Investing in rental property has long been a popular strategy for wealth creation here in NZ, but over the past few years there has been little to no mortgage lending in the property investor space.
This is due to the tax deductibility changes which came into effect in 2021, along with interest rate increases and strict LVR requirements.
However, with the change in government and a recent mortgage adviser survey showing property investor enquiries are at their highest levels since late 2020, in this article we will take a look at some key factors to consider when buying a rental property – from deposit requirements and the new Debt-To-Income restrictions, to rental yields and everything in between.
Understanding The Deposit Requirements
One of the first steps in purchasing a rental property is determining how much deposit you will need. Currently, the minimum deposit required for a rental property is 35% for an existing property and 20% for a new build property. However, the Reserve Bank of New Zealand (RBNZ) is set to ease the LVR restrictions on the 1st of July 2024 which means you will only need a 30% deposit for an existing property.
The New Debt-To-Income Restrictions
Debt-To-Income ratios (DTIs) tie the amount you can borrow to your income. DTIs are calculations used by lenders to determine the maximum amount an individual or household can borrow based on their income. It’s a tool designed to assess the borrower’s ability to manage their debt obligations and reduce the risk associated with excessive borrowing i.e defaulting on your mortgage payments.
DTIs are calculated by dividing your total debts by your gross annual income (before tax) to give you a ratio number. Your total gross income will include your annual salary, rental income and other extra income you receive. The higher the number, the higher your debt is relative to your income and therefore considered a higher risk to a lender.
For example, if you have total debt of $800,000 across your own home, rental property plus a couple of credit cards, and your total gross income is $150,000, your DTI ratio is 5.33. This means your total debt is 5.33 times your total gross income.
From the the 1st of July 2024, both owner-occupiers and investors will face the new restrictions, but it’ll be tighter for those wishing to borrow for investment properties.
The DTI limit will be set at 7 for investors, meaning if you and your partner earn a combined income of $150,000 a year, the maximum you will be eligible to borrow is $1,050,000 as an investor.
Banks will have a restriction that they can only lend 20% of their new lending to investors with a DTI of more than seven.
Investors typically have higher DTIs than owner occupiers so it’s expected this group will be more impacted by the effects of DTI restrictions.
Using Equity for Your Rental Property
Contrary to popular belief, you don’t necessarily need cash on hand to fund the deposit for a rental property. Instead, you can leverage the equity in your own home to secure the deposit.
If you have built up equity in your home, you can borrow up to 80% of its value.
For example, if your home is worth $1,000,000 and your mortgage balance is $400,000, you could potentially borrow an additional $400,000 against your home provided your income supports it. This $400,000 can then be used as the deposit for your new rental property or properties.
Assessing The Income Requirements for Rental Property Investment
Determining the income required to purchase a rental property is slightly more complex than borrowing for a regular home loan.
When it comes to assessing income for a rental property purchase the banks will take into account not only your income but also the rental income you are going to earn from the property. However, rental income is treated slightly differently.
The bank will scale the rental income back to account for costs associated with the property like rates, insurance and vacancy rates. So they won’t rely on 100% of that rental income in your borrowing calculation.
Then the banks will test your borrowing capability on a higher interest rate, known as a stress test rate which are currently sitting around 9%. This is so they can be sure that if interest rates increase you will still be able to afford the mortgage repayments.
You are best to consult with a Mortgage Adviser who can accurately assess your eligibility when it comes to working out your “usable income” for a rental property.
Understanding Rental Yields
When investing in a rental property, one of the key considerations is the potential rental yield or the amount of money your rental property generates.
Rental yield is typically expressed as a percentage and a quick way to work it out is by dividing the annual rental income by the property’s value. So for example, if you were looking to purchase a property for $750,000 and the rental income was $650 per week:
- $650 (weekly rent) x 52 (weeks in a year) = $33,800 (gross rental income)
- $33,800 (gross rental income) divided by $750,000 (the property’s value) = 0.04506
- 0.04506 multiplied by 100 (to get a percentage) = 4.50%
- Rental yield = 4.50%
To determine what constitutes a good rental yield, it’s important to consider your investment goals.
If generating positive cash flow is a priority for you, then you may need to aim for a higher yield. Alternatively if holding onto your property for the long term to grow your capital gain is a goal, then a lower rental yield may suit the situation if you are able to top up the mortgage.
