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Why are floating and short-term interest rates so much lower than long-term fixed rates?

March 6th, 2010 | Author: David Whitburn

I have been asked a few times over the past week by property investors and home-owners alike why are the floating rate and 1 year or shorter fixed rates so much less than longer term fixed rates? Since interest is most investors and indeed home-owners biggest expense, as promised I wanted to provide a comprehensive answer to this. Currently the floating rates being charged (by the major banks) are in a range of 5.25% – 6.40% (5.99% is the average) , 6 month fixed rates average 5.8%, and 1 year fixed rates average 6.25%. Yet the longer term fixed rates are much higher with the average 3 year rate being 7.95%, the average 4 year rate is 8.50% and the average 5 year rate is 8.65%. Source: www.mortgagerates.co.nz

Now I know most of my readers are probably like the majority of our population and are better at assimilating information shown graphically, rather than nestled in a paragraph of text, so lets take a look at this graphically:

So why are the long term fixed borrowing rates so much higher than shorter term rates at present?

Currently the Official Cash Rate (“OCR”) is at emergency levels in response to the Global Financial Crisis (“GFC”). The OCR has a very strong correlation to floating rates, and also 6 month and even 1 year fixed term rates. We have floating rates currently sitting at 40 year lows. Banks aren’t going to lend you money at 5.75% for 5 years right now sorry, and nor are they likely to any time in the next 6 years in my opinion. Some of you will hopefully have joined me and taken my blog on 16 March 2009 seriously, and fixed for 5 years at 6.50% or 7 years at 6.79% with BNZ. I know many of my mentoring students are kicking themselves for not following my advice. Don’t worry as I am regretting that I didn’t fix more a bit more debt for 5+ years. Nowadays 5 years rate are coming down a tad, and the very cheapest 5 year rate is with HSBC Premier (the world’s largest bank) at just 7.95%.

5 reasons why there is such a difference now:

1. OCR doesn’t correlate well with long-term interest rates

The reason that the long term interest rates are so high is that the OCR has very little bearing on them. The US 3, 4 and 5 year swap rates have far greater bearing on our 3, 4 and 5 year fixed rates, than the OCR does. That said the OCR does have an impact. And this is expected to rise from its 2.50% low level towards around 5.00% over the next couple of years. Some economists are predicting the OCR to be risen to 2.75% on June 10th, however after the tax changes announced on May 20th this year in the Budget this year, I think that 6 weeks later in July is a more likely date for the OCR to have its first rise. The rising unemployment and lack of inflationary pressures are what makes me think differently to the majority of economists.

2. Risk premium for OCR rises

In addition many think that the OCR will be 1% higher at 3.50% come Christmas 2010. I don’t see this happening. Therefore there is a lot of upside interest rate risk priced these longer fixed rates.

The next 3 reasons arise from the three major funding channels: deposit rates, short-term wholesale funding, long-term wholesale funding.

3. Deposit rates:

Banks are under intense competition in the term deposit market. As a result the cost of deposits has greatly increased over the past year. Banks are attempting to ensure they maintain and grow, this source of funding. Banks also compete with a raft of recent corporate bond issues targeting retail investors. Six-month deposit rates were generally priced at around 40 basis points below six-month bank bill rates prior to 2008, but have recently risen to more than 100 basis points over six-month bank bill rates. Slightly ironically Kiwibank is again at the forefront of the battle for money invested in term deposits.

4. Short-term wholesale funding:

These costs have risen reflecting the increased spreads between offshore short-term funding rates and expected policy rates. As shown by the chart below, these spreads have risen substantially during the crisis – peaking in late 2008 following the collapse of Lehman Brothers that triggered the greatest impact of the GFC. These spreads have subsequently narrowed as central banks have provided increased liquidity and risk appetite has improved, but they remain above pre-crisis levels. The new Reserve Bank liquidity rules mean that more funding must be sourced from offshore on longer-terms, which means that long-term fixed rates borrowed in NZ will more than likely be matched by long-term wholesale funding. With most term deposit holders preferring shorter terms, there is increasingly less of a need for short-term wholesale funding.

5. Long-term wholesale funding:

These costs have eased from the highs seen in late 2008 – albeit to levels that are still significantly above those prevailing prior to the crisis. Long-term wholesale funding costs are proxied (given the limited amount of recent bond issuance by New Zealand banks) by movements in Australian bank bond spreads, with a margin added to reflect the higher cost for NZ bank issuers. Long-term wholesale funding has to increase under new Reserve Bank liquidity requirements – so longer-term fixed debt borrowed by a property investor in New Zealand, will more than likely need to be matched by borrowing this on the long-term wholesale funding market. This market is more expensive, as the risks involved in fixing a rate for longer are (rightly in many people’s eyes) greater. This new rule is a significant part of increasing the costs of long-term interest rates.

With acknowledgements to the Reserve Bank of New Zealand for answers 3-5.

