Just to recap, in my previous post, I discussed the risk of additional cooling measures for the property market, which I think is low due to the demography of the people who are actually pushing up the housing prices here. In this post, I shall discuss leverage and interest rate risk.
Risk 2: Risk of US-style housing defaults due to falling prices
A primary cause of the housing crisis in the US is the high leverage that homeowners there have on their property. Leverage means the use of loans to finance purchases of assets. Leverage is good in the sense that you’re using OPM (Other People’s Money) to buy your property, which can significantly increase your return on capital. It also allows you to borrow money cheaply against your home’s equity. However, using loans requires you to pledge your property to the bank as collateral, and in the event that market value falls way below the loan amount, then the bank has the right to ask you to pay down a portion of your outstanding loan. If you were not able to comply, the bank has the right to take over your property and sell it in the market to recover their loan. Although you will get any excess after the bank and CPF board are paid, the amount is typically very little, if any, since this usually happens at the worst time when the market is down. Buyers of such properties are looking to buy at fire-sale prices, and the bank’s main concern is to cover their loan, rather than to try to get a good price for the property, so transaction prices tend to be low.
Clearly, the less money you borrow to buy, the lower the risk of the bank coming after you. For example, if you bought your property for $1 mil and borrowed $600k to buy it, even if the price should subsequently fall to $800k, the bank will still be comfortable since their loan is covered adequately. In contrast, if you had borrowed $800k, the bank may then call you up for a top-up of $160k to get the LTV to 80%. If you were not able to pay down the loan, the bank has the right to withdraw the facilities, and liquidate the asset to recover their loan. Of course, although they have the right to do so, typically they won’t do it as long as the borrowers are able to continue paying the monthly payments, but there’s a definite risk of this happening.
In order to reduce the risk of mortgage defaults, the government has reduced the maximum loan amount to 80% for the first property (Round 2 of cooling measures), and 60% if you have existing residential loans (Round 4). With such low leverage for second and subsequent properties, the risk of default is rather low, even if the market should dip significantly.
Risk 3: Risk of increasing interest rates
Another risk associated with borrowing to buy property is that interest rates may rise, and increase the monthly payments on the loans. This is significant risk as current interest rates are abnormally low, and may not continue for very long. If people are not prepared for increasing interest rates, it may lead to inability to service loans in the future.
To illustrate how much interest rates can affect your monthly payments, let’s consider a $1 mil loan with a 35-year tenure. At current rates of 1.20%, your monthly installment is a very affordable $2,917. If rates were more consistent with the historical average of 3.50%, your monthly installment increases significantly to $4,133. If it changes by this much, you can see how interest rate changes can transform your cash-positive rental property to a cash-negative one.
So, that being said, how likely is the interest rate going to go up? 100% guaranteed, absolutely, definitely, confirmed, stamped and chopped. The question is when. There’s a long answer in which we discuss how interest rates are determined and the economic situation and come to a conclusion, or the short answer in which I tell you what I think. In the interest of time (and perhaps your sanity), I’ll just give you the short answer. Singapore interest rates generally mirror that of the US and the US has promised to keep their rates low for at least the next 2 years in order to help their economy to grow. Barring a international crisis where banks refuse to lend to one another, the interest rate looks to be low for at least the next 2 years. However, when the world economy recovers, it should go up pretty quickly, so the property investor should really take it into account and try to work in a nice buffer into your cash flow calculations.
In my next and final post on this topic, I shall discuss the issue of demand and supply of new homes and how it will affect prices.