The numbers that could kill off a rental property

COMMENT: There were always two big levers that could be used to calm the property market: increase housing supply or reduce access to finance. The Government's housing market changes, announced this week, are a big step towards the latter for investors.

The unintended consequences of whether renters will pay more for their current rental or need to downgrade to a lower quality home at a lower rental price will only be seen in future analysis. One thing that can be guaranteed is that the banks will respond to the decision to remove interest deductibility on property investment mortgages by adjusting how they assess the affordability of an application.

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Under current rules, banks adjust or scale the rental from investment properties by approximately 70%. This means if you receive, or expect to receive, $50,000 of investment-property-derived rental income, the bank calculates what you can afford with $35,000 (being 70% of $50,000).

This 70% adjustment is meant to allow for investment property expenses such as rates, insurance, vacancies, and any other related costs except interest from the mortgage. The assumption is that it’s reasonable to expect the costs of a rental property to eat up about 30% of your income. Given the banks are under tremendous pressure to make sure they are lending in a responsible manner, this is probably a reasonable, potentially over-conservative, estimation.

Nevertheless, from here on, the banks are going to have to assume that rental income is going to be taxed. Responsible lending requires the banks to not only calculate how affordable the mortgage is today but in five, ten and 20 years. Expect them, therefore, to apply a full tax deduction to investment property income from the beginning, despite the tax being eased in over the next 4 years. Bank will want to know that you can afford your mortgage after tax is deducted in four years. This will likely mean a scaling of 45%-50% instead of 70%.

Using a 50% scaling, we can now figure out what a property would need to yield to cover itself using the bank’s formula. Despite current mortgage interest rates being around 2.3%, the bank calculates affordability at around 7% interest rate and the payments must be principal and interest (because of the previously mentioned responsible lending requirements).

Once principal payments are added in, a property needs to yield about 9% p.a. return to cover the bank’s calculation - but this is before they scale the income. Assuming 50% income scaling, a property would need to yield around 18% p.a. to cover itself on the bank’s servicing calculator.

In other words, assuming unlimited money for deposits (wouldn’t that be nice!), you could continually purchase investment properties as long as they returned ~18% p.a. - this is about 15% higher than most properties in Auckland actually return.

The obvious outcome of this is that investment property purchasers are going to be able to buy one, maybe two, investment properties but only the top income earners are going to be able to afford more than two investment properties.

- Rupert Gough is the founder and CEO of Mortgage Lab and author of The Successful First Home Buyer.