Risk Management in Buy-To-Let – How to manage interest rate risks

Risk Management in Buy-To-Let – How to manage interest rate risks

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In July this year, the SARB Monetary Policy Committee (MPC) increased the repo rate, raising the prime lending rate for consumers by 0.25% from 9.25% to 9.50%. This was the first rate hike since July 2014, when the last 0.25% rate hike was announced. While this very gradual rise in interest rates is unlikely to impact buy-to-let investors substantially while interest rates remain at historically low levels, it is a red flag that interest rates are moving up.

Interest rate cycles
The interest rate moves up and down in cycles, as do all other economic variables. The cycles are only revealed over time and as such, managing the risk inherent in the interest rate cycle requires a long-term perspective.
Over the last two decades, the interest rates have risen and fallen by around 600 basis points per cycle. However, the cycles are influenced by numerous factors and as such, the extent of the interest rate hikes and cuts vary from cycle to cycle, as does the length of time between the beginning and the end of a cycle. While these two variables – how much the interest rate will change and over what period of time – remain uncertain in each cycle, what is absolutely certain is that interest rates will rise and drop over time as the interest rate cycle completes itself.

Understanding the risk
The monthly bond repayments on an investment property are undoubtedly the biggest expense property investors face, and the higher the interest rate charged on the mortgage bond used to acquire a property, the higher the repayments and the greater the impact on the investor’s cash flow and return on investment.
A significant risk property investors face is acquiring a property at the bottom of an interest rate cycle, when interest rates are low, and the monthly bond repayments calculated on this low interest rate are just manageable given their cash flow situation. When the interest rates begin to increase as the cycle turns upwards, as is happening right now, the monthly bond repayments increase and start placing strain on an investor’s cash flow.
Depending on the extent and the timing of the interest rate increases, the impact could be disastrous. The last upward trend in the interest rate cycle provided a vivid example: between June 2006 and June 2008 – just 24 months, interest rates rose from 10.5% to 15.5%, increasing bond repayments by around 30%. The effect on property investors with a number of investment properties was severe.

Managing the risk
Professional property investors, given their long-term perspective and their focus on minimising risk, understand that the interest rate cycle is an inescapable reality and a significant risk that must be managed proactively.
For this reason, these investors use custom-designed software, such as the P3 Wealth Manager, to evaluate the viability of each and every investment property they consider and their calculations are based on a long-term scenario. Built into these long-term cash flow projects are a buffer against the risk of interest rate increases, to ensure that when the interest rates do increase, it does not place their cash flow under severe strain or make the investment less viable.

Professional property investors, given their long-term perspective and their focus on minimising risk, understand that the interest rate cycle is an inescapable reality and a significant risk that must be managed proactively

Professional investors using the P3 Wealth Manager do so by calculating their cash flow projection on the long-term average interest rate of 12% – not on the current interest rate. This means that the viability of the investment and the cash flow position is based on a realistic long-term average, providing a buffer against inevitable future interest rate increases.
By paying the difference between the bond repayments calculated by the bank on the current interest rate and their own projections of what the interest rate may be in future, these investors not only ensure their cash flow can absorb a number of interest rate hikes, they are also building a cash reserve in the bond by paying a little extra each month. While this provides a financial buffer should the interest rates rise even higher than expected, it also shaves thousands of rands and off the bond repayment amount and years off the repayment term.

By Gert van Staden

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