Property investors highly exposed to interest rate rises

By Martin North, cross-posted from the Digital Finance Analytics Blog:

Continuing our series on potential material risks within investment loans, today we reveal some of the analysis we have undertaken on the potential impact on investors of prospective rate rises using data from our household surveys. We framed the questions here around how large a rise could an individual household cope with before getting into financial discomfort. We considered scenarios between zero and 7%. The overall results are startling. We found that about a quarter of property investors said they would have difficulty meeting any additional interest rises – even 0.5% – implying that they are already under financial pressure. Others could cope with various rises, though more than 50% of investors would be in potential difficulties should rates rise by 3%. On the other hand, more than 30% of investors were able to cope with a significant rise, even above 7% from current levels.

InvestmentSo which households are most exposed? We start by looking across the DFA property segments. We found that 20% of first time buyer investors would be concerned by any rise, whereas more than 40% for portfolio investors (who are more highly geared) and a considerable proportion of people who traded down and geared into an investment property recently would be caught out. Others, such as those refinancing, or holding property appear to be more able to swallow potential rises.

Sensitivity-By-Pty-SegmentThe size of the loan portfolio has a bearing on households, with the average portfolio investor having a balance of over $750,000 in investment property (some much more) so would be more sensitive to rate rises..  We conclude that generally households with smaller investment loans are (perhaps obviously) a little more able to cope with potential rises.

Sensitivity-By-Loan-Value-INVNext we cut the data by states. Here we found that investors in TAS were most concerned about potential rate rises, followed by SA and ACT. These are states were income growth (and property appreciation) is slowest. On the other hand, investors in WA and NT appeared more able to cope with significant rises

Sensitivity-By-State-INVFinally, we examine the data by our core household segments. Here we found that wealthy seniors were the most exposed (incomes relatively flat compared with their investment portfolios), followed by stressed seniors and young affluent.

Sensitivity-By-Core-Segment-INVOf course, if rates were to rise – perhaps this is not likely in the near term – investors have the option of selling up, but the analysis shows that some would need to act quite fast in a rising rate environment. It also raises the question as to whether the banks underwriting criteria are working – because they should be assuming borrowers could cope with a rise to above 7.5%, which is 2-3% higher than most are currently paying. Our research suggests that some households are geared up to the hilt, and have no spare cash for unexpected raises down the track.

Next time we will add in the impact of owner occupied borrowing also.

Leith van Onselen

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  1. ” wealthy seniors were the most exposed…. followed by stressed seniors…”
    That’s what happens when you take away the income needed to survive in old age by dropping interest rates and force asset risk onto the very people that should not have it. It looks good when capital gains allow more borrowing to put the food on the table, but if or when that reverses, not only is there no food, there is no table, and there will be one almighty call on The State to provide both. Well done RBA and Co….

    • But not just wealthy seniors, how much extra in pension does the taxpayer pay out becasue a pensioner who had cash in a bank account is getting less interest, after a income means test.

      • Along similar lines, how long before some of the old defined-benefit pension funds run out of money? They seemed like a good idea when we had a shorter life-expectancy and double-digit interest rates.

      • So far as I know, the income test has a deemed income from financial investments provision for exactly this reason. So the answer is none. The state doesn’t pay out more in social security just because a pensioner isn’t earning as high a return as they once were.

        Although admittedly, it’s possible that with less interest coming in, pensioners might have to dig into their savings. In this case, their deemed income will decrease and the pension will increase. But this would not be significant.

    • That’s what happens when you take away the income needed to survive in old age by dropping interest rates and force asset risk onto the very people that should not have it.

      And herein lies a key problem – Unlike scary sharemarket, property investment is regarded as “risk free”, barring bad tennants but there’s insurance ‘eh?

      Nonsense ideas like falling prices or falling rents are just talk of renter internet weirdos who don’t know that in Australia property doubles in value every 7 to 10 years and because of the good capital gains rent going up is of course better (unless you’d rather lose more money just to get more tax back…) but rental yield is no biggie in the big scheme of things.

      See, what risk? Happy retirement everyone!

  2. This article is a must-read for all property investors and housing commentators.

    When I was speaking to a mortgage broker a few years back she told me that all borrowers should allow for a 2% rise in interest rate on their loan (ie 200 basis points).
    I said that previously interest rates have been much higher than “current” + 2%. What makes her so sure they cannot go back that high?
    The answer: In earlier times people had much less debt. Now that they have so much more debt, interest rate rises affect them much more severely. Therefore the reserve bank would now get the same effect on the economy with a 2% rise, that it earlier needed much higher interest rates to achieve. Therefore higher interest rates will not be necessary to slow the economy and will never happen.

