Debt-to-Equity Awareness

Debt-to-Equity Awareness

The first thing to research when you’re looking to buy an investment property is how you’re going to finance your investment.

It can be tempting to just leave all the decisions to the “investment experts” and buyers tend to do this by signing up for a property investors’ course where you’re sure to be told a lot about equity and valuations. Usually there will be a lot of discussion on how to use your current property as equity and how any increase of value in the investment property will create its own equity in time.

The idea behind this concept is that once the value of your investment increases, you once again use the equity to acquire yet another investment.

Equity is the paper value of the property you own once the cost against the asset, in other words your mortgage, is deducted. So as the market rises so does your equity and then likewise as it falls your equity will reduce.

Regardless of market conditions and besides the money that is paid towards the principal of your loan, debt will always remain, unlike equity and valuations which will continuously fluctuate with the rise and fall of the market. Hence the better strategy would be to focus on the debt and equity rather than your properties value and equity.

During a rising market your debt becomes a decreasing percentage of the property and your equity and valuation also increase. This is always great news!

Conversely when the market is falling your debt becomes a larger percentage of the property. Not to worry though, all markets fall at some time or another and they will always correct themselves eventually but the correction may vary.

Claiming that real estate never falls in price is different from realising that the long term market tends to rise.

The content covered in investment courses can be summarised into three words: debt, valuation and equity.

The idea here is that we first buy a property using minimum money down and maximum debt, then we wait for either the market to raise the value or we can achieve an increase by making small renovations.

Then we create equity on paper by insuring we get the highest valuation price possible.

Buy another property using said equity that was gained and continue to repeat the process until we own a whole portfolio of properties!

This formula is promoted as a means whereby the everyday man can accumulate and “own” 20 or even 30 properties in less than 5 years. But bear in mind it would be equally as accurate to say that these investors have taken on the risk and debt levels of 20 or more properties considering just how debt-fuelled this formula is.

In all fairness though, this strategy does have the potential to be lucrative during times such as the Melbourne and Sydney boom of 2012 – 2016. But at this time Sydney was experiencing a generational boom and it is crucial to recognise this, as the market conditions were not normal trading conditions.

Remember that everyone looks like a real estate genius at the end of a boom. Only the super savvy can look like geniuses at the start of a correction, so if you’re one of the unlucky ones who gets to the party late only in time to see the market falling you’ll be beginning your investment career with negative equity.

To protect yourself against debt you need to manage it responsibly. If you can plan that your rental income covers both your mortgage repayments and running costs, then you don’t have to fear a market downturn as much. While this may mean you won’t be able to own 20 properties, you will at least setting yourself up to prosper in the good times as well as the bad. A far better result if you ask me!

Never forget that your debt will be consistent regardless of the market conditions but that equity fluctuates with the market, so remain constantly aware of your debt-to-equity ratio.