An alternative way of looking at whether it is right to keep a former home as an investment property

[moneymakeover]

I have copied these threads from a case study as they raise a general point which is worth airing separately.

Brendan

 

[Gordon Gekko]

We look at a lot of these but there’s an aspect that doesn’t sit particularly well with me. Are we oversimplifying things and not comparing like with like?

The interest saving on home mortgage repayments that you don’t have is finite in that it has a fixed term and reduces to zero over time.

Rental income, on the other hand, is perpetual and, in theory, can exist and grow forever.

So the capital value of the latter is far greater than that of the former.

We look at these things through the prism of this year, but next year the jaws widen just a little and then a little bit more the year after.

We simply say “two grand saved versus two grand of risky income, sell it”, but one is forever and somewhat inflation-linked, while the other is decreasing each year.

I guess I’m not comfortable with the maths of it.

 

[_OkGo_]

Are we oversimplifying things and not comparing like with like?

That is very true and we are simplifying it to year one and as OP has stated, he could treat it like a business that is loss making for the first few years knowing it will eventually be profitable. Based on the OP's cash flow, there is certainly scope for it to turn a nice profit.

I suppose one could go a step further and use the calculations above to estimate the total equity % at which the rental is break even or profitable (from total financial perspective) knowing that from there on it would have a positive impact on their wealth. While understanding that all equity up to that xx% is coming from your salary gives the OP a clear target and vision. With OP's salary, they could probably aggressively pay down PPR for 2-3 years to reach that number quickly ( probably in the 25-30% range) and from there on, the rental is marginally profitable and only a cash flow problem which they can handle

 

[Sarenco]

Hi @Gordon Gekko

It's a point in time comparison.

The various inputs (rents, mortgage outstanding, etc.) are dynamic so if you run the same analysis again in, say, five years time you will get a different result.

Bear in mind that the mortgage balance on the rental also reduces over time. Taken on its own, that is likely to reduce the advantage of maintaining the rental relative to paying off the PPR mortgage over time.

 

[Gordon Gekko]

Hi @Gordon Gekko

It's a point in time comparison.

The various inputs (rents, mortgage outstanding, etc.) are dynamic so if you run the same analysis again in, say, five years time you will get a different result.

Bear in mind that the mortgage balance on the rental also reduces over time. Taken on its own, that is likely to reduce the advantage of maintaining the rental relative to paying off the PPR mortgage over time.

I think that the best approach would be to build a proper model for these scenarios which plots various ‘points in time’ based on certain assumptions.

I do think though that there’s a fundamental error in our analysis of these cases.

The interest saved in respect of the smaller PPR mortgage decreases to zero over a fixed period of time.

The rental income, on the other hand, should increase over time and should exist forever.

If I crudely compare the €2,000 that I could save this year on my PPR mortgage versus the €2,000 that I might make from a rental property, it’s not a valid comparison. One is shrinking and the other is growing; is it not a ludicrous comparison?

 

[Gordon Gekko]

Put another way, “things” tend to be valued on the basis of the present value of their future cash-flows.

How can an inflation-proofed and growing perpetual income stream be worth less than a decreasing income stream that has a finite lifespan?

Intuitively, if both yield, say, €2,000 a year today, the rental income is worth way more.

 

[_OkGo_]

Put another way, “things” tend to be valued on the basis of the present value of their future cash-flows.

How can an inflation-proofed and growing perpetual income stream be worth less than a decreasing income stream that has a finite lifespan?

Intuitively, if both yield, say, €2,000 a year today, the rental income is worth way more.

That is a fair point but in this instance it is not a straight €2k gained vs €2k saved. The rental income does not translate to rental profit because of the large overall debt and low initial equity, roughly 18% - 200k/1.1m. Depending on interest rates and rental income/costs etc, it would not be a net contributor to their wealth until their total equity is somewhere at or above 30-35%. The sooner they add that 100-150k of equity from their own salary the better but in the meantime it is high risk for very low reward.

I think that the best approach would be to build a proper model for these scenarios which plots various ‘points in time’ based on certain assumptions.

That is exactly what is needed, even at 5 year intervals it would give a good indication of how it could benefit overall by keeping or selling.

 

[Sarenco]

I think that the best approach would be to build a proper model for these scenarios which plots various ‘points in time’ based on certain assumptions.

Predicting future interest rates, rents, taxes, etc., is fraught with difficulty.

IMO the far better approach is to review an investment from time to time - on the basis of the facts that are known at that time.

A rental property can obviously be acquired or a PPR mortgage can be paid down at a later point in time - there is no logical reason to make the decision for "all time" based on some projection of an unknowable future.

 

[_OkGo_]

Predicting future interest rates, rents, taxes, etc., is fraught with difficulty.