    • Sounds plausible. I mean that three week in house course she did would more than qualify her as monetary policy expert. Then again she’s probably no worse than your average bank economist.

      • Yeah I remember having a 35000 loan capped at 13.5 and a mate went out and got a investment home loan fixed at 18 % for 2 years.
        Yeah the good old days 🙂

    • Pretty sure a thread here (MB) somewhere showed the banks on av get 40% of their funding o/s, so how does the RBA cash rate influence that? I’d have thought not much if they (the lenders) deem the return for risk is too low?? Surely the banks will not be able to dictate IRs to o/s lenders as the economy deteriorates regardles of the RBA’s cash rate.

  3. sydboy007MEMBER

    wow. that’s a scary report. it’s barely a house of cards. the smallest pugg of wind could be enought o send things tumbling down.

    how do people willingly get themselves into that kind of situation??

    • “how do people willingly get themselves into that kind of situation??”

      Through the forces of Mortgage brokers, banks, APRA, RBA, Treasury, Govt, House horny partners, MSM, baby boomer parents, BBQs etc etc

      • +1000

        Just remember it wasn’t too long ago that Hockey was itching to let young FHBs access their super to throw on the housing ponzi!

    • most of those investors who said they cannot deal with any rate rises can actually survive interest rate rise of more than few percent.

      What they cannot survive is no growth in house price or, God forbid, house price falls!

      So as long as equity is growing they are fine even if they struggle with cash flow but if equity starts melting they are stuffed

      • darklydrawlMEMBER

        Yep… This was key in the undoing of the US RE market. When prices stopping rising the manure really started hitting the blades. What I found interesting was that prices didn’t even need to fall, just stop rising for folks to get into bother. Crazy stuff.

        I can see why folks might get into bother though. I have seen what some major lenders reckon they will let us borrow for a house – absolutely scarey. Prudent lending procedures my arse.

      • What they cannot survive is no growth in house price or, God forbid, house price falls!
        A gambler should expect to loose at same chances as he also expects to win. After all he is a gambler.
        The casino will not save him when he falls.
        God forbid!

      • @darklydrawl “I have seen what some major lenders reckon they will let us borrow for a house – absolutely scarey. Prudent lending procedures my arse.”

        Me too – at 53 you would think a $1m 30 year loan might not be “responsible” – not according my mortgage broking mate and the Big4

      • Information arb, control fraud, predatory behavior…. so its free will for the criminals and morals for everyone else…

    • Personally I think a lower wage will be the big killer for Mr Average going forward.
      They will be owning a place that’s getting harder to rent, the banks wil continue to cut back on finance and it will slowly get too hard. Lack of cashflow will be the final nail.

      • Yep, that ‘forgone problem/saviour of bracket creep will be sorely missed. It is starting to sink in, even making it to msm.

    • It’s called keeping up with the Jones’. And the Smiths’, the Nguyens and Wongs. Truth is they’d be fine if thy got over their sense of entitlement to an iphone, foxtel, multiple annual holidays, tattoo sleeves, pedicures, jetskis and X5s. What shits me is the Tom Elliotts of the world having highly paid public servants on his show talking about dealing with cost of living pressures. The ABS says what cost of living pressures? They’re not lying to protect the minority 33% of the economy who are mortgage mugs are they?

      • Being a financial quant modeller, what amazes me most is how many people are buying houses without having any model or spreadsheet.

        They’re just going in blind – can’t do sensitivity analysis, don’t see what these numbers actually mean in terms of what will happen to their disposable income.

  4. A potent cause for mischief

    That’s the Australian property “investor” curse: Asset rich (for the time being) but cash flow poor. It is very difficult to explain to them that have made a poor choice when they see 30%+ (paper) profit. I feel they will be more open to discussion (if) the market drops significantly.

  5. People believe that credit is money. My brother in law who is mid 30 say credit is money I tried to explain to him that it is as long the credit tap is open. But it can be shut in a instant than it will become money owed . He and his wife are reasonably comfortable right now but being leveraged to their home as it rose in value( 50%) so did they mortgage as the new car was put on the house . If interest rates rise and property values drop they will be in trouble. I did warned him but fell on deaf ears. How can you make some one see what they don’t want to see.

    • Delusion – we are all guilty of it.

      It’s only when called on it that we have to yield to a shared reality.

      What people including myself need to do is understand that we are all delusional, and factor that into their decision making, especially on big issues.

      The good thing for your friend, is that they’re about to get a chance to experience having to be resilient.

