Borrowing to invest in property

BY MARY HOLM

Q: You note in last week's column that over five years your correspondent made $20,000, or a "reasonable" 7 per cent per annum, on his original $40,000 investment in a $105,000 residential rental property. However, this required him to take on a $65,000 borrowing risk.

Based on the total original property value of $105,000, this $20,000 return represents a capital return of only 3.5 per cent per annum on the total property value.

Was the return of $20,000 on the original capital of $40,000 adequate for the $65,000 borrowing risk? Selling costs will reduce the return further.

As the investment was made five years ago, I checked the New Zealand Government Stock rates available in February 1997 on the Reserve Bank web site, as a proxy for bank deposit rates.

Accepting that any returns from Government Stock or bank deposits would be taxable, I was intrigued to note that your correspondent could have invested risk-free for five years in New Zealand Government Stock at 7.25 per cent pre-tax at that time.

I bet your correspondent, the mortgage lender, the lawyer and the real estate agent advising your correspondent never even considered the alternative, or recognised how close the two results could be.

For me, with hindsight, the property return achieved is not sufficient to justify the extra risk taken on.

You make a valid point.

We're so used to borrowing to buy property that many of us don't stop to think that borrowing to make any investment raises the risk.

It's true that, if the investment does well and you've borrowed, you will do even better.

In last week's case, the man's return has been 7 per cent a year. As you point out, if he hadn't borrowed, it would be only 3.5 per cent a year.

But if the investment had done badly, he would have been worse off because he had borrowed.

Let's say the value of the property fell from $105,000 to $95,000.

Without a mortgage, he would have lost about 9.5 per cent of his investment. Offsetting that, he would have received the excess of rental income over expenses for the period.

With his mortgage, he has paid off $5000 off the loan over the five years, so he still owes $60,000.

If he sells for $95,000, he'll keep $35,000. His $40,000 of original capital has dropped 12.5 per cent.

What's more, his expenses now include mortgage interest. He said the excess of rent over expenses is negligible. So his total loss is considerably bigger than if he were unmortgaged.

The difference between mortgage and non-mortgage scenarios can be much bigger, too, if:

* You borrow a bigger proportion of the total price.

* Your rental income doesn't cover all expenses, including mortgage interest. Even if you sell for more than you bought, if you've been putting money into the investment over the years you can still make a loss overall, or only a low return.

Any investment in which the amount borrowed is close to the total price is pretty risky. If you may have to make further contributions to keep the thing afloat, it's even riskier.

* Mary Holm is a freelance journalist and author of Investing Made Simple. Send questions for her to Money Matters, Business Herald, PO Box 32, Auckland; or e-mail: maryh@pl.net. Letters should not exceed 200 words. We won't publish your name, but please provide it and a (preferably daytime) phone number. Sorry, but Mary cannot answer all questions, correspond directly with readers, or give financial advice outside the column.