10 properties in 3 years: too good to be true?

Yep, it probably is.

I say probably because I’m looking at it from a reasonable and willing investor’s point of view. That is, ordinary people on a medium to comfortable income with a typical family who want to create wealth for later days and generally have little time on their hands.

People ask me why they cannot invest like the investors featured in the property media who claim to have become millionaires in a very short period of time. I look at these cases very closely and am usually not convinced that everything has been disclosed in these articles.

The reality is that it is all about numbers. These numbers are constrained by lenders, in other words, if you want to borrow you have to comply with the bank’s rules. There are three rules, all fundamentally simple, and you need to comply with all of them to get a loan:

  • The more you earn the more you can borrow. A lender will deduct from your income living expenses and monthly liabilities (existing loans, car lease, credit cards and so on) and the rest is available to service a new loan. So an investor’s borrowing capacity is finite. Even if you have a sizeable deposit the bank will not lend to you if you have reached your serviceability limit.
  • The more deposit or equity you have, the more you can borrow. Or, the more cashed up you are the more you can borrow, which also includes equity in any existing property you own. Even if your earnings are sufficient, if you don’t have enough deposit you won’t get a loan.
  • The property you are buying needs to be suitable. Banks will obviously want the security you provide to be acceptable just in case they have to repossess the asset and sell it. It’s common for banks to have issues with serviced apartments, student accommodation, small studio units and so on. They want the property to be as mainstream as possible.

The most common fallacy is that if an investor keeps buying cash flow positive properties the lender will keep lending forever. Most lenders take into account only 80% of the rental income, and it is not common to find a property that generates sufficient rent to increase the investor’s serviceability. Properties that do provide such rent are usually in marginal or high-risk regions (mining towns, rural areas); of course, there are exceptions.

In addition, banks become nervous if the rental income outstrips the investor’s own income, especially if borrowing is over 80% loan to value ratio. Finally, a cash flow positive property today may not be cash flow positive if interest rates rise.

At some point every investor will experience rejection from a bank because of one of the three rules above. The investor may have insufficient serviceability or run out of cash/equity, or the lender might not like the property they intend to buy. So it is important to know which of these three rules is your weak point. Are you going to run out of cash/equity before you run out of serviceability? Or is it the other way round? Does your proposed purchase fit within the bank’s mainstream criteria?

Obviously things change over time. For instance, a new job may attract a better salary and therefore your borrowing capacity increases, so it’s wise to continually review how you fit within the rules.

When a feature article appears about someone on a very low income who buys a small property in a location that subsequently booms, and they use equity to get into the next one and the next one and so on and so on, I just wonder. I can understand that this investor was able to secure a loan for the first property. I also understand how they got the deposit for the second, but unless their serviceability increased somehow they will fall short of rule 1. Most of these articles do not explain how an investor complies with all three rules; instead, they usually explain one or two only.

Typical circumstances where it is possible to acquire a large portfolio in a small amount of time include:

  • Someone who has inherited substantial money and needs little leverage.
  • Someone on, say, a $350K salary who buys very cheap properties (i.e. around $100K each, probably in remote areas).
  • Someone on a very high salary with plenty of savings.
Overall, property investing is a great way to create wealth, but it’s more a marathon than a sprint.