4 Strategies for Managing Investment Debt

The Wall Street Journal (WSJ) recently posted this article, Think New York Housing Is Expensive? Try Wollongong. It tells the story of Anika and Grant, a young Sydney couple who recently purchased a two-bedroom unit near the beach for AU$1.5 million. Putting no cash down, they tapped into unrealised investment property gains to cover their deposit.

As I reported here, 42 percent of all home purchases in Sydney in the first three months of 2015 were above $1 million. In other words, there are countless other couples just like Anika and Grant who are betting big on both the future of Sydney real estate values, and their ongoing earning power. I’d be willing to bet that many of them are not putting saved cash down for deposits.

The WSJ article continues with an assessment of Australia’s overall debt situation. As of December, our debt has risen to a record high of 194 percent of annual income, placing us among the most leveraged people in the world.

To put that into perspective, the debt level in the United States peaked at 135 percent just before the global financial crisis in 2007. Currently, household debt in the States is about 107 percent of annual income.

The Americans deleveraged after the GFC, but we didn’t. We’re not on a sustainable path.

The International Monetary Fund (IMF) is so concerned, they’re sending an economic team to Australia next month to examine the risks to the world posed by our property speculation and record-high household debt.

According to one IMF report, Australia will experience the developed world’s most dramatic surge in debt by 2020.

Still, the RBA just lowered their target cash rate to two percent, which is the lowest level in Australian history. Their goal is to stimulate our economy by both devaluing the Australian dollar, and encouraging Aussies to spend more, but there are side effects.

The problem with cheap money is that it fuels not only spending,it also fuels speculative investment. This is clearly why Sydney and Melbourne property prices have been on such a steep rise. The perception of most people is that low interest rates make houses more affordable; however, over the long term, this is highly unlikely to be true, as this article so effectively illustrates.

Unfortunately, few Australians have a healthy fear of debt. Debt is similar to fire. It can keep you warm and cook your food, but it can also burn your house down. As investors, we must understand how to leverage debt in order to catapult us toward wealth creation, or else it will enslave us and make us broke.

Here are four strategies for managing investment debt that can help you use leverage more wisely:

Buy And Hold ONLY Positive Cash Flow Property

If you’ve been around the PropertyInvesting.com community for long, you’re aware that we’re not big fans of negative gearing. The reason for this is quite simple.

Debt only works in your favour when the return on your leveraged asset is greater than the interest expense on the money you borrowed to purchase it. If you don’t get a profit from cash flow alone, then you’re at the mercy of the market to provide capital growth to provide your profit. We call this speculating, not investing.

Sometimes investors win with negative gearing, and sometimes they don’t. “Sometimes” is not a good strategy for those who want to mitigate the risks of holding debt. It doesn’t take a rocket scientist to understand that if you borrow to invest in assets that go down in value, you will eventually go broke.

Set Aside A Surplus In Mortgage Offset Accounts When Paying Interest Only Loans

Many investors choose to borrow on interest only repayment terms, rather than paying down principle plus interest. I can understand the appeal, as we’re always looking for opportunities to minimise expenses to boost cash flow. We also want to save as much capital as we can to take advantage of other buying opportunities that may arise.

The fact is that we must recognise the assumption we’re making when we only pay interest on investment debt. We are speculating that the property will be at least the same value, or even worth more, at some point in the future than it is today. Otherwise, our loss when selling the asset could cancel out any positive cash flow we’ve banked along the way.

If we are ever going to achieve financial freedom, we must pay off debt. As Steve McKnight often says, “We get into debt to get out of debt.” The long-term goal is to own debt-free real estate, so that we can live off that income.

One debt management strategy is to set aside additional cash each month over and above your interest payment on each interest only loan. By quarantining an amount equal to a principle payment in an offset account, you are not only minimising your risk, but you’re also saving on interest expenses and further boosting your cash flow.

As the account builds up over time, you’ll have the option of paying off the loan someday. You’ll also have those funds available along the way for deposits on quick cash investment opportunities that may arise. Furthermore, if you decide to move into commercial real estate, you’ll have residential lines of credit open to fund those deals.

Think Long-term On Interest Rates

As I wrote here, Australian investors carry considerably more interest rate risk than property owners in other nations. There’s a helpful illustration of this fact here.

With interest rates at historically low rates, it is crucial that you think long term and consider the impact of rising interest rates on your overall cash flow position. All financial variations tend to revert to a mean over time. Interest rates will be no different. They will eventually move toward their historical average of 8.54 percent.

If you haven’t yet worked out a budget for your properties on an interest rate of eight to nine percent, then you aren’t thinking long term. If you want to stay above water, you have to think differently than the masses that are buying properties today with a short-sighted perspective.

Have An Emergency Plan

As John F. Kennedy said, “The time to repair a roof is when the sun is shining.” Rather than waiting until you’re in the middle of crisis to devise a plan, work out now what your crisis point might be, and how you would respond to it.

Whether it’s interest rate risk, the potential loss of employment, or a major shift in the world economy, unpleasant events can and do occur. Just as banks seek to mitigate risk, so must we.

If the economic climate deteriorates in Australia, you may receive an unwelcomed phone call from your lender saying they are revaluing your property portfolio down.

If this happens, they will want you to repay some debt to keep your LVR within agreed limits. This happened to many asset rich, cash poor investors in 2008. For those who were unprepared, it was a painful season.

You should know exactly what interest rate level would bring a personal financial crisis to your doorstep. In other words, if interest rates rose to this point, you would most likely need to sell your properties. If you know what that point is, you can begin to take action long before you end up there, and before most other investors are in the same situation.

Conclusion

We are currently in a season of unprecedented borrowing and speculation as reserve banks around the world are easing their monetary policies. Without a healthy fear of debt, we could get drawn into a mindset that causes us to take on an unfavourable amount of risk.

In this unparalleled time of central bank and government intervention, it is more crucial than ever that we stay on the cutting edge by continuing to grow in skill and competency. Otherwise, as Clubber Lang so eloquently said in Rocky III, “I predict pain.”

In Steve McKnight’s Property Apprenticeship course, we include multiple sessions on identifying and mitigating investment risk, as well as an entire session dedicated to managing debt obligations in a healthy way. We’re also launching a new mentoring program in the coming months, so stay tuned.

If you have any other strategies for managing investment debt, please share your thoughts in the comment section below.

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.