Yes it is but at least it would give you a sense of risk and highlight some key indicators as to stay invested or sell up. It should be reviewed regularly based on factual info but you can also be prepared for different scenarios in 5 years such as: Reduced rent, increased interest/costs, reduced salary, changes to personal expenses such as additional childcare. You can even model the positive impacts, maybe a sudden increase of xx% in houses prices would justify cashing in on the capital gain instead of holding out for rental income

Planning for those scenarios would give you confidence to make the right decisions at any stage to keep or sell so that it is not the 'all time' decision. OP does not have to stay invested for the next 25 years but they can prepare for a few warning signs that if ......... happens, its time to sell

 

[Sarenco]

Yes it is but at least it would give you a sense of risk and highlight some key indicators as to stay invested or sell up.

It's really not rocket science.

Either the capital tied up in the rental is producing a sufficiently higher after-tax profit than the interest savings that could be achieved by cashing out the equity and applying against the PPR mortgage. Or it's not.

There's really no need to model scenarios - it's a simply question of fact that can be revisited at regular intervals.

 

[_OkGo_]

I disagree, it's not rocket science to plan for a few simple scenarios either. It would be foolish not to know the risks involved when you are potentially taking on 900k of debt.

There is an obvious cash flow risk because they will use up all of their liquidity in the process. What if their salaries are reduced temporarily or for an extended period? There is a simple way to limit that risk by taking out longer term mortgages to reduce the minimum payments in case of a salary drop while planning to overpay if salaries remain constant.

It's not just the 80k that impacts the decision, its total debt and total equity, interest rates and more. OP is comfortable with some risk now knowing that investing in their total equity will make it profitable in a few years so it's fairly reasonable to plan 4 or 5 years ahead. If the decision was based on today's facts only then its a definite sell. But if the OP has a longer term plan and is aware of the risks then they should keep it

 

[Sarenco]

You can identify risks today, without any artificial modelling of an unknowable future.

The OP's decision is really very simple - is the projected €3,000 pa differential in keeping the apartment as a rental as compared with cashing out the €80k equity and applying as part purchase of the new PPR sufficient reward for all the risk and hassle of running a property rental business?

The decision can only be made on the basis of today's known facts. The future fact pattern is unknowable.

 

[Gordon Gekko]

I’m not sure about that.

If the interest on my PPR mortgage is €X today and my rental income is €Y, I can be pretty confident that as time passes, X will decrease and Y will endure and in all likelihood increase.

 

[_OkGo_]

The decision can only be made on the basis of today's known facts. The future fact pattern is unknowable.

By that logic, why would anyone ever invest in a pension? You don't know it will grow, you make assumptions and assume that you'll still be around to benefit from it.

How does it not make sense to plan for a few simple scenarios? It would be ridiculous not to. And there are a few knowable facts such as fixed interest rates that help you plan for 3/5 years time. How would it be a bad thing to know that if the SVR at the end of the fixed period goes up for some unknown reason that it would make sense to sell up? You don't need to know why it has gone up, only that this venture is not viable at interest rates above x.x%

 

[Brendan Burgess]

Hi Gordon

Take a simplified example:



The choice is whether to keep the investment property or sell it and pay down the mortgage.

Forgetting cash-flow for the moment, it's making €5,000 after tax for an equity of €100k. That is not a bad return.

If you pay it off the mortgage, you get a return of €3,000 after tax.

So you are getting €2,000 return on your labour.

You are trading off the risk of a fall in the value of your investment against the potential of a gain in the value of your investment.

The interest saving on home mortgage repayments that you don’t have is finite in that it has a fixed term and reduces to zero over time.

This is not the right way of looking at it. Paying €100k off the mortgage is like investing €100k at 3% tax-free and risk-free for 15 years.

At the end of the 15 years, I will have €155k to invest. Put it another way, if I keep the investment property, I will have a mortgage of €155k after 15 years on my home, instead of being mortgage-free.

Put it another way. According to your reasoning, you should not invest in any fixed-term savings product, because the return reduces to zero over time.

Rental income, on the other hand, is perpetual and, in theory, can exist and grow forever.

As is the return on my €100k. It's 3% tax-free and risk-free for 15 years and whatever is available after that.

So the capital value of the latter is far greater than that of the former.

No, the NPV of both is €100k today.

Brendan

 

[Brendan Burgess]

I am not sure of the point in time vs. long-term argument.

If you think that property prices are going to rise by 100% over the next twenty years, then it's well worth the risk and the hassle you are taking for a €2,000 a year return.

In fact, if the above figures show you making a trading loss on your rental property, you might still hold onto it if you expect the capital gains to exceed the trading losses.

But the key point is that if you do choose to retain the property, you must review the decision every few years.

This is particularly important for people whose former homes are on cheap trackers. You often find a scenario of a property worth €300k with a mortgage of €300k because property prices have fallen since it was bought. You have 0 equity, but because the mortgage is at 0.6% , it's hugely profitable.

However, after 5 years, when you have built up equity by paying down the capital, you should review it again.

Of course, if you sell the property now, then you can't review the decision.

Brendan