Whilst the gross rental yield is a simple calculation to use, it’s important to note that it doesn’t take expenses into account. A property may have a high rental yield but may also have high expenses making the rental return low when taken into consideration.
If you want a more precise calculation you will need to know (or estimate) the total expenses of the property including rates, insurance, vacancy costs (lost rent and advertising), repairs and maintenance, property management fees and body corp fees (if applicable).
Take the time to do your research in your desired location to determine the rental yield that aligns with your investment objectives.
Considering the Risks of Rental Property Investment
Like any investment, owning a rental property comes with its own set of risks. It’s important to be aware of these risks and take appropriate measures to mitigate them.
Here are some potential risks to consider:
Cross-Collateralisation: If your investment property and your home are mortgaged with the same bank and you encounter difficulties in paying either mortgage, the bank may have the authority to sell both properties. Diversifying your property portfolio across different lenders will help to mitigate this risk.
Market Fluctuations: Property values can fluctuate, and there is a possibility that you may need to sell the property during a downturn, potentially resulting in a financial loss.
Interest Rate Changes: As we have seen just recently with the rise in interest rates, any increases in rates can impact the profitability of your investment property if you are having to divert more of the rental income towards the mortgage repayment.
Mitigating these risks can involve strategies such as paying off the mortgage as quickly as possible, diversifying your investment portfolio, and staying informed about market conditions. Seeking professional advice from a Mortgage Adviser can help you to navigate these risks and make informed decisions.
How Involved Do You Want To Be?
Investing in property can take up significant time and effort, especially when compared to other investment options.
As a property investor, you will likely spend considerable time searching for suitable properties, managing tenants, and overseeing property maintenance.
While some investors choose to handle these tasks themselves, others opt to hire a property manager. A property manager can assist with finding tenants, collecting rent, and handling maintenance issues on your behalf. They typically charge a percentage of the weekly rent as their fee.
Deciding whether to manage the property yourself or enlist the help of a property manager depends on your personal preferences, expertise and of course, your availability.
Adapting to Changing Legislation
It’s essential to stay informed about changes in legislation and regulations that may impact your investment property.
Changes to investment property tax rules back in 2021, resulted in higher tax costs for property investors. However, the new government is looking to reverse these changes by restoring interest deductibility for rental properties by 2026, which brings good news for property investors. So much so, we are already starting to see more enquiry from property investors in anticipation of this positive change.
There is also the Healthy Homes Standards which came into effect in 2019. The aim of this legislation is to introduce specific and minimum standards for heating, insulation, ventilation and draught stopping in rental properties. This will help to improve the quality of rental homes for tenants and better protect a landlord’s investment.
Between 1 July 2021 and 1 July 2025, all private rentals must comply with the healthy homes standards within certain time frames from the start of any new, or renewed tenancy. So when looking for a rental property be sure to check that either the property already meets the Healthy Homes Standards or take into account any extra costs involved in getting the property up to scratch before you rent it out. You can find some helpful information here.
Existing Property or New Build?
If you are buying a new build then the deposit requirement is a lot smaller as you will only need a 20% deposit.
Also, the current tax deductibility rules don’t apply, which means you will have a lower tax bill to pay and of course less maintenance costs. When the new debt-to-income (DTI) rules come in, new builds will most likely have an exemption meaning you can borrow more to buy a new build than an existing property.
That’s not to say existing property is not a good investment, but you will just need to be a little more active with an existing property as it may need more maintenance and even a cosmetic touch up or renovation to increase the rental income potential for that property. So a little more effort (and cash) may be involved.
However, one of the pros of buying an existing property is to find one that you can add more value to. This way you will be able to make more money (equity) which you can recycle to buy another rental property quicker than you can through buying a new build.
So, now that you have an understanding of the key factors involved in buying a rental property, consider your investment goals and research the rental market to identify areas with favourable rental yields.
Having a knowledgeable Mortgage Adviser on your team can help with assessing your financial capacity including your deposit options, DTI restrictions and income eligibility, ultimately helping to guide you through the process so you can embark on your property investment journey with confidence.
Applications for finance are subject to meeting the lenders criteria, terms, and conditions. Refer to our website www.hbmi.co.nz for our Public Disclosure Document.
