Should You Stress Test Properties For Interest Rate Rises?
When looking at investing in property should you stress test that property in case interest rates rise?
Ryan: Glen is saying, “Do you stress test potential yields for interest rate rises? So in that year the 5% could dip quickly on a 50 plus basis point increase.” So yeah, basically you should definitely always, if you’re investing in a property, especially if you’re investing for cash flow, but even if you’re not, if you’re negative gearing, you need to be able to afford to pay all your expenses on that property.
You need to look at, can I still afford this property? Will I still make a profit, if the interest rates go up? If they go up 1%, if they go up 2%, all of this sort of stuff.
And you can so easily do that. I have a calculator at propertytools.com.au. You can go and check that out. It’s five bucks a month to sign up for that. And you can literally just, in there, you can just change it from 5% to 6%, it’ll do the calculation for you and show you the annual effect on cash flow and the weekly affect as well.
And do it up to 7%, 8%, and say, “At what point can’t I afford this property? What do interest rates have to go to for this property to be unaffordable for me?” And it might be 8%, it might be 9%. The more leeway you have, the better.
Ben: And the fact that the banks are currently calculating it principal and interest, 7.5% interest rates, probably says that you should be calculating it for the same way.
So if historical rates have been … people say they’ve been historically at 7%, it’s complete bullshit. Historical rates are somewhere between 5.5 and 6% over the last 50 years. They’re nowhere close to what people assume them to be.
But principle can take a rate from 5.5 to 7.5% very easily, and most people don’t work out what happens when an interest-only loan that you can’t refinance goes to principal and interest and the effect it will have on cash flow.
This is my gripe around just targeting cash flow as opposed to capital growth and cash flow, because as long as you own a property completely outright, a 7% gross return is a 7% gross return, give or take an expensive maintenance year. But buying properties purely for cash flow and not getting any capital growth, at some point the house is going to take you and it’s going to win because interest rates are going to rise above your costs.
And if at that time the property value hasn’t increased or you haven’t bought something that you can add some value to, you’ve effectively got 300k leverage tied up in a non-performing asset, which is absolutely death to your long-term position.
If that cash isn’t consistently growing, one way or the other, your long-term position is sliding in a very bad way and that’s why I really believe in capital growth, adding value to properties as well as cash flow. And that’s why personally I don’t do regional property anymore.
Ryan: Well, no. That’s another thing that people don’t talk about as well. If you’re getting growth in an area. There’s capital growth but there’s also rental growth as well that tends to … I don’t actually know if that lines up with capital growth but I’m assuming it would. If capital growth goes up, then rents will follow. Maybe not as quickly.
Ben: It moves like this. Like it’s always like an elevator moving ways, counterbalancing one way or the other.
Ryan: Yeah but that’s the thing. If you stress test your property, and interest rates are going up, but if you do what we always recommend, and you’re not just going for cash flow, you’re going for capital growth as well, or manufacturing growth, then you want to be getting rent increases as well, on a consistent basis, to improve your cash position as well.
So then hopefully a few years down the line, if interest rates do go up, your rent’s gone up as well, so that can help to cover that.
Ben: Absolutely. When I’m doing my numbers in my own little spreadsheet, I look at 7% interest rates, and I look at a 3% gain per year in rental returns, and obviously 3% doesn’t consistently occur.
It might be 30% in one year, and nothing for ten years. But at some point or another it adjusts, especially when interest rates start rising significantly, or finance becomes too difficult to access.
Ryan: Yep. And so, yeah. Definitely stress test your properties. Look at a whole bunch of different scenarios and get yourself prepared.
Ben: [inaudible 00:04:08].
Ryan: Hey guys, I hope that you enjoyed the answer to this question, which came from a live Q&A episode with Ben on YouTube. We will be doing more of these in the future.
If you want to check out Ben, then he is offering free strategy sessions to On Property listeners. To find out more about that, go to onproperty.com.au/session, and you can see all the details over there. That’s it for today, and until next time, stay positive.