Saturday, 14 May 2016

For Your Interest-Only

"Buy a house. Say, a hundred thousand. No money down, interest only loan to keep repayments low. Rent it out. Claim the loss on tax, that's negative gearing. Ten years later, sell it for double. Boom. You've made a hundred thousand out of nothing."

I would love to pick this Australian dream to bits.
"If he mentions negative gearing one more time ..."

I would love to say that you needn't feel like a coward for demurring on a scheme that seems too good to be true.

But the math checks out.


Think twice 007, it's a long way down.

Interest payments should not be underestimated. In Australia at least, they will run into the thousands, even if offset by rental income. That's thousands that must be sustained with sufficient alternative income for ten years.

We assume letting out the property will not completely cover interest because gross yields are lower than rates. Furthermore, from my experience, net yields average around 60% of gross yields due to vacancies, maintenance, and other expenses. Then again, the greater the loss the more you can claim on tax, right?

Negative gearing - where investment losses can be written off against personal income and not quarantined to investment income - will only refund you a maximum of 38 cents to the dollar, and doesn't change the fact that you're making a loss.


The fantasy you freed in me

Doubling over ten years implies a growth rate of 7.2%. This bears limited resemblance to statistics. Only two of eight Australian capital cities - Darwin and Perth - averaged above that rate between 2004 and 2015. The national weighted average rate over the same period was 5.24%.

Naturally, the property you choose will be well above average, but it will have to be exceedingly so to beat the average discounted lending rate over the period of 6.33%. It makes sense that banks would charge more than homes appreciate. Homes can yield additional gains through rent, and if house prices consistently grew faster than interest, banks would flip property directly instead of relinquishing that opportunity to the hoi polloi.

You won't need to read between the lines

Let's model this. Assumptions:
Borrowing interest6.33%
Growth rate5.24%
Gross yield3.80%
Net yield of gross60.00%
Buy/Sell costs2.00% per transaction
Which gives us the following cash flow over a ten year investment period:

So at that MIRR - Modified Internal Rate of Return - the money has been little more than doubled, but not materialised out of nowhere. Over $40,000 will have been sunk in.

These variables also do not favour gearing. A more conventional 80% LVR will achieve a 7.56% return, and perhaps negotiate a better interest rate.

The odds favour standing pat

If $4,050 per year were simply invested at the same growth rate plus net yield, the same overall rate (7.52%) would be achieved, with a slightly lower final figure of $57,866 to go with the much lower transaction costs. Though if the ten year ASX average to 2013 of 9.1% were used, returns would be $62,423.

Ultimately, there is nothing flawed about the no-money-down interest-only dream, apart from that in most tellings, the downside is glossed over, and the upside exaggerated. You can achieve similar returns with little outlay and regular saving. After all, that is the core of the initial scheme, but re-framed as forced repayments of huge long-term debt, in a story of deal-making derring-do that is far more likely to hold a listener's interest.


  1. Australia is heading for a once in a century economic downturn as its housing bubble (and likely banking sector) collapses. The country has nothing but low margin red dirt and overpriced housing; all the other trade exposed sectors were annihilated when AUDUSD went over 0.75.

    Now Oz has the highest household debt to GDP ratio in the world, and the 3rd highest foreign debt to GDP ratio.

    If you want to see the near-term future of Oz, look at Michigan and Florida in 2009. Maybe with a bit of Ireland thrown in.

    1. Great points.
      You're spot on about Australian household debt to GDP.

      As for Foreign debt to GDP:

      Naturally, interest-only speculation on capital appreciation will be unprofitable during a bursting property bubble.

      This is because downturns require time to recover (a la U.S. and Ireland); time which a leveraged speculator haemorrhaging money may not be able to endure.

  2. Oops... apologies for the wrong second factoid. Always check your sources.

    Plus there's another risk for Johnny Foreigner: exchange rate risk. I'm betting on further AUDUSD declines.

    Anyhow, interesting times.

    1. Actually, you were quite accurate with the Foreign debt to GDP as well... for economies that actually matter :).

      Because of the long time frame, I think exchange rates are less of a disadvantage to foreigners than discriminatory regulation or tax treatment. A stronger USD would make paying that interest-only loan cheaper.

      That said, there are far less complex and more prudent ways for a USD based investor to conduct foreign investment.