  6. They have only focussed on the cashflow effect and ignored the capitalisation rate effect, it seems to me.
    If rates rise from 7 to 10% then a 300k loan repayment on a 500k house will rise from $21kpa to 30Kpa. But if that change in rates is sustained other investments (eg new Corporate Bonds go from 5% yield to 8% yield) will appear more favourable unless the price of houses realigns. as bond prices fall and yields increase house prices will be rerated over time. Maybe investors required 4% gross rent before the rate rise but now require 5.5% gross now (maybe more because the market might fall more). If the house was $500k yielding 4% gross pa ie $20kpa but now the requirement is 5.5% then the house falls in value by about $136k. So now the LVR which was 70% is now 96% so there is little equity left and the bank calls for a security top up. The additional security needed to restore to a 70% LVR is about $100k. The investor is forced to sell because they can’t find the cash and the bank is panicing because they don’t have teh equity buffer even to cover the costs of mortgagee sale elt alone any further falls in value.
    A 3% rise wasn’t that much when rates were 15% but it is huge when rates are 6% and most of the negative impact if the rate incease is sustained is in the capitalisation rate and teh inability to keep playing in the real estate casino. Most Australians have never experienced a sustained cyclical increase in interst rates and no one looks at the capitalisation rate effect of a sustained interst rate rise on their capitalisation rate of their rentals. Governments will eventually have to keep things working by increased government debt and spending when bond rates are 0.5% and housing loan rates are 2.5% because there will be deflation and no incentive to purchase assets whose prices are falling. They certainly won’t be able to ever increase interst rates much until inflation gets to around 3%. any adjustments before then will have to be in letting the currency go or increased government spending.

    • Explorer deflation is a lower price loop, its hard to keep one item out of the mix. Deflation via slower credit expansion means higher unemployment and wage regression.

      Result more deflation.

      • yep and if you have deflation the only way to stop it is to give the population at large more tokens to spend. Governemtns do that by increasing spending on things that have the highest direct impact on employment of the people in the sectors that are suffering most from unemployment. If the construction industy labourers are being laid off in their hundreds, you could keep them employed by introducing a home insulation scheme, if small and medium builders are going broke you could fund lots of medium sized construction projects all over the country, somehting like school halls, libraries and class rooms. The lower ther capacity to save the more they will spend of the new money coming in. They will pay their rent or make their housing payments and their spending will reduce the tendency to lower hours and wages in the retail trade, helping keep those people employed (and spending) too. Allow too many tokens to get distributed and people start demanding increased wages, bidding up the price of goods and services and slowly inflation arrives. None of this can happen with an austerity loving neo-con government. It can happen with a soft/wet Liberal government (glad Abbott is gone and Turnbull is in) and will happen with a Labor government a la Rudd and Swan during the GFC. Do the Libs have the states and fderal bureaucracies lined up with their now better equivalents of NBN, school halls and pink bats? I hope so and they have no excuse if they don’t!

        Australia having a fiat currency and currency sovereignty (unlike Euro users) can easily distribute tokens.

    • Rent Seeking Missile

      Excellent point Explorer.

      Everything starts going the wrong way, and there’s nothing you can do about it.

  7. What are the chances of interest rate going up? Look what 0.25% US increase has caused?

    Question is, what the world will look with like with 0% (close to 0%) for next 10 years?

    More debt, more asset bubble, QE3, QE4……………QE1001

    • …. and permanently low CPI. Who would have thought that the answer to chronic inflation is ZIRP?

    • “What are the chances of interest rate going up? Look what 0.25% US increase has caused?”

      What are the chance of off-shore lenders demanding a higher risk premium to lend to our banks if our housing market goes to shit? Pretty damn high I’d suggest.

      • And what will they do with their AUD if we just don’t pay higher interest rates? If no one wants AUD and people aren’t borrowing what can holders of AUD do? They either deposit it or buy Australian assets or goods or sell the AUD for whatever they can get. Most of them can’t even bury it as it is just digital 1’s and 0’s on a bank computer somewhere in the world. We have a fiat currency, they can’t bankrupt us they are essentially powerless in the face of a smart sovereign with a fiat currency and without foreign currency borrowings.

        We get into trouble more when the country or corporates or even citizens have relatively large FX borrowings like Argentina did.

      • @ Dennis. Read the BOE papaer on how commercial banks create money out of nothing when they make a loan and put the funds in the borrowers account.
        The adjustment takes place in the free floating currency. Someone has to hold all AUD not taken back in bank repayments or taxes. So if some foreigner has an AUD balance now they have to deal with it as I described above. If we can’t buy eg USD or CNY/RMB with our currency to buy imported goods and services we will have to make those type of goods ourselves. Of course that would mean that those overseas countries, manufacturers and their employees would all lose income and that colours thinking too!

