This is perhaps the least understood component of risk for property investors.
The way your portfolio is financed will impact the level of risk you are taking on. Your finance risk stems from the underlying nature of the finance used for your portfolio, rather than the more macroeconomic factors considered above. This includes 3 important considerations:
Your current loan terms (P&I vs. IO) form a key risk consideration that is often overlooked. Many investors have their debt on interest only terms to maximise their tax position and manage their cash flow, which makes complete sense. However, remember that from the banks perspective they are only offering you interest only repayments temporarily, they still expect that you’ll be paying the principle during the 30-year loan period. As such, any extension of your interest only terms are at the complete discretion of the bank. Further still, many banks retest your servicing to ensure that you can still pay back your loan in the original term before they will extend interest only repayments.
When you consider the risk level of your portfolio, you should consider that a portion of your interest only debt will revert to principle and interest and there is nothing you can do to prevent it. While this might not eventuate, it’s crucial you have sufficient buffers in place to weather this if it does occur. You should run the numbers based on 25% of your IO debt reverting to P&I and run it again based on 50% reverting to P&I. This will give you a buffer range to help contextualise the extra repayments you could need to make in the future to support your portfolio.
As you might expect, how leveraged you are is a key metric when thinking about risk. Someone with a 40% equity position in their portfolio is obviously in a much better place to weather market changes, price drops or other unfavourable events than someone leveraged at 90%.
The question really is how should we quantify this in our risk analysis? A good starting point is to think about a good middle of the road LVR. For a number of reasons, 80% is a good benchmark. From a finance perspective 80% LVRs is the cap below which Mortgage Insurance (LMI) is not required. This is an important distinction as loans with LMI restrict your flexibility to refinance and release equity. Below 80% you will have more options and flexibility with your finance, placing you in a less risky position.
As such, you should consider your buffers and position in context of your portfolio’s LVR. LVRs less than 80% need less buffers to mitigate risk, while portfolios above 80% need additional buffers to reflect this additional leverage and your diminished flexibility to adjust your finance to changing circumstances.
Your finance risk is also determined by the lenders you hold debt with. In particular, how much debt to you hold with ‘non-banks’? Non-banks is a term use to describe smaller institutions that operate at the most aggressive end of the lending market. They have the most favourable servicing calculators and will lend you more money than a major bank. They also tend not to have a deposit side to their business (i.e. they only lend money), hence the term ‘non-bank’.
Being a smaller institution servicing the most aggressive segment of borrowers, these institutions tend to have less stability on interest rates and policy. The larger banks tend to have quite a diversified loan book. For every loan they have similar to yours they will hold a number of more and less aggressive positions with different types of borrowers. This means that they are less affected by market changes in a particular segment and as such their pricing and policies on things like equity releases and extension of interest only terms tend to be more consistent. When the GFC hit, many of the non‑banks sold their debts to other institutions, who aggressively ramped up interest rates and caught borrowers of guard. The larger banks, who are subject to community expectations, are less likely to act this way under stress.
On the other hand, the aggressive ‘non-banks’ are less diversified and tend to have more sharp changes to pricing and policies. Further, as you are generally stretched for servicing on these loans, you have limited refinance options to go back to a major bank. This is why it is important to hold additional buffers against debts held with ‘non-banks’ to reflect the additional uncertainty and your reduced ability to respond.