This is the second post in my three part series regarding the risks you should be aware of if you want to build up income streams with real estate. You’ll find Part 1 here. Today I’ll talk about financing, i.e. taking out a real estate loan.
Quick reminder upfront: All the information in this post refers to the situation in Germany as of writing this post. Things might work differently in your country. And as always: I’m not a professional financial adviser and just share my own thoughts and experiences. So always make sure to gather all information relevant to your circumstances and get a professional to cross-check if necessary.
Ok. Let’s go.
Debt versus equity
If you buy a property you’ll most probably not have saved up so much that you’re able to pay cash for it. So you will take out financing for at least part of the price. There’s nothing wrong with that since – different from consumer debt – this debt is secured with an asset. Since banks take this into account for their rates, interest on standard mortgages is lower than for consumer loans.
If you don’t want to live in the property yourself but plan to rent it out, using debt makes a lot of sense from an economic perspective this will boost the return on your investment. That’s the famous ‘leverage effect’.
Since you take out the loan to generate income you can deduct the interest as costs for tax matters. They lower your profit. That’s particularly attractive if you currently have a higher income – and are correspondingly taxed in a higher bracket – than what you expect at the point in time when you want to live off the rents.
If you have a very good credit standing you might be able to finance up to a 100 percent of the purchase price. There are banks that will finance transaction costs on top of this, i.e. real estate agent fees, notary fees and real estate transfer tax. Due to legal changes, this has become increasingly difficult, though (Link in German). And from a risk point of view this makes sense.
Generally, the higher the amount you’re financing, the higher your mortgage payment will be. If you want to have as low a payment as possible, you can try to bring down the part of the mortgage that goes to equity build-up. But this will prolong the time till your mortgage is completely paid off.
A high level of debt, a high monthly mortgage payment or a long mortgage term will increase the risk associated with your investment. That’s why, especially as a starter, I wouldn’t take on excessive debt. In my post ‘Is Real Estate the New Bitcoin’ I’ve expanded on this and also ranted on a bit about why I think that some of the web content around this issue is highly problematic. So if you think about 100% financing or similar, just check out that post before your final decision.
You have to be able to service your debt long-term
When you play around with financing scenarios, it’s important that the mortgage can sustainably be covered by the rents. Otherwise debt leverage works against, not for you. That’s why your calculation has to work even when you take into account vacancies and maintenance costs.
The lower the gap between the rent and the mortgage, or the longer the term, the higher is your risk, that you might run into a problem. On average, you should be able to raise the rent in line with inflation across the years. But on the other hand political decisions like rent caps (‘Mietpreisbremse’) or the current property tax reform in Germany can always upset your plans.
And similarly to the stock market where a lot of the FIRE-crowd have only known near-constant growth since the Great Recession in 2008/09, recent spikes in real estate markets cannot been taken for granted in the future. Yes, real estate prices can drop as well. And in that case, you’re carrying less risk, when you’re not over-leveraged.
Interest change risk
With a long-term mortgage comes the additional risk – apart from the general difficulty to plan 40+ years into the future – of interest rate changes. If you haven’t agreed to pay back the complete loan within the period for which the interest is fixed, you’ll still have a lot of debt at this point.
In Germany, interest rates for mortgages are often fixed for 10 to 20 years. But can are free to go as short as five years or below, and some banks will agree to terms as long as 30 years. The longer the term, the higher the interest rate.
So you have to balance certainty of calculation versus the corresponding costs. There are scenarios where it makes sense to fix only a short term. If an investor buys a property with a view to a short-term rise in value, he can use the new valuation, say after five years, to unlock some equity from this property to fund further purchases. But this is obviously speculation which carries its own risks. So nothing I’d do if I were just starting out.
(There are mortgages with variable rates as well. But this gets too specific for the purposes of this post.)
Calculate the worst case
If you want to buy a property as a long-term investment, you can think about fixing the interest for 15 or even 20 years, given the current extremely low interest rates. Always run some ‘worse’ and ‘worst’ case scenarios on potential future interest rates and the implication for your total mortgage rate after the fixed period has run out.
I would have to look up the exact number for the mortgage we took out for our first apartment. But it must have been close to 7%. Looking at the current situation in the Eurozone I don’t assume interest rates will go to that level again in the short-term or even in the mid-term. Still: if the European Central Bank starts raising the interest rate at the end of this year, mortgage rates will start rising again as well.
Right of termination by law
There’s a little ‘joker’ if you go for fixed-interest periods of more than ten years: You can terminate any mortgage after ten years with a notice period of six months. That’s what we did with the apartment that we rent out to a hotel. When we bought it, we fixed the interest rate for 15 years.
Since the rates had come so far down, we asked the bank what interest rate they would offer for if we left the mortgage with them rather than using our right of termination. So you can use this option to negotiate as well.
If you look at risk, this legal option provides another advantage. Generally, you are obliged to keep the mortgage up to the end of the period for which the interest has been fixed. There’s only one exception: If you want – or have – to sell the property.
Within a time frame of ten years, in most cases it will not make sense for you as a long-term private investor to sell the property again due to tax reasons. Any profit would be taxed with your personal tax rate as long as the speculative period applies.
On top of that, you’d be liable for a prepayment penalty (Link in German) towards the bank. But if a ‘want/have to sell’-situation occurs AFTER ten years, you can just terminate the mortgage contract as outlined above. No matter what your reason is.
So here again, you have to weigh the more ‘secure’ option of fixing the interest for 15 or 20 years against the higher costs in interest. That’s important to take into account, as the original rate of interest will be applicable up to the point where you make use of your legal right of termination.
Wow, that’s been a lot of information again. So I’ll give you a break now to let things sink in. In the last part of the series I’ll share my thoughts regarding risk associated with your future tenants. See you there.
Financial Independence Rocks!