How do rising interest rates affect the quality of property as an investment?

By Michelle Coleman

Ask The Experts Question of the Month: Subscriber J Wills asks..

“I am wondering if property investment continues to be a sound investment where interest rates get close to the capital growth rate? If I assume a capital growth rate of say 12% and interest rates get to 12% as well, do they in effect cancel each other out? I understand I have used a very simplistic approach here, but I am highly geared and I am getting a little nervous as interest rates creep past the 10 year average capital growth rate. Thanks :)”

Thanks for your Ask The Experts question. It is a very pertinant one considering the doom and gloom that is currently in the market place - both from a finance perspective and property market perspective.

Would you invest in property if interest rates are high and property isn’t growing?

If you were after short term gain then the obvious answer is no - especially when you add set up and exit costs BUT if you are in it for the long term, then that is another story.

Overall, what we talk about in our consultations in regards to your finance strategy hasn’t changed. In fact the current climate highlights the importance of having a robust strategy. Getting your property selection right along with having a contingency plan you are more than comfortable with including a solid buffer is vital to weather the storms or periods of not so attractive interest rates

It’s easy in times like these to lose a bit of perspective and forget that property investing is a long term investment, seven, ten, fourteen years…more even.

To get the most out of your investment you need to be committed for a few property cycles, not just a few years.

I’m sure you are probably familiar with the historical statistic that in Australia residential property doubles every 7-10 years. Now this doesn’t necessarily mean it will consistently grow 10% every year - there may be years of 30% growth or 5% growth but it should all average out in the end when you look at it long term.

By choosing the property well you will have a better chance of securing a property with a good track record and give you that long term growth. Below are the rules we use to choose a good solid investment property:

Golden Rules of property selection:

1. Land content should be greater than 40% of the whole property price, above 70% would be ideal;

2. At or around median price in the area, shouldn’t go over more than 50% of the median price;

3. Area should have increased in value with consistency by 3-4 times in the last 15 years;
4. Lenders will lend 80% low-doc without problems;

5. Go for high demand properties in well established areas, avoid mortgage sensitive areas;

6. Avoid luxury and specialized properties, avoid extremely low yield properties;

7. Properties you can add value to quickly to create equity;

The most important part of your investment strategy is your risk management strategy.

Having a comprehensive risk management strategy that you thoroughly understand will help you sleep at night if you are highly geared.

In edition to your income, the equity in your property portfolio is precious - you need to utilise this effectively through buffers and careful cash flow management to ensure that you can set aside a certain number of years of shortfall. It’s very important that when you get a burst of growth that you plan your next steps well and that’s ensuring that you have a buffer will last for periods of low or no growth.

Having a buffer is what allows investors to cope in these times of interest rates uncertainty. It is possible to cover the extra 3-4% that you may have to cover because of the economic environment with your buffer. It will weather you through this storm.

The only thing that I would strongly recommend at the moment is reviewing your risk management strategy and getting your buffer in place while you can - because even if you think you have enough, with the possible effects of the credit crisis it may get harder to access that equity this year. Whilst there have been some recently small slivers of light that indicate a possible of recovery - it could get worse before it gets better.

We still believe in the long term and that holding your properties for as long as possible to ensure the best result for wealth creation. Residential property’s average annual growth rate of 10% pa (meaning property prices will effectively double every 7-10 years) is what I plan for to get you through the good times and the bad times both personally as an investor and as a finance strategist.

So in light of the current market conditions I think that depending on where you are investing we are most likely to see slower growth over the short term than we have in recent times. With interest rates at a relative high level they are it is imperative to ensure that you have an appropriate buffer in place to get through this.

What is going to happen with rates?

Will they go as high as 12%? Most indicators and market commentary are saying no. Some are even predicting rates to come down as early as next year. My personal opinion is that they will go up again (maybe 1 or 2 increases of 0.25%) and then come down mid to late next year but of course there are no guarantees what the rates will do.

If you believe that they will go up as high as 12% you can look at fixed rates to give you some confidence of locking the fixed rate in now. You need to really weigh up the possibility of where you think the rates are going & make that bet. The banks are banking on you to get it wrong so they earn more profit.

The advantage of a Fixed rates is giving the customer the comfort of knowing the repayments and that is worth more than the cost savings to certain people. There are some good fixed rates out at the moment but I personally believe that they are on the high end of the scale and will come down to a lower rate. You should be ahead over a 3-5 year period by sticking with the variable rather than fixing it for the same term.

So to answer your question - to gauge the impact of the rising rates on your property portfolio really depends on whether you have a short term vision or a long term one with your investing. But if you have your buffer in place and you have selected sound properties I have no doubt that over long term you will find yourself ahead when you retire.

This article was written by Michelle Coleman, Investment Mortgage Strategist at Investors Direct™. Michelle is an active investor and has been an Award winning broker for 6 years. In 2006 Michelle was National finalist & State champion in the Choice Individual Number of Loans and Individual Dollar Volume categories. In 2007 Michelle was named Top Female in the National Broker of the Mortgage Professionals of Australia Broker of the Year awards (3rd overall).

This article is contributed by InvestorsDirect with the aim to help you become more knowledgeable in Property Investment. Visit their website for more detailed information

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