  8. reusachtigeMEMBER

    LOLOLOL!!! Sif we’re ever gonna get substantial rises in interest rates again. The world is all about “lower teh interest rates”!

    • Just read the Reserve Bank Charter. It basically requires the RBA by legislation to lower interest rates when unemployment rises, provided there is no inflation above target and no danger to the banking system from doing so. If a governemtn implements fiscal austerity causing unemployment, RBA *MUST* lower rates.

      The Reserve Bank Board’s obligations with respect to monetary policy are laid out in Sections 10(2) and 11(1) of the Act. Section 10(2) of the Act, which is often referred to as the Bank’s ‘charter’, says:

      It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank … are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:

      a the stability of the currency of Australia;
      b the maintenance of full employment in Australia; and
      c the economic prosperity and welfare of the people of Australia.

      • Ronin8317MEMBER

        The RBA cannot lower interest rate when capital outflow cause the AUD to crash, leading to inflation.

      • @Ronin The RBA has no real mandate to protect the currency’s interantional value (although I know it has often taken big market positions as the currency fell), and no mandate to reduce the prospects of inflation if it is already below range.
        They might slow the fall of the currency but they are basically locked into lowering rates if unemployment accelerates significantly higher, and austerity driving down the economy or just the current resource and auto industry runoofs in employment might cause lower rates. Sometimes excess demand evaporates, rates fall because there is little demand for money, and eventually the RBA follows the market down. I just don’t see any possibiilty of sustained significantly higher rates becasue it will destroy so many borrowers and so much super balances and so much “wealth”. And no one lobbies like an industry association or a group of uber wealthy individuals.

    • We should all listen to this guy, the rates won’t rise because they can’t. The world will end.

  9. Ok conspiracy theorists and assorted skeptics.

    We know that if you control the money supply you have the ability to expand the money supply and contract the money supply.

    We know that booms and busts are often the result of expansions of the money supply (read expansion in lending/debt) and busts are often the result of contractions in the money supply (lending collapsing/credit crunch combined with loan defaults).

    We also know that the preferred international money supply is the $US.

    So if you were the sole international super power and had control of the international money supply and you knew that, after a period of rapid expansion of that money supply and the associated rapid increase in debt, a lot of countries might be vulnerable to a reduction in the money supply – aka a credit crunch – what might you do ?

    What might you do if you were confident that in the event of a credit crunch your economy might manage or scrape through by virtue of the reserve status of your currency or simply because you are large enough and self sufficient in energy, know how and other resources to cope with a bit of splendid isolation?

    What might you do if the popular mood in your country was turning away from being the international policeman and instead TKOB at home.

    What might you do if you were feeling a little bit sensitive about some jostling upstarts.

    Would you be tempted to twist the monetary spigots (increase rates) and get ready for a bit of debtor asset foreclosure action as all those folks around the world who borrowed your cheap debt now find paying it back ruinous as the supply dries up.

    After all if your domestic banks get into trouble you can always bail them out but who says you need to do the same for everyone two bit outfit around the globe.

    Just as well there are good people running the international reserve currency who have our best interests close to their hearts or some wild eye conspiracy theorists might drive a wedge in our affections.

    Just as well we have kangaroos and surfing too!.

    • sure is Jabba.

      Or perhaps let a pack of dogs of war loose. The dumb as dogsh!t’ golden retriever we are dog-sitting mauled a ‘roo last Saturday. Fortunately for demented dog that roo was already injured and vulnerable. Our own kelpie-cross was bewildered. Two days to go……

    • The Olympics of currency strategy sports is currently in full flight.

      USA thinks they have this in the bag for reasons as mentioned.
      Euro is sunk
      Yuan and Yen totally smashed
      AUD needs to do a Steve Bradbury to make the quarter finals
      Russia the smokey

      IMF rubbing their hands

  10. Locus of ControlMEMBER

    “Here we found that investors in TAS were most concerned about potential rate rises, followed by SA and ACT. These are states were income growth (and property appreciation) is slowest. On the other hand, investors in WA and NT appeared more able to cope with significant rises.”