Conclusion

So there you have my answers with some help from BNZ Chief Economist Tony Alexander in his latest weekly overview, ANZ National Bank Chief Economist Cameron Bagrie with his February Property Focus, and the good people of the Reserve Bank of New Zealand. As for what I am doing now on the debt I didn’t fix for 5+ years in March 2009, I am mixing it up a little bit between floating and taking 1 year rates. In doing so I am paying from 5.25% to 6.15% (I like and have good success in negotiating discounts to interest rates with banks but that is another special topic that I prefer to reserve for my paid mentoring students). With the ten year average interest rate across all categories (floating, 1 year, 2 year, 3 year, 4 year and 5 year fixed) averaging just under 8% now, I have big savings which I don’t blow on cars, lottery tickets or fancy holidays. I use this money saved to repay debt, by paying down principal on loans. Obviously if you have a mortgage on your own home, you should be paying down the principal on that firstly, as your own home’s debt is not tax deductible (I don’t want to know if you are one of the ’special’ people renting their home from their own LAQC). Once your own home is paid off, then you can tackle the debt on your investment properties later!

Posted in General, Interest Rates & Loans, Property Investment Strategy | Tags: February 2010 interest rates, graph new customer average interest rate, long term fixed rates, OCR, Property Investment Strategy, repay debt, short term fixed rates, short-term versus long-term interest rates | No Comments »

PM John Key’s thoughts on tax changes for 2010

February 9th, 2010 | Author: David Whitburn

We have pretty good news fresh to hand with the keenly awaited comments from Prime Minister John Key in response to the Tax Working Group, in the opening of NZ Parliament this afternoon for 2010. In Key’s opening address there is reason to celebrate for many commercial and residential property investors alike.

John Key stated:

we will not be developing any proposals for a land tax, a comprehensive capital gains tax, or a risk-free return method (RFRM) for taxing residential investment properties,”

Therefore our pockets aren’t going to be to heavily upset and the market will not be significantly impacted as there will be no Land Tax, no Capital Gains Tax, no Risk-free Return Method on equity or any new tax imposed on property investors.

However John Key raised concerns with the tax treatment on property investment as an asset class:

The government does believe there is a gap in the current tax system around property investments where income is being derived but, in aggregate, no tax is being paid – in fact the government is actually losing revenue in this sector,”

We will therefore be making changes to the way property is taxed, which will result in increased Government revenue and more fairness for the taxpayers. These changes will be announced in the budget.”

So it’s good news for now, with no Capital Gains Tax introduced, no re-introduction of a Land Tax and no tax on equity in property (the Risk-free Rate of Return Method). Key and Minister of Finance Bill English had already ruled out imposing a Capital Gains Tax last year, and no-one in their right mind would impose the “risk-free rate of return method” on property investments as deductions would have been disallowed and equity would be taxed, not income/expenses. The carnage in the market the risk-free rate of return method could only be caused by having economic pygmies in charge, and New Zealand is too smart to vote these socialist leaning parties into power. Tenants can breathe easier too in that their rents will not be going up, to pay for our increased costs of a land tax. Councils will be happy that their rates revenue will not be cut from land values reducing (a 0.5% land tax had been costed at around 17% reduction in land values by Westpac’s Chief Economist).

However there is the very real risk still open of depreciation changes and potentially more and different legislation put forward in the May budget with relevance to property investors. It is likely that GST will be raised to 15% will compensation which will impact residential property investors a little bit, since residential rent is exempt from GST.

I personally predict in the May budget that there will be the following changes:

trimming of depreciation to all buildings (residential and commercial) to 1%,
lowering the chattels depreciation rate reductions,
a line drawn in the sand to state that if you own an investment property for a period of time (eg. less than 10 years) and then resell it and make a profit, then that ‘capital’ gain is taxable.

We have to wait and see what happens in May next. However now is clearly not the time for making rash decisions like selling your long term buy & hold properties.

Posted in General, Property Investment Strategy | Tags: capital gains tax, land tax, risk-free return method, Tax Changes, Tax Working Group | No Comments »

Foregone Equity and my Mistake

November 27th, 2007 | Author: David Whitburn

I want to add a little bit more to my previous blog on whether to go for capital growth or equity as your property investment strategy? Before I go on I will say that this is my opinion and the right strategy for you will depend on a number of things. Particularly early in your wealthdevelopment you are going to need good cashflow - if you don’t have this from your job or Business then you will need this from your properties.

