Source: Melbourne Investor Feb/March 2007

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Buy & Hold - An Effective Property Strategy?

Source: Melbourne Investor Feb/March 2007

Written by Bill Zheng

Investors Direct

Bill Zheng is CEO of Investors Direct, Australia’s leading mortgage company that solely services the property investor market. Unlike other mortgage brokers, Investors Direct does not just write mortgages but draws on its experience and knowledge of investment property to provide strategic finance solutions.
 

Buy & Hold - An Effective Property Strategy?

‘Buy and Hold’ generally means that you buy a good asset such as shares or property, hold it for the long-term and never sell. In general, good assets always increase in value.

However, most property investors have interpreted ‘Buy and Hold’ as ‘relating to properties only’. Let me explain why this is not quite correct.

Statistics show that residential properties and shares perform pretty much the same. Over the last 20 years, if you did not borrow money to invest, it would arguably have made little difference whether you bought and held shares, or properties.

If you did borrow money to invest, the result would be quite different.

Did you know that 40 years ago the average Australian home worth $400,000 today was valued at about $10,000? $10,000 40 years ago was a lot of money, $10,000 today is a lot easier to pay back.

Imagine someone had lent you the whole $10,000 to purchase a house 40 years ago, and all you had to do is to look after the interest repayments. Assume the interest rate is eight per cent a year for 40 years, rental yield is four per cent and capital growth is 10 per cent;

Year 1:

• Property value is $10,000.
• Interest repayment is $800.
• If inflation was three per cent the $10,000 has decreased in value by the rise in inflation – it is now worth $300 less. By borrowing $10,000 (and using it more usefully elsewhere) you have saved this drop in value – you have saved $300. This is a difficult concept to grasp. Your lender has just lost $300 and you have saved $300 by not using your funds. So you’re paying $500, the $800 interest payment less your $300 ‘profit’.
• Rental gives you $400 income.
• Capital growth gives you $1,000 in equity. Technically it has only cost you $100 ($500 to $400) in the first year to hold onto your property.

Year 2:

• Property value is now $11,000.
• Interest repayment is still $800.
• If inflation is still three per cent it would have cost the lender a further $300 meaning you saved this loss on your money. You are still paying $500 ($800 interest payment less your $300 ‘profit’).
• Rental now gives you $440 income.
• Capital growth gives you $1,100 in equity

So technically it would only cost you $60 ($500 to $440) to hold onto the property in the second year.

The mortgage interest repayments become cheaper each year and the principle outstanding also becomes less valuable each year – thanks to inflation.

The important point to understand is that money loses its value through inflation – this includes the money others have lent you. Apart from the basic rule of supply and demand, your profits are made in two ways:

1) Over time property prices and rental values gain monetary value due to inflation (more expensive).
2) Over time your mortgage and its repayment lose monetary value due to inflation (cheaper).

This is why property investors make more money than other types of investors – the leverage of inflation through the effective use of mortgages.

If you can find a way to delay interest and principle repayment of a mortgage, you will make more money due to inflation alone. One smart way to delay principle repayment is to pay interest only forever and never pay back your mortgage or sell your properties.

Another effective way is to delay a portion of your interest repayment into the future.

Property investors make similar returns to other types of investors if they only ‘Buy and Hold’ properties. You will make a lot more money if you ‘Buy and Hold’ mortgages. So for property investors, to ‘Buy and Hold properties’ is actually not an effective strategy, to ‘Buy and Hold mortgages’ is.