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A Conservative Approach To Buying Real Estate
It is a clear sign of how the market is evolving when more and more businesses are promoting the acquisition of real estate with things like “no money down” or “no credit check mortgages”. It is a sign that the market is boiling over. The simple reason being that there must be a huge market for these profile of prospects when more and more advertising space are being bought to promote them. And it does not reflect anything otherwise when posters and flyers are getting more and more aggressive in using this line of marketing messages.
I do agree that the more risk you carry, the higher returns you can look forward to. But if you are a newbie or have a more conservative view on how to approach investments, don’t get manipulated by glossy brochures and savvy agents into biting off more than you can chew.
You might be able to obtain a million dollar home loan from a bank. But do you have the appetite to swallow it?
To simplify things, make a mental note of these 5 factors as a simple guide to quickly get an overview of whether you can afford a property.
30 – 30% of property price in cash
The first 30 represents 30% of property price. This is the amount of cash you need to have in order for it to be a truly safe purchase. You should be safe from any shortage of cash flow in the transaction if you meet this 30%.
Most people pay a down payment of 10% or 20%. Their problems arise when 10% or 20% is just about the amount of cash they have access to. Closing costs can really cause financial chaos when you are not prepared for it. The smaller expenses include legal fees, commissions, insurance, etc. The big ticket item that many first time buyers often forget is the stamp duty. Another big ticket item is renovation expenses which run up to an average of $40,000 for a modern home design.
Let’s not forget that when you don’t have an existing tenant, you could be facing vacancies while your mortgage payment won’t wait for you. This is why you want to have at least 30% of the purchase price in cash. The more the merrier.
20 – no more that 20% income currently spent on credit card bills and other loans
Many people claim that their excessive spending habits are just rash decisions that can be easily curbed. The problem is it’s easier said than done. Without company travel expense claims, some people are already spending 50% of their income on maintaining a car. If you need to live life on the edge this way, you probably don’t need to buy a house. Just go sky diving.
The reason why you want to keep below 20% is that it’s a reflection of how much leverage and gearing you go about each month. The lower your numbers are, the less you are dependent on credit. It would then be easier to substitute current expense items into your new mortgage.
35 – 35% of income towards mortgage repayment
The biggest recurring liability you have when you buy a house is the monthly mortgage commitments. Failing to make these payments puts your property at risk of foreclosure. This is why it is the one expense that you cannot ignore.
Many people feel that 35% is a little too conservative. They have no problems saving 50% or more of their monthly pay cheque on a consistent basis. So they are more than comfortable putting that 50% towards the loan repayment. But remember that doing so will have an impact on your lifestyle and you could face huge cash flow problems if you lose your job or have costly repairs to undertake.
You can sure go all out and fork out 50% of your income for loan repayment if you are comfortable with it. But don’t for a moment think that how you live your life is a good representation of how other live theirs. Most people hardly save any money at all!
For a conservative approach, you want to be able to comfortably set aside 35% to repay the mortgage. If you cannot afford that, it might be good idea to buy a cheaper house. If you can go higher than 35%, do think twice before signing up for a mortgage with a high repayment. Restructuring a loan in future is not an entitlement that the bank will surely agree to.
7 – Property price is reflective of 7 years worth of income
There are many ways to judge whether a house is overpriced. In terms of a conservative approach, you are not looking at how cheap a house is compared to recent comparable transactions that occurred in the same area. You are looking more at your own affordability factor.
The more number of year’s income the price is, the more the house will be unaffordable to you. In an ideal world, we would like to be able to pay off a house in 1 year. But that is not going to happen. 7 is an average number of years to based your analysis on.
The more of a risk-taker you are, the more years you can add to this equation. But for a conservative approach, you want this to be 7 years or lower. This is so that you run a smaller risk of buying beyond your means.
When we use this number for analysis, we do take into account the prospect of income increases in future. So if you are confident of getting a significant pay raise in future through promotions or job-hopping, do take those numbers into consideration. The opposite can be said if you do not hold a stable job or have a good feeling that some form of corporate restructuring is impending. In this instance, do consider a more conservative approach.
2 – Maximum of 2 borrowers for the mortgage
Ideally, there should only be a maximum of 2 persons who are borrowers of the housing loan. You and your spouse. We are referring to a single house for 1 family here. If you need to bring in a third party guarantor in order to get the loan quantum you desire, you probably know deep inside that you are overstretching yourself.
Of course, if you are buying a multi-family home like a 4 storey landed property housing a family in each floor, it would be a different story.
Why use a conservative approach?
A conservative approach to your investment portfolio will mean a good diversification of your asset holdings. The reason why many investors have a preference for real estate is the stability associated with it. So why be conservative when the investment asset is already a conservative class in it’s own?
If you really believe that real estate is low risk, you need to read up more about real estate markets before buying into anything. It is just as risky as other forms of investment. With how connected assets are in the modern global economy, you cannot support the traditional notion that real estate are safe bets anymore.
Look at what the financial markets did to real estate markets in 2008. If anything, property has become more risky since then. REITs are becoming more main stream, crowdfunding has been legalised, more and more cities are being overbuilt with little demand, governments are getting more involved in directing traffic instead of letting market forces do it’s job, financial products tied to real estate are becoming more complex, etc.
Soon we might see the first crowdfunded REIT made up of collateralized debt which is managed by a government body using cryptocurrency. Now that would be something…