Timewarp to 2002 – triggers to me starting investing

I had read Andrew King and Lisa Didson’s best-selling book The Complete Guide to Residential property Investment in New Zealand, and Dolf de Roos and Jan Somers’ book Building Wealth Through Investment Property. I went as a guest of a friend’s parent to a couple of APIA, listened to property investment accounting guru Mark Withers talk on tax savings from property investment, and since I was a young corporate solicitor in what was then the top law firm in New Zealand I was on the top tax rate. Some family and family friends were investing in property, I had helped my grandmother for years drive to collect rents from tenants and be her assistant property manager, so I knew it was time to invest myself. Having been to fund manager, sharebroker and property investment seminars the presenters were saying that only between 1 and 8% of people retire rich, most are dead or dead broke (and obviously statistics get a little bit distorted or mis-interpreted a fair bit to sell a story sometimes).

So I had enough positive affirmation to make the decision to buy property. I am delighted with all of the above that helped inspire to get me into property.

So I started looking in the property presses of Auckland, various papers, using websites and agents.

My $200,000 mistake (my case study)

Back in 2002 when I started my own direct property investing, I made a mistake. At the time I didn’t think so, but hindsight is a wonderful thing.

I had narrowed my selection down to two properties - one in the lower decile suburb of Manurewa and one in the exclusive subrub of Remuera:

1) a 3 bedroom house on just over 800sqm in Manurewa, to be auctioned with agent’s estimated price and vendor’s RV of ~$152K, rental appraisal $260/wk, owner occupied, that would benefit from a minor cosmetic renovation; or

2) a 2 bedroom unit in Remuera with less than 300sqm land, list price $250K sale by negotiation, rental appraisal $275/wk; owner occupied by an elderly couple in need a cosmetic renovation.

Options:

Manurewa house: After talking with the respective agents and attending the Manurewa house auction where I was the only non agent there, I made a bid at the auciton at the nice low price of $125K. This did not meet the vendor’s reserve so the auction was canned. The vendor’s reserve and requirement was in fact $140K as he needed to clear his Mortgage of $133K and play to relocate to Australia $6K and of course $1K legal fees. So $140K I was told would definately buy it. The property would cost $7K to renovate with professional assistance or $2.5K if I did it myself and with friends. The rental then would be $280/wk giving a 10% yield.

Remuera unit: I was told the vendor wasn’t very negotiable at all, the agent not revealing the vendors reasons to sell, apart from time to move on to a new place. They said $250K would buy it. The property would take $10K to renovate professionally or taking out the bits I could do $6K. The rental then would be $300 per week giving a 6% yield.

Which property would you choose?

Well I choose property 1 the Manurewa property - being very attracted to the yield. Cashflow is King right! I got myself a pre-tax positive property and thought I was very clever.

After my renovation the property was valued at a Massive $160K up from the $150K if I hadn’t touched it. In mid 2005 I still owned it and it was valued at just $175K.

Guess what the Remuera property was worth…

It sold two months after that registered date at $470,000. All it needed was paint, carpets and a new benchtop, so even if the asking (list) price was paid, $10K for renovating this small-medium sized unit, it still went up over $200,000. Allowing for the tax rebate this property was after-tax Cashflow positive.

Tired of my assigned property managers sadly hating their job managing South Auckland properties I had 7 property managers in this time, and rent arrears so I terminated their contract. I managed the property myself for a while and got bored of turning up to collect rent arrears and finding their 5 children aged from 2-9 years of age unattended. I asked the 9 year old where’s Mum, where’s Dad – I got told at the pub! Sadly after won of these big day’s out Jake the Muss put his fist through the mother face fracturing her skull. This didn’t help my rent arrears and I saw blood on the walls of my rapidly deteriorating home.

I rang Tenancy Services wanting to get an immediate eviction – but to no avail. They were not 3 weeks behind in rent! I had had enough and was pretty disappointed with project and managing it myself was rather stressful – so I changed my mind as I wanted to keep this property forever, and I sold it.

Look at my foregone equity – taking into account the nearly $150/wk after tax positive cashflow I made (interest rates were sub 7%), reno costs, but subtracting the lost rent and damage to the property that they couldn’t pay (they split up) I made less than $20K on this property. The Remuera property would have made more than $200K after allowing for the costs of reno and cashflow

So I cost myself $200,000 by going for the positive cashflow property.

Equity is King.

I now know what my Granny and parents know – that cashflow is nice, and is needed when you are starting out building a portfolio. But whenever you get a choice – choose equity.

Remember that when you have an equity portfolio you can choose to change to a cashflow portfolio (or even putting the money in the bank!), but try changing from a cashflow to equity portfolio straght away. You will not be able to do it as you will not have much equity and hit debt sevice walls with the bank straight away.

Conclusion

I conclude that not everything you are taught is right. Just because other investors do it does not make it right. Cashflow is very important and you must be able to meet your debt obligations. However once that is achieved then Equity is King.

Some readers may not like my message as I am directly seeking that they question their own cashflow strategy – however I want to say there are other strategies out there and I guess if I can help a couple of people reading this blog not blow many hundreds of thousands of dollars in lost equity as I did, my job is done.

Posted in General, Property Investment Strategy | Tags: cashflow, equity, equity is king, property investment | No Comments »