    WA has in recent times (eg. during the mining investment boom) experienced higher than average incomes courtesy of the mining boom. What happens when the highly paid job in mining is replaced with one half as generous (eg. geologist going from the mines to Uber driving or construction worker on one of the LNG plants reverting to workshop/ retail/ whatever) or with none at all (eg. unemployment) as a result of cutbacks in the mining and construction sectors? At what time was this survey undertaken? If it was June last year I’d understand how so few could see what was on the horizon, but if it were any more recently surely the hurt/ alarm was starting to spread as a result of resource prices falling, investment scale-backs, mine sites cutting jobs here and there…

    The NT and the ACT may be alright, underpinned by the public service as they are, but there are no phenomenal wage rises occurring there right now to offset rising rates should they manifest.

    I’d also expect, given this is self-reported, any comfort with the possibility of rising rates that investors may express may be a confidence bias of sorts.

    Just my 2 cents.

    Excellent work as always DFA. I’d be curious to see modeling with savings/ offset accounts taken into consideration vis-à-vis mortgage liabilities with the prospect of rising interest rates/ increased unemployment (aka household stress testing). I suspect there are many leveraged-to-the-max households out there that’d be in considerable pain given the occurrence of either.

  11. Sad truth is there is no need to interests to go up at all and they will not.
    If China stops buying Iron (reduce importing by 30%) which is very possible due to overcapacity and transitioning, and with that Coal also will be impacted that will do the job. Plus Guido will not be able to keep our Auto jobs alive (he will be gone once elections are over).
    These events will cause massive job loses and loss of overtime for those who manage to keep their jobs due to overall weakness that will come. Households are so leveraged that they will go down just by losing their Overtime. All builders (employees working in building industry) to stop working on Saturday will be enough to trigger massive defaults.
    People – just go for a walk along South West Sydney (workers class part of syd) and you will be shocked to see every third house has new BMW or Mercedes or AUDI and off course new bogan ute.

  12. Can’t see interest rate rises any time on the horizon. If anything they are headed in only one direction- DOWN.
    Out of controll Inflation is a thing of the last century. The new enemy is deflation. Stock markets, houses prises and wages, all coming under downward preasure.

  13. BoomToBustMEMBER

    I notice a lot of the discussion here is about the RBA raising interest rates. I note however that banks have been moving independent of the RBA in the last few years. In my opinion it may not matter what the RBA does, the banks will always pass on funding cost increases. What happens to bank shares when profits halve in the current environment? Banks are currently the only profitable game in town, crashing them will be….well rather interesting !

    • V. good comment.

      What is patently clear – if you have a job, you will be able to meet your payment obligations.
      If you have no job – then no matter how much you cut rates, you’re going under. This, combined with a declining AUD and potential higher risk premiums on the interbank market means that Aussie banks are on a hiding to nothing.

      What we have heard the last few years is that banks are a protected species – especially by boomers. Whenevr I have mentioned that they need to be reigned in, any boomer within ear distance would tell me that their super depends on bank shares and to leave them be.

      Too big to fail, probably, yet I can see the Occupy Mvt making a comeback

    • Very good observation. The twin forces that could lead to a housing crisis are rate rises and mass unemployment. With respect to rate rises my focus was on the RBA hiking the rates. Given the statements coming out of the committee I had dismissed this probability as being remote in the current climate. However, unlike the UK with tracker mortgages (which move only with the base rate), many Australians do still have variable rate mortgages which can be adjusted upwards by the banks. As Basel III will push up the cost of capital for banks so too will the banks pass that cost onto homeowners in the form of rate rises. Whilst this is supposed to make the banking system safer it may unintentionally lead to greater defaults occurring where homeowners have leveraged too highly. The other trigger is the economy faltering, resulting in mass redundancies. We can see the effect in WA with an exodus of workers and capital. What would be the case if this also happened across ACT, NSW and VIC? What are the main industries there? Finance and services? Could these sectors crash in tandem with the mining bust? Could external forces contribute to a crash? China? Whilst the financial world is interconnected I had viewed the financial system in Australia (ANZ aside) as more inward focused than say the U.S. or the UK. However, there are still indirect links to miners and agricultural farmers that heavily rely on exports to Asia. A Chinese cold could create an Asian pandemic causing a domino effect hitting Aussie banks hard. The result? Tightening lending criteria. Less liquidity in the economy. Redundancies. Low growth. Hold on. I’ve got a good idea. RBA QE!

  14. Tassie TomMEMBER

    This is great data, but it’s terribly represented. The graphs are really difficult to meaningfully interpret unless you study each graph for about 5 minutes, which more or less defeats the purpose of a graph.

    • same, linking graph terminology to definitions to meaning into aggregated measures where scales are not sympathetic to the final presentation.

      Good stuff but break it down please Martin. Build it up to the final presentation (that you have here) is ok but too dense as is for occasional viewers.