need prices to increase by more than 6% on average each year for the added leverage to be worth it.

Conclusion

If you scrolled down here in half a second after glazing over numbers and charts, I don’t blame you.

But the numbers are important.

If something isn’t worth doing, why do it? If you wish to build wealth, leverage is a very powerful tool — especially if property prices are rising. How much leverage? I cannot answer that question. Leverage can work, but it can also go bad.

We can only find out by crunching the numbers and performing rigorous analysis to inform you. And that is something only the best mortgage brokers can offer.